Bonded for growth: How performance bonds can pave the way to major projects

So you just got a big job on a 400-home subdivision development. Or maybe you’re in the running to serve as a subcontractor on a new high school construction project, and suddenly, you’re being asked to get approval for a ‘performance bond.’

If you’ve only handled smaller jobs in the past, your first questions may be, “What exactly is a performance bond?” followed by “How do I get one?”

If you’re not familiar with a performance bond, it’s something you need to take seriously, especially if you’re looking to grow your business by working with large general contractors or government customers. In fact, performance bonds represent a billion-dollar industry (See sidebar).

“A performance bond is needed for virtually every single major construction job,” says Sharon Emek, former chairman of the board for the Independent Insurance Agents and Brokers of New York state and currently a partner at CBS Coverage Group, a Plainview, N.Y.-based insurance broker and provider of these bonds. “You will not qualify for consideration without one. It’s a guarantee to the customer that the work will be successfully completed.”

Bonds are Not Insurance

Top insurers can provide performance bonds, but don’t get them mixed up with an insurance plan. Your business will need certain kinds of insurance to simply exist, no matter how big or small the projects you handle may be. You need general liability insurance, for example, to cover your assets should something go wrong on a job. You’ll also need worker’s compensation coverage if your employees are injured, so that they can be paid while out of work.

Unlike insurance, a performance bond covers none of these things. It’s essentially a stamp of approval from the insurance company, certifying that your business is able to successfully complete the project. “In the case of general contractors, it protects them from hiring a subcontractor who finds that the job is too big to handle,” Emek says. “In the case of a public job — like installing the electrical wiring for a new, large school building — it protects the taxpayers’ investment in hiring you."

"All contractors pay insurance companies for this," Emek continues, "[and] the cost for the bond is small compared to the exposure as the insurance companies never expect to actually have to reimburse the general contractors or public agencies for any work that wasn’t successfully completed.”

The insurance company will pursue an extensive amount of screening to get the bond approved for your business. You’ll be asked detailed questions about essentials such as cash flow, as well as any losses that your insurance carrier had to pay out because of lawsuits, so your books will have to be in terrific shape. You will also need to provide extensive documentation on the projects you’ve completed in the past, and those that your company is currently working on, as well as projects that you expect to perform in the immediate future. Expect that your banking references, vendors and customers will be contacted for verification purposes.

Get Professional Players on Your Team

Due to the emphasis on bookkeeping, Emek urges bond-seeking contractors have a Certified Public Accountant (CPA) on hand to handle the books, specifically a CPA well grounded in construction-industry accounting. “If you don’t have a certified public accountant, you won’t get approved for a performance bond, and you won’t get the job,” Emek says adding, "If you don’t have a CPA firm that understands the construction industry, insurance companies will be extremely dubious when it comes to approving your business for a bond.”

Emek also notes that insurers are often interested in the kind of attorney you use to get contracts approved. She recommends hiring an attorney who specializes in construction-industry law.

Despite all of the steps involved with the process, many contractors fail to allow enough time to get a performance bond approved. Emek says no less than three weeks are required for even the simplest of bond approvals, even for contractors on relatively routine jobs who happen to have great cash flow and reserves. “Those would be rare,” Emek says. “I’ve worked on some performance bond approvals that have taken three months.”

One way to reduce the time investment is to get approval for a “performance bond line,” for which you estimate, for example, the value of construction projects you’ll undertake for the upcoming year, and pay for that in a lump sum. “For many contractors, that’s much easier than getting approval for every project, one-by-one,” Emek says.

The approximate cost of a performance bond line is generally, 1.5 percent of the total job estimate for contractors whose books are in great shape, but up to 5 percent for those who don’t fare as well. And while it’s true that in many cases this cost is routinely added to the bid — especially for those who don’t have great cash flow and reserves — building and equipment assets and even one’s personal property could be used as collateral.

There are dangers to using your personal assets as collateral in a performance bond. “If you fail to do the job,” Emek says, “the insurance company will liquefy your assets and pay someone else to do the job you were supposed to get paid for.”