Performance and Payment Bonds – When and Why Do You Need Them?

You are just starting your contracting business or you have been successfully operating for a while. But then you are told your next project requires a surety bond, which you previously thought to be either an Egyptian hieroglyph or a rare Australian animal species. Luckily, it's not that complicated and you don't need to book a flight to the other end of the world to find out what it is. Let's have a look at the types of surety bonds most frequently required from contractors – performance and payment bonds.

The Basics of Performance and Payment Bonds

Broadly put, surety bonds are a type of financial guarantee that involves three parties. The principal, or your business, is required the bond which makes sure you will be held responsible should you fail to meet the requirements of your contracts with the obligee(s). The third party, called the surety, is the surety bonds company, which issues the surety bonds, thus “bonding” the agreement. In case of a claim against the principal, the surety will compensate the obligee for the losses. After that, the principal is required to reimburse the surety for that amount.

Performance and payment bonds are types of surety bonds that fall under the category of contract bonds. In fact, they usually go together, so it's not uncommon to see them under one name – performance and payment bond. Under the Miller Act of 1932, regulating government construction projects, and then the Little Miller Act, dealing with state projects, contracting businesses are required to put a performance and payment bond if they wish to work on public projects. Performance bonds are there to make sure your business will stick to the terms set out in your contract. Payment bonds, on the other hand, are protecting all the people you are working with – suppliers, subcontractors, workers, etc. They are a guarantee that you will be able to pay them for labor and materials as stated by the contract.

If you want to bid on public work projects, you will also need a third kind of bond, called a bid bond. It is there to ensure that in case you win the project, you will perform all the work at the price you put on your bid.

How to Get Bonded

Obtaining performance and payment bonds might sound like a big deal and a great amount of paperwork, but don't be quick to get discouraged. The truth is that the whole process of approval, quotes and payment is now made easy through an online application. There's no straightforward way of determining the cost of your surety bonds. It is determined by a variety of factors such as state-specific requirements and certain information about your business.

Typically, you'll be required to pay anywhere between 1% and 5% of the total amount of the bond. In other words, if the total amount of your performance and payment bond is $100,000, you will have to pay a one-time fee of $1000 - $5000. Generally, for a project below $300,000, your percentage is calculated solely on the basis of your personal credit score. The process for more expensive projects is a bit more complicated and you will need to provide some additional details such as your business' net profit. Companies who shows a higher net profit can qualify for a reduction in the price of the performance and payment bonds. Thus, if you are waiting for overdue payments, you might do wise to go ahead and collect them.