What’s a surety bond? It’s defined as a three-party agreement binding together a principal who needs the bond, an obligee who requires the bond and a surety company that provides the bond.
It guarantees the principal will perform its contractual obligation and if that principal fails to perform in that manner, a bond will cover the resulting damages or losses. In construction, a bond is often required on public projects to protect against an adverse event causing disruption or the failure to complete a project while protecting public funds. This includes insolvency of the builder or the inability to meet contract specifications.
The process of securing a surety bond can be overwhelming. Contractors complete a series of forms and include detailed information on the company, provide follow-up pieces and then answer a few more questions. While a contractor may be confident in his ability to perform the work and remain optimistic he will qualify for the bond, he may also be unsure of the whole underwriting process. What happens if the surety declines to issue the bond? After spending hours on a bid – not to mention thousands of dollars – the declination is frustrating to say the least.
So, what’s actually happening behind closed doors? How do underwriters decide if a contractor qualifies for a surety bond? Understanding the underwriting process and knowing the potential outcome up front will help in prequalifying which projects to actively pursue, saving time and thousands of dollars.
Although there are a lot of variables that go into each case, it’s a pretty straightforward process that keys in on three determining factors: experience, financial strength and financial presentation.
Experience plays a big role in determining the largest single size project a surety will approve. A surety may not be willing to approve a project that pushes past three times a contractor’s largest successfully completed project. Sureties find comfort in slow steady growth, so when determining which projects to bid, try to stay within this multiple.
A company’s net worth and working capital are two areas of focus on the balance sheet. Working capital is determined by taking current assets and subtracting current liability. The surety may discount working capital for items such as receivables over 90 days, inventory and prepaid items. Once a final working capital number is determined, a multiple of between 10-20 times working capital (or net worth, whichever is less) is applied to calculate underwriting limits (e.g. $500,000 net worth = $7,500,000 bonding limit at 15 times).
Financial Presentation (Reporting)
Many contractors are confused about why they were declined for a bond. They met the three times experience factor mentioned above and fit within the financial strength working capital multiplier only to be declined due to their financial presentation. Besides financial strength, the financial format is equally the most important piece of information the surety will rely upon in making its decision.
For a bond less than $1 million dollars, a surety may accept a tax return or simple financial report provided from the contractor’s internal records. However, if the bond is larger than $1 million, the contractor may want to have a Certified Public Accountant (CPA) upgrade the format to a reviewed financial statement. Having a reviewed financial statement gives the surety an additional level of assurance that financials were accurately prepared by an independent third party.
The financial format among all others is a ‘don’t pass go’ requirement. Regardless of how financially strong a contractor is or how much experience he has, if financials aren’t in the correct format required for the size bond, it’ll be an uphill battle.
There are other factors that go into the underwriting process such as credit score, bank line of credit, personal assets, owner’s character, etc. But understanding these three key areas will help secure an approval.