Construction Bonds Explained: Everything You Need to Know

Before you can bid on most government construction projects, you’ll need to secure construction bonds. If you’re a contractor preparing to bid on your first government project or a business owner trying to understand bonding requirements, this guide breaks down what these bonds are, how they work and what they cost.

What Are Construction Bonds?

Construction bonds are financial guarantees that protect project owners if a contractor fails to complete work according to contract terms. These bonds involve three parties:

• The contractor, called the principal, purchases the bond.
• The project owner, known as the obligee, receives protection.
• A surety company issues the bond and guarantees the contractor’s performance.

Unlike insurance that transfers risk away from you, construction bonds keep you ultimately responsible. If the surety pays out on a claim because you defaulted on a project, you must reimburse those costs. Surety companies vet contractors carefully before issuing bonds because they expect zero claims.

Federal regulations require performance and payment bonds for any federal construction contract exceeding $150,000, as outlined in the Federal Acquisition Regulations. For contracts between $35,000 and $150,000, contracting officers must select at least two alternative payment protections. Many state and local governments have similar requirements through their own bonding laws.

The Three Main Types of Construction Bonds

Bid bonds demonstrate that you’re serious about a project and have the financial capacity to complete it if awarded the contract. When you submit a bid bond, you guarantee that you’ll honor your bid price and provide required performance and payment bonds if selected. Many surety companies provide bid bonds at no cost once they’ve approved your qualifications.

Performance bonds guarantee project completion according to contract specifications, timeline and budget. If you default due to financial problems, poor workmanship or missed deadlines, the surety can provide financing to help you finish, hire another contractor to complete the work or compensate the owner for losses up to the bond amount. Performance bonds typically equal 100% of the contract price.

Payment bonds protect subcontractors, laborers and material suppliers. If you don’t pay them, they can file claims against the payment bond. The surety investigates valid claims and compensates unpaid parties, then seeks reimbursement from you. Payment bonds generally match the contract value and are usually issued together with performance bonds for a single premium.

Understanding Federal Bonding Requirements

The Miller Act governs bonding on federal construction projects. Under this law, prime contractors must furnish both performance and payment bonds before starting work on contracts exceeding $150,000. The bonds must come from surety companies listed on the U.S. Treasury’s approved list.

Subcontractors who have direct contracts with the prime contractor can file claims against payment bonds. Second-tier subcontractors can also make claims, but they must provide written notice to the prime contractor within 90 days after their last day of work or material delivery. Claims must be filed within one year of that final work date.

Most states have enacted their own versions of the Miller Act for state and local public works projects. These laws vary in their specific requirements, thresholds and procedures. Some states require bonds on contracts as small as $25,000, while others set higher minimums.

How Much Do Construction Bonds Cost?

Bond premiums typically range from 0.5% to 5% of the contract value. On a $1 million contract with a 1.5% rate, you would pay $15,000 for both performance and payment bonds combined.

Your credit score significantly affects bond costs. Contractors with excellent credit scores above 700 generally pay between 0.5% and 2% of the bond amount. Those with credit issues might face rates of 3% to 5% or higher.

Financial strength matters tremendously. Surety companies prefer CPA-prepared financial statements because they’re more reliable. Strong working capital, solid cash flow and healthy profit margins help secure better rates. Your balance sheet must show you can handle the project’s financial demands.

Work history and experience also play key roles. A proven track record of completing similar projects on time and within budget reduces the surety’s risk. The complexity and duration of your specific project also impact costs, with longer or more complex projects carrying additional risk.

Surety companies often use tiered pricing structures. For example, they might charge 2.5% on the first $100,000 of contract value, then 1.5% on the next $400,000 and 1% on amounts above $500,000.

Prepare Your Business to Secure Bonds

Strong financial statements form the foundation of bondability. Work with a qualified CPA to produce accurate, timely financial reports that clearly present your company’s financial position. Surety companies scrutinize your balance sheet, income statement and cash flow statement. They want to see adequate working capital, manageable debt levels and consistent profitability.

Your work in progress (WIP) schedule becomes critical as you pursue larger projects. This report shows the status of each active contract, including costs incurred to date, estimated costs to complete and profit recognition. A well-maintained WIP schedule demonstrates that you understand job costing and can manage multiple projects simultaneously.

Building bonding capacity takes time and strategic planning. Start with smaller bonded projects to establish a track record with surety companies. Complete these projects successfully, on time and within budget. As you prove your capabilities, sureties will increase your bonding capacity, allowing you to bid on larger work.

Build Financial Excellence in Construction

Construction bonds protect billions of dollars in projects annually and open doors to profitable government and public works contracts. Understanding how bonds work, what they cost and how to prepare your business for bonding puts you in position to compete for larger, more lucrative projects.

Ready to strengthen your construction company’s financial position and increase your bonding capacity? Our construction CPAs and advisors help contractors build robust financial systems, produce the reports sureties require and position businesses for growth. Contact a James Moore professional today to discuss how we can support your construction accounting and bonding preparation needs.

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