The question is often asked, " Do performance bonds require collateral?" The short answer is that performance bonds do not require extra collateral for most contractors. However, a complete breakdown is below.
Performance Bonds are a type of Contract Surety Bond. They are a three party guarantee between a Principal (usually a contractor), an Obligee (the project owner requiring the Bond) and a Surety (bond company guaranteeing the Principal's performance).
Performance Bonds guarantee a contract. A Principal either completes the bonded obligation for a project owner or the owner can make a claim against the performance Bond. The bond provides assurances that the project will be completed or there will be funds available to finish it.
Performance Bonds are underwritten based on 3Cs. These are Credit, Character, and Capacity. Much of this underwriting is centered around the credit piece. This is a contractor's financial resources.
A Surety bond underwriter provides performance bonds based on a contractor's financial strength. This is usually a multiple of the contractor's analyzed working capital and net worth.
In normal circumstances a performance Bond company takes no hard collateral such as a letter of credit or property. However, performance Bond companies do require that the company obtaining the performance Bond and usually the owner(s) of the company sign an indemnity agreement.
If there is a claim on the performance Bond, the Surety bond company will seek to be reimbursed by the company and/or the individual indemnitors.
Indemnity makes performance bonds unique. If there is a loss, a performance Bond company is entitled to the company's receivables and other assets to finish a project or reimburse the Surety bond company. You can read more about indemnity here.
Even though a performance Bond company can take over a company's assets in a claim situation, they do take a collateral position and make a filing under the Uniform Commercial Code (UCC) unless there is a claim on the performance Bond or related bond such as a payment bond. Therefore, performance bonds and other contract bonds are considered unsecured credit.
There are times when a performance Bond company may require collateral in order to issue a performance Bond. These usually apply in two scenarios.
Many companies and individuals fall on tough times and it hurts them financially. When this happens, a performance Bond company may not be willing to write bonds for the company without additional Surety tools to strengthen the underwriting case. One of these options is to have the company put up collateral.
The amount of collateral required depends on the bond company and the contractor. There are specialty Surety bond companies that focus on writing contractors in these situations with Surety tools such as collateral.
Another scenario when collateral may be required is when a contractor is taking on their largest project. Most Surety bond companies will write performance bonds for contractors that are twice as large as their previously completed project. Other bond companies may go as high as four times. However, collateral may be a way to help the bond company stretch on project size for a contractor. Read more about acceptable types of Surety bond collateral here.
The second scenario when collateral may be required is when the performance Bond is guaranteeing a difficult obligation. This could be a project with forfeiture language, a project with a long term warranty or international Surety bonds. These are certainly not the only examples, but collateral can make a difficult obligation more appealing to a bond company by reducing their exposure to loss.
Even when contractors have a difficult job or financial challenges there are potential alternatives to posting collateral.
The SBA Surety Bond Guarantee Program can help new contractors and those that have had financial difficulties. If a contractor can qualify, it is usually a better option than posting collateral.
Funds Control in Surety is similar to using escrow. The funds control company handles the contract proceeds on a bonded project. Performance Bond companies will often accept funds control as an alternative to collateral. The benefit to the contractor is that this option does not tie up a contractor's assets and those assets can be used elsewhere.
Another alternative to collateral is a third party indemnitor. A third party indemnitor is an outside individual and/or company. A third party indemnitor is like a co-signer on a loan. The idea is that they bring additional financial strength to the Bond company to support the Performance Bond.
Not all Surety bond companies will accept a third party indemnitor. It is also very important for the third party to understand the risk before they agree to indemnify. Bond claims can be very expensive and it is usually a big risk for an outside party to indemnify.
Most performance bonds do not require contractors to put up collateral. Collateral should be viewed as a last resort. At Axcess Surety we exhaust all other options before asking a contractor to post collateral. Contact our bond experts anytime.