Bonded projects help protect owners and contractors from defaults and payment issues. If you want to work on these bonded construction projects, you have to be able to get a bond, which means you have to have bonding capacity.
The companies that provide bonds use this capacity as a measurement for how confident they are in your ability to do the work properly and pay your suppliers and subcontractors. Knowing how bonding capacity is determined can help you position your company to work on larger projects.
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How construction bonds work
A construction bond is similar to an insurance policy — it protects the parties to the bond in case the work isn’t completed, payments aren’t made, or repairs aren’t made during the warranty period. There are three parties involved in each bond — the obligee, principal, and the surety company. The obligee is the one that’s being protected by the bond, the principal is the party that purchases the bond, and the surety company is the one who pays if a claim is made and proven.
Bonds can cover many different facets of performance on a construction project. Some protect suppliers from non-payment, others protect owners during the warranty period. The types of bonds that may be required on a project will depend on the type of work being done, who it’s being done for, and jurisdictional requirements.
If there’s a dispute on a bonded project, the obligee can file a claim with the surety company, seeking reimbursement for damages they’ve suffered. The surety company investigates the claim, and if it finds that it’s legitimate, it will pay out funds to cover the claim.
After the claim is settled, the surety will then collect the funds it paid out from the principal who purchased the bond. It’s in the principal’s best interest to avoid issues that may lead to a bond claim, as they will have to pay the costs, and claims damage their reputation.
Surety companies ensure contractors will meet their responsibilities on projects, whether it’s completing the work, honoring their warranty, or paying their suppliers and subcontractors. The surety spends a lot of time assessing the risk of bonding a company.
By getting to know the company and its officers or owners, the surety determines how much risk it’s willing to take. The limit of this risk is called bonding capacity.
What is bonding capacity?
Bonding capacity is the maximum amount of coverage a surety will provide to a company. Through investigating the financial standing, experience, and business practices of the company and its owners, the surety decides how much it’s willing to support them.
There are two limits that are spoken about when it comes to bonding — single-job and aggregate.
The single job bonding limit is the maximum amount the surety will guarantee on one project. The aggregate limit is the total amount of bonded work that the surety will back at one time.
For example, a contractor may have a $1 million single-job limit, with up to $5 million aggregate. This means the contractor can have five $1 million bonds or ten $500,000 bonds active at one time. Depending on the type of bond and its terms, a bond is considered closed when the work is complete or the warranty timeline has expired.
Why does bonding capacity matter?
Like most things, a higher bonding capacity is good. Contractors should be striving to increase their bonding capacity, as it shows that their business is stable, that they complete their work, and are able to avoid bond claims.
A higher bonding capacity shows that a contractor has experience completing projects. Contractors can’t apply for bonds when they’re just starting out. They have to develop a portfolio of projects that they’ve completed, along with good references.
Even if a project isn’t going to be bonded, bonding capacity may come into play when qualifying to bid a project. Owners often use bonding capacity as a way to prequalify contractors for a project. They let the surety companies investigate the contractors, and then rely on their judgment to help make the decision.
Owners may make contract decisions based on the bonding capacity of bidding contractors. If one contractor has a higher limit, the owner may feel more confidence in going to contract with them than a contractor with a lower limit.
A higher bonding capacity also means that you can bid on larger projects, helping your company grow. It’s a good practice to go after projects slightly outside your bonding capacity. You’ll need to provide additional information to the surety company, but as long as the project isn’t outside your capabilities you should be approved. Stretching the limits is a way to grow your bonding capacity.
Factors that determine bonding capacity
Sureties look at several factors when reviewing a company’s bonding capacity. They include accounting practices, financial stability, and experience.
If you’re still running your business out of a shoebox with receipts stuffed inside, it’s going to be difficult to qualify for bonding. Surety companies are looking for companies that are organized, with organized records, job costing reports, and accurate financial statements. You’ll also need to hire a construction CPA to review and audit your financial records.
Your company’s financial stability is also a factor when it comes to determining the number of bonds a surety will issue. The surety measures this by looking at some key accounting ratios, as well as gauging the level of equity, liquidity, and debt that your company is carrying. They consider the type of work your company does, so equipment-heavy companies with a lot of bank loans won’t be penalized.
They are also likely to look at the amount of jobs you have in your pipeline, to see how well you’re managing the backlog of work. If a contractor is stretched too thin, or the surety doesn’t believe they have the ability to complete the promised work, they may reduce the bonding capacity.
Surety companies are also looking to see how much experience your company has completing jobs successfully. They want to see that you’ve completed several projects and have happy customers. To help them out, keep your surety informed about positive reviews and project and employee awards.
How to increase your company’s bonding capacity
There are four primary ways for contractors to boost their bonding capacity.
1. Provide proper financial statements and reports
Work with a construction CPA so you know which reports the surety will be looking at, and make sure they are presented professionally.
2. Improve your personal finances
Sureties look at your personal credit report when reviewing your bonding capacity. Work on lowering debts and cleaning up credit issues.
3. Build a portfolio of successful projects
You don’t want to jump into $100 million high-rises out of the gate. Start with smaller projects and build your skills and your crews. A steady increase is better than taking a giant leap.
4. Choose a good surety agency
Look for a surety agency, instead of a single surety company. An agent will shop around and find the best surety for your business and get you the best rate. The agent can also coach you on any areas that need improvement.
Don’t forget to protect your bonding capacity
Working to increase your bonding capacity is a good way to get on larger projects and grow your company. By concentrating on your financial statements and position, getting good reviews from customers, and developing a good working relationship with a surety agency, you can steadily improve your bonding capacity.
As your bonding capacity grows, set up processes that protect your bottom line. Your office manager or credit team will need the right tools to track lien deadlines, manage waivers, and ensure you are getting paid on time for the extra work you’re taking on.