Things aren’t the way they used to be when it comes to obtaining surety bonds. The days of a contractor requesting a bid bond and receiving immediate approval are long gone, and the annual check-in meetings with surety companies are a thing of the past.
As a result of the construction recession, many contractors are feeling the pinch from their surety company and it’s affecting their balance sheet. Every job is scrutinized and subject to intense questioning, which leads to slower approvals. Profit margins have decreased, bid lists are long, private work is minimal and the credit markets aren’t loaning money. Now, more than ever, it’s imperative that contractors do everything in their power to build or maintain their surety relationship. Following are eight ways to do just that.
1. FINE-TUNE FINANCIALS
Surety decisions are largely based on a contractor’s financials. Supplying a fiscal year-end CPA audit is a must for contractors with more than $15 million in annual revenue. If the need for surety bonds is minimal, a contractor might be able to get away with a CPA reviewed statement depending on the company’s internal controls and quality of interim financial information. Utilizing a reputable, construction-oriented CPA firm is a must. The statement should be a comparative statement, including open and closed job schedules that tie to the income statement and have detailed footnotes that explain the company’s banking facility, disputed claims and any slow receivables. Contractors should notify their surety if they switch CPA firms. Surety and surety brokers handle many contractors and can actually be good references for CPA firms.
2. CLEAN UP THE BALANCE SHEET
Construction company owners should resist the temptation to use their company as a personal bank. Working diligently to clean up any shareholder receivables or loans is a smart strategy. Surety companies expect owners to keep their personal funds separate from the company’s funds. If contractors have significant receivables over 90 days old, their surety will move those receivables to a long-term asset or eliminate the receivable from the balance sheet altogether. They should improve their position with the surety company by focusing on improving the turnover of their accounts receivables.
3. MAINTAIN WORK-IN-PROGRESS REPORTS
The first thing a good surety company will analyze is a contractor’s open and closed job schedules. Their balance sheet and income statement are reflective of how well their jobs perform. Typically, a surety company will look at three years of job schedules. Did under-billings result in profit fade? How much do jobs deviate from the original gross profit estimate? Contractors must be prepared to address jobs with significant profit fade. Often, there is a good explanation, but a consistent trend of profit fade makes a contractor look less reliable. Bond companies make decisions based on financial information that is not current. As a result, a contractor’s job performance plays a crucial role in building and maintaining trust with their surety.
4. PREPARE A FORMAL SUCCESSION PLAN
Many construction companies are family owned, which can make succession planning easier. However, even if the goal is to have a family member take over the business, a surety company expects a formalized continuity plan. Surety companies, among other creditors, want assurance that the transition will have minimal impact on the balance sheet. The surety also will want to make sure the business will be in the hands of someone who is qualified and has been groomed to lead the company. In most cases, there is a buy-sell agreement in place between the existing and future owners. It is imperative that the funding of this transition is transparent and achievable without impacting the firm’s financials. Typically, this is accomplished with life insurance.
5. STAY THE COURSE
Surety companies do not usually encourage contractors to get involved with projects outside of their typical scope of work or territory. For example, a surety company is unlikely to support a paving contractor getting into the wastewater treatment plant business. They also want to see their clients stay in the territory they know best. If contractors have operated in Pennsylvania and New Jersey for several years, they should have a well-thought-out plan for moving to a new territory and have a balance sheet that warrants more risk. The top reasons for contractors failing are getting involved with unfamiliar work and unfamiliar places. If contractors decide to go outside of their typical scope and location of work, they will need strong financials and a detailed plan. A surety will need ample lead time to become supportive of these types of endeavors.
6. PROTECT AGAINST SUBCONTRACTOR FAILURE
In today’s construction economy, it’s imperative to go above and beyond to protect against subcontractor failure. Both profit margins and volume are down for many contractors. Plus, subcontractors work for many different contractors. If a subcontractor is not being paid or is having difficulties with other contractors, it will increase the risk of them failing on their work. Contractors with more than $100 million in annual subcontractor volume sometimes utilize subcontractor default insurance to protect themselves against failing subcontractors. For contractors with less than $100 million in annual subcontractor volume, a surety often will require clients to obtain performance and payment bonds from the critical subcontractors on a project. Unfortunately, in a competitive bid environment, the bond costs from subcontractors could prevent them from getting a job.
Following are recommendations if contractors opt not to obtain a subcontractor bond:
- joint checks and supplier reference;
- review of subcontractor’s financials;
- copy of subcontractor’s bond rates from its surety on the surety company’s letterhead.
- consent of surety; and
- supervision by project managers. If a subcontractor is beginning to struggle, the project management team needs to pay close attention so the performance doesn’t slip and the subcontractor doesn’t bill too far in advance.
Additionally, it’s always wise to stick with reputable subcontractors that have a long track record.
7. EVALUATE THE SURETY
It is the surety broker’s job to place a contractor with a surety where both parties will be satisfied and a long-term relationship will be established. The last thing a contractor wants to do is bounce around from surety to surety. It is also important for contractors to look at what other contractors their surety writes within the contractor’s territory. Do they understand the type of business? Do they write similar contractors? Does a broker have a good relationship with the surety and its home office? How long has the company been in the surety business? Staying up to date on the surety’s credit ratings is also important. Most owners require bonds from surety companies with a minimal credit rating of A or A-. In some cases, a contractor can default on a contract if its surety company’s credit rating falls below a certain rating. Additionally, if a surety’s credit rating falls below an A-, it is a major hassle to replace all of its outstanding bonds. Standalone surety companies and surety companies that are a division of a large insurance company frequently go in and out of business. Sticking with a surety that has a long, successful track record in the surety industry is a contractor’s best bet.
8. PLAN AHEAD FOR LARGER PROJECTS
In addition to deviating from a typical scope and location of work, contractors may have a hard time obtaining approval if they want to bid a job that is two to three times the size of their largest project ever completed. It is critical to contact the surety as early as possible to discuss a larger project. The surety will need to understand where the bulk of the risk is located and what a contractor is doing in order to mitigate the risk. A surety will want a detailed cost breakdown. Financials play a major role in getting a larger job approved. Following are some suggestions for obtaining surety support on large projects.
- An open or silent joint venture partner. The surety will have a list of acceptable companies with which to partner. Contractors should communicate potential joint venture partners with their surety.
- Obtaining surety bonds from critical subcontractors. For example, if a project is $100 million and there is $30 million of subcontractors providing surety bonds, a surety will conceptually view this as the contractor reducing its exposure by 30 percent.
- Capital infusion to bolster financials. This can be a tough way to go, as the owner is required to place a significant amount of cash into the company, and there will be a tax burden if he or she ever wants to take the money back out of the company.
- Subordinated loan. The owner can loan money to the construction company and subordinate the loan to the surety until the job is complete. This is often more attractive for the owner of a construction company and somewhat less attractive for the surety company. However, it typically results in a good compromise to help improve a contractor’s financials to obtain surety support on a large project.