Subcontractor Performance Bonds

Categories

Many construction projects require contractors to carry performance and payment bonds. They act as a guarantee to the owner that the project will be completed for the price agreed upon, pending any approved changes. In most cases, the GC will carry these bonds on a project, but occasionally subcontractors are asked to provide bonds as well. In this article, we’ll take a look at what subcontractor performance bonds are, when you need them, how to get one, and how much they’ll cost you.

What is a subcontractor performance bond?

A subcontractor performance bond is a project-specific agreement between the GC, the subcontractor, and a surety company (similar to an insurance company). It will typically be required by the construction contract. The performance bond ensures that the sub’s work will be completed on the project. According to the agreement, if a subcontractor finds that it cannot complete a project, the surety company will step in and either help the sub complete the project or find another company to complete the work for them.

In general, a performance bond protects the hiring party from the risk of default on the work. A GC’s performance bond protects the property owner, and a sub’s bond protects the GC. A subcontractor performance bond ensures that the work will be completed at no additional cost to the owner or GC.

There are a variety of types of construction bonds. The most common, payment bonds and performance bonds, are quite different. When a contractor obtains a performance bond, it protects the party above them from default risk. A payment bond protects subcontractors and suppliers beneath them from the risk of non-payment.

What does the bond cover?

Performance bonds typically cover contract default due to financial or staffing issues. For example, if a sub is having trouble completing a project, the GC can make a claim against the sub’s bond. Once the claim is investigated by the surety company, the GC will either receive payment from the surety to help complete the work, or the surety company will help the GC find another sub to finish the project.

Note that performance bonds do not protect a sub’s lower tier subs or suppliers. In order to guarantee payments to lower tier subs and suppliers, a payment bond is required. Performance and payment bonds are often required together on projects, so it is not unusual to have both.

When do subs need a performance bond?

Performance bonds are most commonly a requirement on public projects (federal, state, and local). GCs need to provide performance bonds (and payment bonds) on federal construction projects over $150,000. Subcontractors can typically expect a performance bond requirement on federal projects over $100,000

State and local laws vary on when bonds are required, so be sure to check with your local jurisdiction. Bonds may also be required on some private projects, depending on the project requirements.

GCs may decide to require their subs to provide performance bonds on a project, even if there is no legal requirement to do this, and even if the project owner doesn’t require it. There are a few reasons a GC might choose to require a sub to provide a bond.

Why GCs require subs to get performance bonds

GCs may require new subs that they haven’t worked with before to provide a performance bond. This helps to ensure that the work will be completed, and the GC won’t have to worry about paying additional costs if the sub defaults.

Subcontractor prequalification

They may also take advantage of the fact that the surety company will do a very thorough check on the sub before issuing a bond. The surety will look at a sub’s financial situation, ability to complete the job, experience with similar projects, and research the company and its owners to see if there are any red flags in their background. The surety will be selective about who they issue bonds for, since they are the ones who will ultimately pay if the sub defaults. A GC can use this to weed out sub-par subcontractors.

Specialized work

A GC may also require performance bonds to ensure that the sub’s portion of the work will be completed. This may especially come into play when a sub’s work is highly specialized and there aren’t many companies that can do the work. The GC can use a bond to protect themselves, and the owner, from any additional costs or delays due to a possible default of the sub.

How to get a subcontractor performance bond

The first step for a subcontractor to get a performance bond is to find a surety company to purchase the bond from. Your insurance agent or a bonding agent will be able to help you shop around without spending too much time and energy. They can get quotes from several companies, allowing you to get the best deal.

Surety application process

You will need to fill out a bond application with your information and the history of your company. The application will typically require backup documents, such as financial statements, a list of completed projects, work-in-progress reports, and references. Make sure that these documents are current and accurate. You will also need to submit specific information about the project that you are bonding, such as a copy of the contract with the GC, drawings, specifications, and any other project documents.

Background research

Once you submit the application and your backup documents, the surety company will begin researching your company and reviewing the documents. They are looking for three things: 

  • Capacity
  • Capital
  • Character

They want to make sure your company can complete the project with your current workforce (capacity), that you have enough money to complete the project (capital), and that you have a good record of completing work in the past (character). Yet another reason why good record-keeping is so critical for construction companies

Performance bond cost

Performance bonds generally cost about 1% of the contract amount that they are covering. That means if your construction contract is for $100,000, you can expect to pay $1,000 to the surety for the performance bond. This may vary depending on the financial status and credit history of the company. However, subcontractors may be able to include the cost of a performance bond in their payment application, especially if the contract or project documents require bonding.

What happens if the subcontractor defaults

If a GC or owner feels that a sub isn’t going to be able to complete a project, or there are significant performance issues, the GC can start the process of making a claim on the subcontractor’s performance bond. The GC contacts the surety company with their issues, and the surety starts an investigation.

Once the surety has completed its investigation, it will decide what response is best for the project. The surety has a few options it can exercise at this point:

  • Pay the GC the amount of the bond or the cost to complete the work, whichever is lower.
  • Help the sub complete the work by offering financing.
  • Work with the GC to finish the work. This may include selecting another sub, with the surety paying any additional costs.
  • Take over the work completely, assuming full responsibility for finding and funding a replacement sub.

The surety doesn’t just pay out all this money from the goodness of its heart! After the project is complete and all costs have been paid, the subcontractor will need to pay the surety back for any money it paid out. This can be expensive, but is often preferable to the alternatives, such as not completing a project or bankruptcy.

Subcontractor performance bonds reduce risk

Subcontractor performance bonds are a way for a GC to ensure that their subs’ work will be completed. They protect the GC if the sub defaults in the middle of the project. If there is an issue with a sub’s performance, the surety company will step in. The surety may assist the current sub in finishing the project. Or they will help the GC find another sub to complete the work.

Either way, the owner and the GC will not have to foot the bill for any additional costs. That’s why bonding is so attractive, even on private projects. There is a small cost impact, but it can be worth it for peace of mind, knowing that the work will get completed.