Understanding Performance Bonds: What They Are and How They Work
A performance bond is a financial guarantee that ensures one party is protected if the other fails to fulfil their contractual duties. It is commonly used in construction and development projects. The bond is usually issued by a bank or insurance company.
Purpose of a Performance Bond
A performance bond ensures that a contractor completes the job as promised. You might wonder how is a performance bond different from a labor and materials bond, since both protect the project owner but cover different risks. If the contractor fails to do the work or performs poorly, the bond provider (known as the surety) will pay for the damages or help complete the project. These bonds are often required for government contracts, especially those over $100,000, under a law called the Miller Act.
Who Is Involved?
A performance bond involves three parties:
- Principal – The contractor responsible for the work.
- Obligee – The client or project owner paying for the work.
- Surety – The company that issues the bond and guarantees that the principal will complete the job. If not, the surety covers the costs.
Where and When They’re Used
Performance bonds are commonly used in construction, real estate development, and government projects. Investors and project owners want assurance that their investments are protected. These bonds are also used in commodity trades, where a seller must guarantee delivery. If the seller fails to deliver, the buyer will receive financial compensation.
How to Get a Performance Bond
To get a performance bond, a contractor must apply to a surety company, which may initially provide a non-binding letter of bondability indicating the amount they’re willing to guarantee. To be fully bonded, the contractor must submit financial statements, tax returns, and credit history. The contractor pays a small fee—typically 1% to 4% of the bond’s total value.
Advantages and Risks
Advantages:
- Protects the client from incomplete or low-quality work.
- Reduces financial risk in large-scale projects.
- Encourages contractors to meet project standards.
Risks:
- Surety companies may try to avoid paying a claim.
- If the client underestimates potential losses, they may have to cover the difference.
- The cost of the bond may increase the project’s total expenses.
Example
Imagine a developer hires a contractor to build an apartment complex. The developer requires a performance bond. If the contractor fails to deliver, the developer has the right to file a claim, and the surety will review the case and compensate for losses up to the bond amount.
Duration and Cost
Most performance bonds last 12 months, though some may extend up to 36 months. Bonds may be renewable or non-renewable. The cost depends on the project size, the contractor’s credit score, and financial strength.
Conclusion
Performance bonds play a crucial role in ensuring the proper completion of contracted work. They provide protection for clients and help minimize financial risks in case a contractor fails to fulfill their obligations. These bonds are especially important for large-scale construction projects and government contracts.
