A performance bond is a type of contractor bond. Contractor bonds (also known as construction or surety bonds) are bonds which must be paid by the contractor to a project’s investors before starting on a project. They are meant to reassure the project owners that the contractors can complete the project within the deadline and to the specified quality requirements in the agreement.
Given the enormous risk involved with large scale construction work, contract bonds act as a financial safety net from those risks (e.g. contractor declaring bankruptcy)
There are three types of contractor bonds:
- Bid Bonds – Bid bonds are paid during bidding to ensure that the contractors don’t bail out after being chosen.
- Performance bonds- This bond protects a project’s investors from poor quality work from the contractors
- Payment bonds- These are paid by the contractors to ensure investors they can financially support material and labour costs
There are usually three parties involved during contract bond agreements: project investors (obligee), contractor and a surety company. Normally an obligee is a government agency or organization that hires contractors for large scale public infrastructure projects (although more private sector entities are now requesting contractor bonds too).
Surety Companies
A surety company acts as a guarantor for the contractor obtaining the bond. If the contractor defaults on the project (either by performance or payment), the surety company is responsible for compensating the project’s investors. They either must make financial compensation or find other contractors that can complete the project. A surety company evaluates a contractor’s financial and performance history to see how likely they are to adhere to the terms of the contract. Premiums will then be charged accordingly.
A contractor can estimate the cost of the performance bond to be around 1-2% of the contract value (but this obviously depends on the contractor’s credit profile).
Surety companies will usually require the following documents:
- Copy of the contract
- Application of surety
- Minimum 2 years of financial statements from CPA.
Benefits of performance bonds
So, how does using performance bonds benefit you as a contractor? Well, because a surety company will carry out an extensive pre-qualification process analysing your financial and performance history, being able to secure a performance bond is seen as a badge of honor as a contractor. It shows that a contractor is reliable and can complete a construction project within the deadline and to the quality specified. It builds up a reputation for a contractor, helping them secure contractor bonds more easily in the future.
Performance bonds also reassure project investors of the quality of your work, enabling you to build a positive rapport with them from the start.
Only project investors or owners are eligible for payment from a performance bond.