Surety bonds play a vital role in the construction industry. They guarantee that contractors perform on jobs in compliance with contractual conditions and legal requirements. They protect project owners, other contractors and the public by playing the role of a financial security mechanism. However, they also provide contractors with legitimacy and help build up their capacity and industry reputation.

Yet, for many contractors, especially those new to the industry, surety bonds and their purpose remain somewhat unclear.

Construction Bonds Explained

Surety bonds for contractors are legally binding agreements between three entities:

• project owners, known as the bond oblige;
• contractors, known as the bond principal; and
• the surety company that issues and backs the bond.

Depending on the specific type of bond, these agreements have different conditions, though they all serve the same purpose of securing protections and guarantees for bond obligees.

Construction bonds are equally requested by public obligees, such as federal and state governments, as well as private obligees - i.e. private project owners. Bonds on public projects are requested under certain legally defined circumstances, whereas on private projects this is up to the project owner to determine.

Under the Miller Act, construction bonds are required for contractors performing on federal projects over $150,000. Similarly, every state has its own "Little Miller Act" which specifies the contract amount above which construction bonds are required.

How do construction bonds function?

These bonds function as financial security for obligees, guaranteeing compensation if the contractor violates the conditions of the agreement. Every construction bond is issued in a specific amount. This is the amount of maximum compensation that the surety may extend to the obligee. Compensation is made if the principal violates the agreement, causing losses and/or damages, and the obligee files a claim against the bond.

Yet, while sureties assume risk when issuing a bond, as contractors may default on their contract and generate a claim, the surety generally does not assume the final liability in cases of default. Every surety bond agreement is premised on the condition that the contractor is ultimately liable for claims against the bond.

In other words, even if a surety covers a claim initially, the bonded contractor must reimburse the surety in full. This is why bonds are frequently compared to lines of credit for contractors.

Of course, a bond claim can be costly and time-consuming to resolve, and it may also harm a contractor's reputation. Yet, bond claims are a rather extreme measure, and most contractors, even when they experience difficulties under a project, do not face claims. Moreover, there are several very real benefits to contractors when they get bonded.

How are construction bonds beneficial for contractors?

Sureties exercise great care before issuing a construction bond during the prequalification process. Before a contractor is provided with a bond, the surety will carefully evaluate financial standing, capacity to handle the project, the status of previous projects and more.
Only when a surety determines that a contractor is sufficiently reliable will it issue a bond. By issuing a bond to a contractor, the surety guarantees to the oblige that the principal will comply with the agreement.

Over time, the trust extended by sureties grants legitimacy to contractors who have demonstrated they are capable of fulfilling their side of the agreement. This trust also translates into an increased bond capacity, which allows contractors to take on more projects that require bonds.

Moreover, if a contractor does run into difficulties on a project, their surety is also a valuable partner and ally who can provide expertise and solutions long before things go bad.

Types of construction bonds

Depending on the situation, different surety bonds can be required of contractors. The most common types of construction surety bonds include:

• Bid bond. This bond is required to submit a bid on a contract. It guarantees that the contractor will execute the contract at the bid submitted if awarded the contract.
• Performance bond. Contractors must post a performance bond when they are awarded a project as a guarantee that they will perform according to the conditions and requirements of the contract.
• Payment bond. This bond serves as a guarantee that the contractor will pay subcontractors, laborers and suppliers for services and materials.
• Maintenance bond. This bond functions as a guarantee to project owners that there will be no defects or faults in a structure for a certain amount of time after its completion by the contractor.
• Public works bond. This bond is similar to the performance bond but is typically required for projects on a state level.
• Site improvement bond. This bond guarantees that improvements to a structure will be made in accordance with building codes and standards.

Contractor license bonds are a separate type of bond frequently required by contractors. This bond is not a construction bond. Rather, contractors in most states require this type of bond when applying to receive a professional license or permit.

The licensing bond guarantees contractors' compliance with state laws and protects the public in cases of injuries or losses, whereas construction bonds are concerned with the performance of a particular project. Licensed and bonded means that a contractor has obtained a license, along with submitting a contractor license bond.