Can contractors get performance bonds with bad credit? This is a question we are often asked. The answer is usually “yes” but it may take a different approach. Learn more about what options are available to contractors that have had credit challenges.
The definition of bad credit varies when trying to obtain a performance bond. Many credit only programs will only entertain credit scores of 700 or higher. That’s a pretty high score for many contractors. Fortunately, there are surety bond companies that have credit only models that will go as low as a score of 600.
Beyond just the credit score, certain activities may give bond underwriters pause and fall into the “bad credit” category. These are discussed below.
Bankruptcy is a legal solution available to businesses and individuals who cannot pay the debts they owe. There are different types of bankruptcies and reasons for them. Performance Bond companies will look at the reason for bankruptcy. For example, was it caused by medical bills? Anyone at any time could be struck by an expensive illness and these bankruptcies are becoming more common.
On the other hand, a contractor with a recent chapter 7 business bankruptcy may find it very difficult to get a performance bond. Bond companies will want to know that the liability under the former business is completely gone. They do not want the bankruptcy courts coming after new revenue that the contractor makes. Further, bond companies will be highly concerned about the circumstances surrounding the old company and why the contractor will not be in the same situation again.
Tax Liens are particularly challenging when trying to obtain a performance bond. The IRS defines a Federal Tax Lien as,
“The government’s legal claim against your property when you neglect or fail to pay a tax debt. The lien protects the government’s interest in all your property, including real estate, personal property and financial assets.”
States can also file tax liens. Nobody wants to be behind the government as a creditor, including performance bond companies. Generally, tax liens will need to be discharged before getting a performance bond. Some bond companies will consider performance bonds if a contractor has an approved payment plan in place with the IRS.
Another very challenging contractor issue is a UCC filing from another bond company. A UCC filing is a legal filing against assets under the Uniform Commercial Code. Performance Bond companies generally do not make a UCC filing unless they believe there will be an issue. Having a UCC filing against a contractor by a surety bond company will make them believe a bond claim has happened or may happen. This will make getting a performance bond very difficult.
Performance Bond companies regularly run both a personal and business credit report before writing a bond for a contractor. If either the personal or business credit reports show bad payment history, it will make getting a performance bond more difficult, even if the contractor has a good credit score. Performance Bonds guarantee that a contractor is going to complete a project, but they are often written with payment bonds that guarantee that a contractor will pay the bills on the project. Having a poor payment history will make it more difficult to obtain a performance bond.
Now that we have discussed some of the items that may make getting a performance bond difficult, let’s review some of the solutions.
The SBA Surety Bond Guarantee (SBG) Program is an excellent tool to help contractors get performance bonds when they have had credit challenges. The SBG program does not directly write the bonds, but it gives performance bond companies incentives to write bonds when they would not otherwise. If approved, the SBG will provide a performance bond company 80% – 90% backing if they suffer a loss. This is a powerful tool to help contractors.
For small projects, the SBA has a quick program that can provide performance bonds up to $450,000 with very little information. In fact, it is a simple application.
Contractors needing larger bonds will need to provide additional information to the SBA. However, the SBA SBG program can write contractors with previous bankruptcies, tax liens, low credit score, and bad payment history. Generally, they will require bankruptcies to be discharged and they will require an approved government payment plan to be in place for any tax liens. Still, this provides a great solution for contractors needing performance bonds with credit challenges. Learn more about the SBA Bonds here.
Another option to get performance bonds when contractors have bad credit is third-party indemnity. Third-party indemnity means getting another financially strong party to agree to indemnify the performance bond company for any losses. An analogy would be a cosigner on a consumer loan. The strong third-party gives the performance bond company comfort by knowing that there are strong assets available to take care of any potential issues. However, third-party indemnitors should understand that they will be fully liable if the performance bond goes into claim. Additionally, indemnitors are generally joint and several. This means the performance bond company could choose to pursue the third-party indemnitor for all losses, simply because they have more resources, and it may be easier to recover damages from that party.
Funds Control is another means for writing performance bonds for contractors with bad credit. Funds Control is like escrow. The contractor and the funds control open a joint account together. Contract proceeds are deposited into the account and the funds control company pays the project invoices and does the project accounting. The remaining funds are given to the contractor. Funds control gives the performance bond company a lot of confidence to write performance bonds for contractors because the project funds stay on the project. It makes it more difficult for contractors to use the project proceeds to fund other projects. This reduces the chances for a claim on the project.
Funds Control can be used when a contractor has had previous issues, bankruptcies and other credit issues. Certain performance bond companies specialize in writing performance bonds when a contractor utilizes funds control. Learn more about funds control here.
Collateral is another tool that can be used for contractors with credit challenges. Collateral can take many forms such as an Irrevocable Letter of Credit (ILOC), property, securities, cash and others. However, the most common form required is an ILOC.
Real estate collateral can be very useful when a contractor has credit challenges but owns their building, land, their homes or other property. The property must generally be free and clear of loans for a performance bond company to accept it.
My experience shows that ILOCs are the most requested form of collateral but also the least realistic. If a contractor has bad credit, they will likely have the same challenges getting an ILOC as they will with getting a performance bond. Learn more about surety bond collateral here.
Another strategy for contractors with bad credit is to make the project and performance bond requirement smaller. There are several ways to accomplish this, and the contractor will need to get the obligee on board. However, many bond companies may be more willing to write smaller performance bonds for contractors with bad credit than they would on larger projects.
Phasing a project is one way that contractors can make it smaller. Phasing a project involves dividing the project up into separate smaller contracts and bonding each contract. For this strategy to work, the smaller contracts will need to be set up so that one is closed before the new one begins. This strategy will not generally work if the obligee still requires performance bonds for each “phase” at the beginning.
Another strategy to make contracts smaller is to remove the material and bond the labor only. Many obligees are willing to do this. They can issue a joint check on the material and get a performance bond for the labor portion. For this strategy to work, the contract will need to reflect “labor only”. Not every performance bond company will work with this strategy, but it can work in the right circumstances.
Although this strategy does not technically make the project smaller, it does reduce a bond company’s exposure and give them more incentive to write a performance bond for a contractor with bad credit. The contractor must ask for subcontractors and/or suppliers to provide a performance bond to the contractor with bad credit. This significantly reduces the risk of default for the contractor and will help them obtain a performance bond of their own.
Bad credit does not mean a contractor cannot get performance bonds. In fact, there are many bond companies that focus on contractors in these scenarios. There are tools and strategies available to help contractors in almost all circumstances.
Axcess Surety is the premier provider of surety bonds nationally. We work individuals and businesses across the country to provide the best surety bond programs at the best price.
