When starting a new business, you will have to complete many different tasks. In addition to creating a business plan, securing startup capital, and determining your business’s legal entity structure, you will also need to secure any licenses and certifications that might be required for the business you intend to operate.
One requirement for some types of businesses is to obtain a surety bond. These types of bonds might be considered to be necessary evils for business owners, but they are required within certain industries and for those that will contract with the federal government. If you are an entrepreneur who is preparing to launch a startup, here is some information about surety bonds that you should know.
What Is a Surety Bond?
Many entrepreneurs and startups might be confused and want to know: what is a surety bond? Some people confuse surety bonds with insurance. However, they operate very differently from insurance policies and are sold by surety companies. While insurance covers losses on behalf of the companies’ insureds, surety bonds do not work the same way. Instead of protecting the companies that purchase them, surety bonds protect the obligee and the people for whom the work is performed.
Surety bonds function as a guarantee that the work will be performed on time and according to the obligee’s specifications. When it isn’t, claims can be filed against the bond. However, the principal rather than the surety company will have the obligation of paying the filed claims in full. The surety company will only step in if the principal fails to pay its claims, and unpaid claims can make it difficult for the company to obtain new surety bonds. Since they are required for companies operating in certain sectors, failing to pay claims and losing the ability to secure a surety bond could result in a business’s closure.
Parties Involved in Surety Bonds
Surety bonds involve the following three parties of interest:
• Principal – The business/entrepreneur purchasing the surety bond that is required to make good on any claims that might be filed
• Obligee – The person or agency that requires a guarantee of the principal’s performance
• Surety company – The company that issues the surety bond to guarantee that the principal will perform
How Surety Bonds Work
When a surety bond is required, the principal will pay a set amount to the surety company to secure the bond. In exchange, the principal will sign an indemnity agreement in which the principal pledges its company and personal assets to the surety company if a claim is filed. Since surety bonds are secured against the business and the business owner’s assets, avoiding claims is important. Surety bonds do not protect you from liability if you fail to perform your obligations as called for in your contracts.
Claims against your bond also can harm your business reputation and function similarly to a credit score. Just like it is difficult for people with low credit scores to obtain credit, if you have multiple claims against your bond, you could find it impossible to obtain a new surety bond, which could force you out of business.
Types of Surety Bonds
There are many different types of surety bonds. However, three of the most common types include the following:
• License and permit bonds – These are bonds that are required of specific types of companies operating within different industries before they can conduct business. Some examples of businesses that must get license and permit bonds before performing work include automobile dealers, auctioneers, and electricians.
• Contractor bonds – Businesses and individuals that enter into contracts to perform work on public projects with government agencies are often required to secure contractor bonds.
• Court bonds – These are bonds required by the judicial system for various purposes, including probate and judicial bonds.
Characteristics of Surety Bonds
While there are many different types of surety bonds, most share the following characteristics:
• Working capital requirements – Most surety companies require companies to have specific amounts of working capital. In general, companies will only be able to secure surety bonds of 5% to 10% of their available working capital.
• Maximum bonding capacity – Depending on the working capital of the principal, the maximum bonding capacity is the maximum amount that the principal can obtain.
• Bond term – Surety bonds have a set duration that might range from one to four years before they expire. However, they can be renewed.
• Bond fee – This is the amount the principal is required to pay the surety company upfront for the surety bond, which can range from 1% to 15% of the entire bonded amount.
Industries in Which Surety Bonds Are Required
While there are many different types of surety bonds, companies operating within certain industries are required to secure them. Some examples of the types of companies that might be required to obtain surety bonds include the following:
- Construction companies
- Government contractors
- Licensed trades professionals, including electricians, pipefitters, and others
- Auto dealerships
- Mortgage brokers
- Debt collection companies
- Medical equipment companies that are covered by Medicare
- Health and fitness clubs
- Freight and transportation companies
These are just a few examples. Many different types of companies are required to have surety bonds. Others might also be required to get surety bonds based on local ordinances and regulations. You should check with your state and local government to determine whether or not you will be required to secure a surety bond before beginning your business operations.
While surety bonds are not something that business owners ever want to have to use, they are required within numerous industries. Securing a surety bond and then taking steps to ensure that you always perform your work on time and well can help to prevent claims from being filed against your bond. Avoiding surety claims can help to build your company’s reputation and allow it to further its success.