What is a bid bond? | Bond investment
When municipalities hire contractors and tradespeople to complete projects, they need some level of assurance that the work they pay for will be done accordingly. When presenting bids to eager contractors, organizations can ask for a bid bond to protect themselves.
A bid bond is a type of bond that guarantees payment pending certain stipulations. In the case of large-scale construction projects, the bond is paid if the contractor fails to deliver on their bid, fails to meet the agreed parameters, or simply does not start the project. These types of bonds are very common in commercial construction. Additionally, they are mandated for state and federal development projects.
Bid bonds are common practice for most construction projects, and they are widely applicable whenever there is a project involving qualified contractors. Here’s an overview of how they’re used, the protections they offer, and the benefits of using them.
Breakdown of a Bid Bond
There are three parties involved in a bid bond: the creditor, the principal and the guarantor. All three work together to create an accountability pact before starting a project:
- The bond is the owner who will request a bond if the contractor does not deliver.
- Pmajor is the contractor responsible for purchasing the bond as a sign of trust.
- gguarantor is the surety company facilitating the issuance of the premium bond.
It is better to consider the guarantor as the intermediary. The principal works with the guarantor to establish the bond based on its reliability and credit rating. Once issued, the principal submits this bond to the creditor as proof of its credibility. If selected and the principal does not deliver, the creditor files a claim with the guarantor for the bond.
An example of how bid bonds work
To show the importance of a bid bond in practice, it is best to take a common example: construction. Major municipal construction projects use bid bonds as a form of surety, and the practice looks like this:
Big Bob’s Builders bids $10 million for a commercial construction project, with a 10% ($1 million) bid bond. If Big Bob’s Builders does not start the project at the agreed upon $10 million, the municipality can raise the $1 million bid bond claim to cover the cost of the overage or the cost for someone else complete the project.
The reason bid bonds are so prevalent in construction is due to the extremely high cost and schedule of these projects. Owners pay construction companies as they go along, rather than when the project is completed. Bid bonds offer them some protection against disruptions that may occur during the project.
Bid bonds come with a few general stipulations that have become industry standards. Specifically, here’s what to expect with most bid bonds:
- Bond values are 10% of the contract amount; 20% for federal projects.
- Guarantors perform thorough credit and background checks to determine the bond premium.
- Once approved, principals submit bid bonds during the bidding phase of a project.
Ultimately, a bid submitted with a bond represents a bona fide bid on a project. It offers owners peace of mind that if you win the contract, you will follow through or they will receive compensation.
Surety Agreement and Additional Sureties
Once a contractor wins a bid, there is a bonding agreement. This is a document notarized with the surety company that stipulates the issuance of a performance bond and a labor/material bond. These bonds have relatively the same objective: to protect the contracting authority against payment defaults or overruns.
- Performance guarantees ensure all work is completed on time, within budget and to specification.
- Labor/Material Obligations ensure that all suppliers and workers are paid for their contributions.
Performance bonds and labour/material bonds are secondary to bid bonds, representing the next level of security after the project manager accepts a bid during the tender stage. The cost of a performance bond is usually very low. This is usually less than 1% of the contract. Labor/material obligations are even lower between 0.25% and 0.5% of the contract price.
How to qualify for bid bonds
Contractors (principals) coordinate with sureties (surety companies) to qualify for bid bonds. Typically this means two stages of evaluation: operations and finance:
- When evaluating operations, the bond company will assess your past projects, business structure, assets, and your general ability to perform the job you are trying to bid for. The more capable you are, the lower the bond premium.
- Looking at finance, the bond company wants to see healthy cash flow, liquidity and the ability to cover upfront costs for things like labor and materials. This also includes lines of credit and even personal finance.
Depending on these factors, the guarantors will accept or refuse the bond application. If accepted, they will assess the premium (cost) of the bond based on the strength of the business.
Non-compliance with obligations
If a contractor fails to meet expectations, withdraws from the project, or breaks the agreement in a way that costs the project owner money, they have the right to file a claim against the surety for non-performance. . In fact, it can mean one of two things. With the first option, the guarantor will pay the full value of the bond to the project owner as compensation. In the second option, the guarantor will pay the difference in the deposit between the accepted offer and the next lowest bidder. Nevertheless, the client benefits from the protection he needs.