A performance bond provides a guarantee that a contractor will fulfill all of their obligations under a construction agreement. Also known as a contract bond, a performance bond provides financial compensation to property owners in case a contractor fails to complete a contract.
There are many types of bonds used in construction, and performance bonds are a useful ingredient in lowering the risks associated with building projects—especially with large-scale and public construction.
Read on for more details about how performance bonds work, why performance bonds are important, and how to get a performance bond as a contractor.
How performance bonds work
Performance bonds, which are secured by a contractor before the beginning of a project, provide financial compensation for a property owner if the contractor fails to complete work according to the contract terms.
But how exactly does this work? Take a closer look at the parties involved to see how performance bonds work.
The property owner, also called the obligee, may require a performance bond for the prime contractor on a project. Ultimately, the bond protects the property owner against the risk of a job not getting finished.
General or prime contractors
The general or prime contractor, also called the principal, secures a performance bond to work on the project—for a fraction of the cost that the bond covers. For example, a contractor may pay $1,500 for a performance bond that secures $150,000 of work. The bond serves as an incentive for the contractor to fulfill the project since they’ll likely have to pay back the full bond if they don’t fulfill the contract terms.
The financial institution that provides the bond, also called a surety, prequalifies contractors to lower their own risk. If the contractor does not complete the contract, the surety has to provide funds to the property owner until the GC pays back the surety. As a result, the surety has a financial incentive to only provide bonds to qualified contractors.
In essence, a performance bond exists to lower financial risk for property owners while providing financial incentive for general contractors. Ultimately, performance bonds help ensure that jobs do get done—either by the original contractor, or by the surety stepping in to provide funds (and sometimes replacement contractors).
What happens if a contractor does not fulfill the contract?
If the contractor fails to perform, the owner can file a claim against the performance bond. In the event of a valid claim, the bond surety steps in and takes corrective action.
If a claim is eventually filed by the project owner, the surety will conduct an investigation. This is to determine if there’s an actual breach and the extent of the damages. Again, this is the time where little communication can go a long way.
The surety will assess the work that needs to be completed, the cost of any changes, and may find and hire another contractor to finish the work. Typically, a performance bond claim will come along with the termination of the prime contractor. However, termination is not always a cut-and-dry scenario.
The owner may make arrangements to avoid termination. Terminating a contractor can be an expensive process for all parties involved. Termination could be avoided by reducing the scope of work, supplementing the workforce, or advancing payments to keep the project moving. If not, the surety will have to step in.
Every bond has specific terms that must be followed in order for a claim to be valid, often including a timely notice of default. If notice isn’t provided according to the terms, the surety has every right to deny the claim.
While the performance bond is in place to protect the owner from contractor default, the surety actually has quite a bit of authority in exactly how to remedy the situation. In some cases, they even have the ability to reinstate the defaulting contractor, with or without the consent of the owner.
How surety companies respond after a contractor defaults
If the contractor is ultimately in default, then it’s time for the surety company to decide how to take action. There are a few options for sureties to resolve the claim.
- Payout. The surety will pay either the amount of the bond or the cost of completion of the work; whichever is lower.
- Financing. A surety may decide the contractor was so close to completion, that they will finance the contractor’s completion of the work.
- Arrangement. Here, the surety and the client will work together to finish the contract performance. Typically the client will select a replacement contractor, and the surety will absorb any additional costs.
- Takeover. The surety will assume full responsibility for finding and funding a replacement contractor to complete the remaining work.
At the end of the day, the contractor still must compensate the surety for any money that’s to be paid out. Again, that’s why communication is so important when dealing with bond claims. Contractors should always try to find alternative solutions when experiencing problems before the issue becomes too serious, and well before a claim is made.
From a contractor’s perspective, avoiding a claim requires not defaulting on a contract. But even the most qualified contractor can run into unanticipated problems. So what should a contractor do if they sense they might not be able to perform? Pick up the phone. Reach out to the surety company. After all, they are trained to deal with these types of scenarios, and may be able to resolve the situation before the owner files a claim.
Defense is the best offense, as they say, and that applies to bond claims as well. The best way to avoid a claim is to prequalify contractors before hiring them for a contract.
Why are performance bonds important?
Performance bonds are important for lowering the risks associated with many types of construction projects—and in the case of public projects, these bonds are often legally required.
On a federal construction project, the Miller Act requires the prime contractor to hold a performance bond (along with a bid bond and payment bond) if the project exceeds $100,000.
In addition, each state has adopted most of the same bond requirements for public projects under their own “Little Miller Acts.” Requirements will vary by location for state and local jobs.
While performance bonds are typically not required on private projects, it’s increasingly common, especially for large and complex commercial jobs.
Performance bonds, along with several other types of bonds, provide the financial backing and incentives for many parties to work together without the fear of unfulfilled contractors or non-payment.
For example, performance bonds and payment bonds work together: The performance bond protects the property owner from a job not getting completed, while payment bonds protect subcontractors and material suppliers from not getting paid for their work.
Without performance bonds, many property owners would be concerned that contractors won’t fulfill their end of the bargain. In short, the system of bonds that are common in construction help make sure that projects get completed and everyone gets paid.
How to get a performance bond
The first step in securing a performance bond is contacting a bond surety company. The Surety & Fidelity Association of America and the NASBP are two of the largest surety member organizations in the country. The Treasury Department also publishes a list of certified surety companies.
For performance bonds in particular, it’s important to get the bond from a surety with experience in the type of construction you are performing. This is because, in the event of default, the surety will step in to manage the situation. They will need to be intimately familiar with all of the moving parts on a project, the work required to finish the job, and how to find and assess qualified contractors.
Every bond has a specific amount that it guarantees. A performance bond is generally issued for the full amount of the contract, and typically costs about 1% of the total amount. However, there are a lot of factors that could affect the price and amount of a performance bond. Anything in a company’s credit history could affect the cost of a bond.
Performance bonds benefit everyone
Although seemingly geared towards the owner’s protection, construction performance bonds are a great way to build financial security for all parties.
When a prime contractor fails to complete performance, things can spiral out of control quickly. For project owners, they are guaranteed that the contract will be fully performed, and will be compensated in case something goes wrong. For subs and suppliers, this can keep the project moving forward and the cash flowing without having to deal with delays or filing payment bond claims.