Contracts continue to be the lifeblood of business arrangements. But what happens when a contract alone isn’t enough to guarantee that everything agreed to will be done the right way? Thankfully, there are several legal measures that contract signatories can rely on to help make sure that everything will go according to plan. One of the most common kinds is a performance bond. But despite their popularity, you might be wondering what is a performance bond and how do they work?
Each performance bond depends largely on the kind of contract and work involved. There are several kinds of arrangements that fit the description of a performance bond, each with different elements that are designed to accommodate the terms of a contract and the scope of work detailed therein.
This may not sound all too clear quite yet—but the idea behind performance bonds, and what a performance bond could do for you, is surprisingly simple to understand. We’ll go through the definition of a performance bond, explain how common performance bonds work, when you might want to use one, and why they’re an important aspect of your small business operations.
Performance Bond Definition
A performance bond is a guarantee that previously agreed-upon work (laid out in a contract) will be completed per the terms of said contract. Performance bonds have been around in one form or another since before the Roman Empire, serving as one of the earliest examples of a good faith deposit made in order to ensure that contractors will complete a job as agreed upon with the other signatory of an agreement. The common definition of a performance bond has since expanded to include a host of other agreement types, such as real estate development and commodity sales.
In the case of construction-related contracts, a contractor or construction company (known as the “principal”) is required to obtain a performance bond from a surety agency. The surety agency—typically a bank or insurance company—assures the other party to the contract (the obligee) that they will be compensated in the event that the principal cannot complete their work.
In other words, surety agencies serve a similar role to guarantors on an agreement: In the event that something goes amiss—such as bankruptcy or a company’s inability to live up to the terms of a contract—a surety agency provides compensation to the other party of the agreement. The party paying for the work enjoy a greater degree of certainty knowing that they’ll be compensated if the principal can’t complete the job for whatever reason.
Most real estate and construction contracts will include a performance bond after a bid is accepted. Civil and public works projects on the federal level require a performance bond by law, and states often require performance bonds (although they are not necessarily obligated to from a policy perspective).
How Performance Bonds Work
In the case of a real estate and construction working arrangement, there are several components that most performance bonds go through before anyone breaks ground on a project.
First, the real estate company solicits bids from contractors for a specific scope of work. Contractors then bid on the project and usually obtain a bid bond—another form of bond that provides a guarantee that the contractor that wins the bid will perform the job within the confines of the proposal they’ve submitted.
Next, after the bid is selected, the contractor will furnish a performance bond that guarantees a financial sum to the real estate company in the event the contractor can’t do the work they’ve promised in both the bid and the contract. If the contractor cannot or does not complete the work as promised, the real estate company can obtain a sum of money up to the full dollar amount of the bond. This helps prevent the real estate company from suffering financially in the event that work isn’t completed as planned.
The general contractor obtains a performance bond from a surety agency (or surety bond company). The surety agency offers a performance bond so long as the contractor matches a set criteria that assesses their confidence in the companies with which they do business. In most cases, this criteria consists of the type of bond requested, the dollar amount of the bond, and the applicant’s risk. Risk calculations would take into consideration the contractor’s prior business dealings, financial health, and any failure to complete work that may have occurred in the past.
When to Use a Performance Bond
A performance bond is a great addition to any contract that involves general contractors, construction, or a real estate transaction that includes a building component. These bonds help assure real estate companies or other groups that the contractors they hire for work will be able to complete the work they’ve signed on to do. Or, in the worst-case scenario, that the obligee will receive compensation in the event that the contractor they’re working with can’t finish the work they’ve promised to complete.
On the flipside, if you run a contracting or construction business, you should be prepared to offer a performance bond whenever doing so is an obligation for you to get a bid. This is particularly true when bidding on government work—be it local, state, or federal. Most governing bodies will require you to have a performance bond anyway, so it’s better to be proactive and get the procedures in place that you’ll need in order to get your bond quickly.
Performance Bond Example
There are several scenarios that can help illustrate how performance bonds work. For the sake of simplicity, let’s say that a real estate company is looking to build a new condominium on a plot of land they own. The real estate company would solicit bids from local construction companies, ultimately picking the right business for their needs (be it based on cost, specialty, or how quickly they can complete the work).
While this is going on, construction companies interested in bidding on the project would put together proposals, secure bid bonds, and answer any questions that the real estate company might ask. If the real estate company accepts a construction company’s bid, the construction company would then have to secure a performance bond in order to lock in the work.
The construction company would approach a surety agency (again, a bank or insurance provider) to apply for a performance bond. The surety agency would assess the business’s request, including the sum of money in question, the company’s credit history, financial solvency, and other markers that suggest a business is fiscally responsible and healthy. The surety agency then sends things over to an underwriter who evaluates the conditions at play and assesses a premium based on what he or she finds in his or her professional opinion.
Now, let’s say that the construction company experiences unforeseen circumstances that forces it to go out of business halfway through the project. This is where a performance bond would kick in. The real estate company would receive payment from the surety bond provider, thus covering at least some portion of their expenses and recouping lost money due to the construction company not being able to finish the work. The surety agency would then look to collect money from the construction company as a result of having to pay the bond to the real estate company.
If, in a more likely scenario, the construction company is able to complete the work, the performance bond would not need to go into effect. The construction company would pay its premium for the bond, and everyone walks away happy.
Why a Performance Bond Is Important for Your Small Business
Performance bonds are essential for real estate and construction transactions. There is too much money at stake behind major construction projects, and too likely a risk that contractors may not be able to complete the work they’ve promised to undertake as part of their bid.
Unforeseen circumstances happen all the time, and contracting is a competitive industry where money can dry up quickly. Performance bonds help ensure that real estate companies aren’t left high and dry if the contractors they’ve enlisted can’t complete the work they’ve promised to perform. And, for their part, construction companies benefit from performance bonds because they offer a degree of certainty and trust for their clients. Plus, building a longstanding and trusting relationship with a surety agency can make it easy to get performance bonds quickly and easily, as the agency will have a trusting relationship (as opposed to trying to determine if your company can deliver without personally knowing your track record.
The Bottom Line
Few things in life—or business—are guaranteed. That’s why financial solutions like performance bonds exist. If you’re undertaking a major construction project, you’ll want to make sure you’ve secured a performance bond that can help you recoup money if your contractors can’t complete the job. These bonds help deepen trust between contractors and the clients they serve, and can help forestall major financial losses if things go sour.
Although performance bonds add an additional layer of paperwork and financial responsibilities, they help make sure that agreements go as smoothly as possible, even in the event that a project doesn’t end up going as planned. In some cases, these bonds are required by law, making their procurement a no-brainer.
Meredith Wood is the founding editor of the Fundera Ledger and a vice president at Fundera.
Meredith launched the Fundera Ledger in 2014. She has specialized in financial advice for small business owners for almost a decade. Meredith is frequently sought out for her expertise in small business lending and financial management.