Waiting for retainage to be released is a pain point for every construction business. This delay in payment puts a stain on cash flow, especially considering retainage amounts regularly mirror (or even exceed!) the profit margin for a job. By issuing a retainage bond, contractors and subs may be able to get their hands on retainage payments early to keep the cash flowing.
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Background on Retainage
Before we get into retention bonds, let’s do a lightning-fast recap of retainage. Retainage is an agreed upon portion of the contract price that’s withheld until the completion of the project. The amount of retainage is usually between 5-10% of the total contract price. The point of retainage is to safeguard against defects and ensure that contractors and subs accurately complete all the required tasks under their contracts.
Retainage Pushes Construction Businesses to the Brink
If you’re in the construction industry, you’re already familiar with this concept. In construction, profit margins are thinner than ever. At the same time, retainage commonly holds significant portions of payment (again – generally 5-10%) until the end of the project. That means contractors and subs are often left breaking even or even operating at a loss until retainage is released. Getting that cash moving earlier in the project would go a long way for most construction businesses – which brings us to retention bonds.
Let’s Talk About Cash Flow:
How do Retention Bonds Work?
Retainage represents some security that, if a project goes sideways, there’s a pile of funds to help smooth things over. A retention bond does the same thing, but without withholding funds from progress payments.
A typical retention bond agreement will state that in exchange for not withholding cash retention, a construction business will pay the premiums of a surety bond that takes the place of retainage funds. The customer of the party who submits the bond is the beneficiary of the bond. Meaning, if there’s an issue with the work of the party who’s paying the bond premium, their customer can make a claim against the bond to pay for it.
As a result of this setup, progress payments and/or final payment is made in full. Of course, anything that might have affected the ability to get your hands on retainage payments might also result in a claim against the retention bond. But, just like when ordinary retainage is in play, contractors and subs will generally have the opportunity to correct any issues before claims are made against retention. Retention bonds make the most sense for contractors and subs when the bond premium costs less than retainage would have (i.e. when the bond premium is less than 5-10% of the contract price).
A retention bond might be secured at the beginning of the project in order to stave off retainage from the outset. However, a retention bond might also be introduced later on in a project in order to get ahold of retainage that’s been building up.
Types of Retention Bonds
Retention bonds, like most performance bonds, come in two forms: conditional (default) and unconditional (on-demand).
Conditional (Default) Bonds
A conditional (default) bond, is when the surety agrees to pay only when there is a breach of contract or other forms of default, making the surety partly responsible for the performance of the contractor or sub. A conditional retention bond requires a heightened level of proof in order to recover on a claim against the bond.
Unconditional (On-Demand) Bonds
An unconditional (on-demand) bond is one that is payable upon demand, without actually having to prove a contractual default. This type or retention bond doesn’t require any triggering contract language – just that payment should be made due to the contractor or sub’s actions (or inaction). Obviously, the burden of proof is lower when a retention bond is unconditional.
Advantages to Utilizing a Retention Bond
The most obvious advantage to the use of retention bonds is the ability to maintain steady cash flow. Instead of receiving partial (90-95%) payment, payment is received in full. That may not seem like much, but a little goes a long way.
When construction businesses are financially stable, they’re much less likely to default. Also, retention bonds help avoid the stress involved with the pursuit and disbursement of the withheld retainage funds. Meanwhile, top of chain parties still maintain their leverage throughout the life of the project (and up to completion). Much like retainage must be released by a certain deadline, retention bonds will have an expiration date. After a certain amount of time passes, the surety will no longer be liable for claims against the retention bond.
If the bond premium costs more than the amount of retainage that would have been withheld, then securing a retention bond doesn’t make much sense. Rather than missing out on a small percentage of every paycheck, this would constitute paying more than that amount up front. A simple time value of money analysis shows that’s a bad idea. Ultimately, the cost of a retention bond will come down to the financial health of the party looking to secure the bond.
Retainage is a flawed and potentially outdated practice. They put undue pressure on construction businesses, and often, construction businesses leverage retainage into discounts from their sub-tiered comrades. Retention bonds are an imperfect solution for the retainage problem. However, when a retention bond can be obtained at a low premium, posting a retention bond might be worthwhile in order to make for steadier cash flow throughout the life of the job.