While down payments or upfront deposits are increasingly uncommon on construction projects, some contractors or suppliers do request them. When a payment is made in advance, before materials or work are provided, the GC or owner may request a guarantee in the form of an advance payment bond. Here’s how advance payment bonds work in construction.
What is an advance payment bond?
An advance payment bond protects a project owner when they are asked to provide a down payment to a contractor or a supplier. It’s sometimes called an advance payment guarantee or an advance stage payment. The bond protects the owner in case the contractor or supplier defaults before providing the service or material they were contracted to provide.
There are three parties to a bond – the obligee, principal, and the surety company. The obligee is the party who would get paid if there was a problem of non-performance; this is usually the owner or general contractor.
The principal is the company purchasing the bond; in this case, the supplier or contractor receiving the deposit. The surety company backs the bond and is the one who will pay out if any claims are filed.
By making a claim on one of these bonds, the owner can recover the full amount of the down payment. Unlike other types of bonds used in construction, if the owner requests the down payment be refunded, the surety company pays up.
When are advance payment bonds used in construction?
These bonds are used on both private and public projects when a down payment is requested by the general contractor, a subcontractor, or a supplier.
Since materials not yet furnished don’t technically belong to the project until they are delivered on site, the owner has no recourse if the contractor or supplier doesn’t come through. These bonds protect the owner or hiring party from having to pay twice.
Advance payment bonds aren’t used that often, perhaps because down payments are rare before beginning a project. And if suppliers do request some money down before placing an order, the GC or subcontractor ordering the material often bears the burden of the cost until the material is delivered and they can get paid for it.
By passing the down payment burden on to the owner (where it should probably be) and requiring that a bond be provided, no one on the project has to bear the risk for a supplier not delivering or a subcontractor not performing. That’s the surety company’s responsibility.
Securing an advance payment bond
Generally, the contractor or material supplier requesting the down payment is asked to provide an advance payment bond either to the project owner or to the contractor in the tier above them.
The owner or contractor is the obligee on the bond – the one the money goes to if a claim is filed. The supplier or contractor purchasing the bond, the principal, bears the additional cost of supplying the bond.
Advance payment bonds require a thorough review of the principal’s financial statements and holdings. Since the most common cause of default on these bonds is company insolvency, the surety needs to ensure that they are covered and the company is on strong financial footing.
These bonds typically cost between 1-3% of the down payment amount, which could be a small amount to pay for financial peace of mind.
What happens if there is a claim?
Unlike traditional construction bonds, advance payment bonds are “on-demand” as opposed to “conditional” or “default” bonds. What that means is that if a claim is filed against one of these bonds, the surety must pay the obligee immediately, no questions asked.
With traditional bonds, the surety only pays if there was a breach of contract. Because of this condition, the surety first investigates the claim and determines if the principal was in breach of the contract before payment is made.
After the surety has paid a claim, they will attempt to recover the amount of the payout from the principal.
Protecting project funds
Similar to a performance bond, advance payment bonds protect project owners and contractors from non-performing lower tier suppliers and contractors.
Advance payment bonds are unique in that they provide special protection only when a down payment is being requested. Standard performance bonds protect owners and contractors throughout the life of the project, no matter how much money has been paid or work completed.
If you are a GC or a project owner and are being asked for a down payment, it’s to your benefit to ask for an advance payment bond. This is true especially if the down payment is for a large sum or if the product won’t be on site for a while.
Improving cash flow for contractors & suppliers
Managing cash flow is one of the hardest parts of running a construction business. When a contractor or supplier is strapped for cash, they may find it difficult to start a project without a deposit up front. Offering to secure an advance payment bond could be a valuable bargaining chip with the owner or GC.
For a relatively low cost – typically up to 3% of the total value of the deposit – an advance payment bond can help a construction business get the funds they need to float material costs or other initial expenses.