How Do Bid and Performance Bonds Work?

Contractors submit bonds as required in order to win construction projects. In case of poor contract performance, the project owner is capable of getting compensation for any losses they incurred. In public construction works, such bonds are required by law but other private owners are copying the practice in order to provide them with security.

There are three parties involved in the agreement. The principal is the contractor who purchases the bond. The obligee is the project owner who the bond protects, and the surety is the company that provides the financial backing of the bond.

There is more than one type of bonds in construction, with these being used differently during the building process. Bid bonds and performance bonds are two of the most common types out there. Find out more about them here.

Bid Bonds

During the bidding process, contractors are required to submit a bid bond along with their bids. This will guarantee that the principal will follow the bid contract and will finish the job following the contract’s specifications. In bigger projects like big residential buildings or commercial projects, such bids are hugely valuable. Beyond just offering the project owner some financial security, it will also show they can depend on the contractor to finish the job.

These bids came to be a requirement due to construction companies and contractors submitting fake or insincere bids just to secure contracts. Once they win the project, they would either increase their price or say they cannot finish the project due to the price being too low. The project owner will then lose time and money due to the need to find another contractor or renegotiate the project. Bid bonds now exist to prevent this from happening.

Contractors submit bid bonds to prove that they are serious and capable of finishing the project for the price they bid for. If the project is then awarded to them, they are under obligation to finish it. Otherwise, they will have to repay the surety company when the project owner claims against the bond.

Performance Bonds

As opposed to bid bonds, a performance bond is issued after the contract is awarded to the contractor. It normally is submitted with a payment bond and guarantees that the project will be completed in a satisfactory manner. Otherwise, if the contractor is not able to do so for any reason, the performance bond will guarantee the project owner against any financial loss. Performance bonds, like bid bonds, are required by law on public works projects or projects costing over $100,000.

The performance bond is purchased during the negotiation of the contract, and the cost of the bond is based on how big the project is, as well as the credit rating or financial history of the contractor. Those with good credit can expect good rates while those who have no credit or have bad credit may see their rates higher.

Performance bonds cover normally 100% of the contract price and once the contract has been awarded, they will replace the bid bond. In case of the contractor being unable to fulfill what was stipulated in the contract, the surety company has 3 options. The first is to pay the amount that was set in the bond as a form or penalty. The second is to complete the project themselves or hire a new contractor. The last option is to provide money to the owner so they can finish the job.

Applying For Bid And Performance Bonds

The process for applying and underwriting a bid and performance bond is quite strict. The surety company normally requires a financial indemnity from the contractor or the owner of the construction company just in case they fail to follow the contract or has financial trouble for the duration of the project. This is why the personal credit rating and financial history of the contractor are required by the surety company in the process of underwriting. Rates will also depend on the financial standing of the contractor.

Thanks to bid and performance bonds, construction projects are finished efficiently, with as little delays as possible. Project owners are also able to weed out the unrealistic bids and still end up with the most cost-effective way to finish the development.