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What Is a Surety Bond?
Surety bonds act as legally enforceable guarantees that help small business owners secure third-party contracts. Learn how they work.
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Businesses and organizations need a reliable way to ensure that the vendors and contractors they hire fulfill their obligations. Surety bonds provide this protection. These legally enforceable guarantees allow one party to recover losses if another party doesn’t meet the terms of a contract. For example, a contractor may obtain a surety bond when bidding on a job to reassure the client that they’ll honor their commitments.
We’ll explain what surety bonds are, explore the different types available and show how small business owners can access and use them to win more contracts.
What are surety bonds?
Surety bonds are legally enforceable three-party agreements that guarantee compliance, payment or performance.
They help small businesses win contracts by giving customers confidence that the hired company will complete the work as agreed. Many public and private contracts only accept proposals from businesses that carry surety bonds.
A surety bond’s three parties
A surety bond involves three main parties: the principal, the obligee and the surety, which is the party that backs the bond financially.
- Principal: The principal purchases the surety bond to guarantee they’ll fulfill an obligation related to compliance, payment or performance. According to Chris Peterie of Tower Street Insurance, “If the surety steps in and pays a claim on behalf of the principal, the principal is still responsible.”
- Obligee: The obligee is the party that requires the principal to obtain the surety bond to guarantee the obligation’s fulfillment. The obligee is typically the principal’s client or customer, but it could also be a court or a local, state or federal government agency.
- Surety: The surety is the insurance or bonding company that serves as a neutral third party in the agreement. “The surety acts as a third-party guarantor if the principal fails,” explained Dennis Shirshikov, adjunct professor of economics at City University of New York.
How surety bonds work
While there are many types of surety bonds, here’s a typical scenario of how they work:
A neutral third party (the surety), acting as the bond’s issuer, guarantees that one party (the principal) will perform the terms of a contract for the other party (the obligee).
If the principal doesn’t meet the obligation, the obligee can file an insurance claim against the bond. If the claim is deemed valid, the surety will pay damages, and the principal must repay the surety.
What are the primary types of surety bonds?
Just as there are different types of business insurance policies, various types of surety bonds exist. The most common surety bond types include the following:
- Bid bonds: Bid bonds guarantee that a contractor has submitted a bid in good faith, will honor the bid’s terms and will provide the required performance bond. Bid bonds are usually for 5, 10 or 20 percent of the amount bid. Bid bonds prevent contractors from submitting low bids to get a job and then raising their prices.
- Performance bonds: Performance bonds protect a business owner from financial loss if the contractor fails to perform the contract in accordance with its terms and conditions, including plans and specifications.
- Payment bonds: A payment surety bond guarantees the contractor will pay specified subcontractors, laborers and material suppliers associated with the project.
Other surety bonds
Other surety bonds may be used in small business projects and operations, including the following:
- License bonds (also called permit bonds): Local and state governments often require license bonds when a contractor or business offers a service to the public. This bond guarantees the business owner will conduct their operations in compliance with all local, state and federal regulations. Shirshikov noted that the cost of these bonds can range from a few hundred dollars to thousands, depending on the industry and risk involved. Typically, license bond costs are around 1 percent of the total bond amount.
- Construction bonds (also known as contractor license bonds): A construction bond is a type of license bond often required before starting a construction project. It provides assurance that the contractor will perform the work in accordance with the terms of the construction agreement.
- Completion bonds: Completion bonds offer assurance that a contractor will complete a project according to the contract terms, on time, within budget and free of liens. If the contractor fails to do so, a claim can be filed to compensate the obligee.
- Ancillary bonds: Ancillary bonds guarantee that the principal stands by their work and will provide any necessary maintenance or corrections in a timely manner.
- Maintenance bonds: Maintenance bonds guarantee a contractor will maintain a project according to agreed-upon standards and specifications for a predetermined time following completion.
- Fidelity bonds: Sometimes called “employee dishonesty bonds,” these protect businesses from losses caused by employee accounting fraud, theft or embezzlement. They’re most commonly used by businesses that handle cash and valuable assets.
- Customs bonds: Businesses importing goods into the United States can take out a one-time bond for a single shipment or a continuous bond if they import goods regularly. These bonds guarantee that all required duties, taxes and fees related to imported items will be paid to the government.
- Utility bonds: If your business is in a specific location or consumes high levels of electricity or gas, your supplier may require you to have a utility bond as a guarantee that you’ll pay your utility bills on time.
Who needs a surety bond?
Generally, any business that works under a contractual agreement with another party or provides a public service may be required by the obligee to obtain a surety bond. For example, a construction business may deal with surety bonds that enforce construction terms. “You’ll commonly see surety bonds in construction, especially for government jobs,” Peterie said. They’re also needed in other industries.
The following surety bonds are often used within professional industries to meet specific obligations:
- Auto dealer license surety bonds
- Real estate broker surety bonds
- Credit repair service surety bonds
- Mortgage broker and loan originator license surety bonds
- Public insurance adjuster license surety bonds
What are the benefits of surety bonds?
Even if a surety bond is required for a project, it isn’t just a formality. It can offer genuine advantages that help contractors and project managers alike ensure the job gets done right.
Here are a few key benefits:
- Risk transfer: The surety company takes on the risk if something goes wrong, giving everyone peace of mind.
- Financial protection: Surety bonds help ensure projects are completed and that subcontractors, laborers and material suppliers get paid.
- Stronger trust: Having a bond in place builds trust between contractors and clients, showing you’re serious about meeting your obligations.
- Competitive edge: Being bonded makes your business more attractive when bidding on jobs, especially those with stricter requirements.
- Licensing and compliance: In many industries, bonds are essential to staying licensed and legally operational.
How much do surety bonds cost?
Although prices vary, the surety bond’s premium is usually a percentage of the bond’s coverage amount. Once underwriters review your application, they’ll assign it a risk category with an associated premium amount.
Several factors determine the final premium amount:
- The bond’s required coverage amount
- The type of surety bond
- Your credit score
- Your financial history
Several bond providers note that quoted contract bond rates usually reflect the bond’s size and the contractor’s experience, financial stability and reputation. Typically, contract bonds cost between 1 and 15 percent of the contracted amount. They may also be tiered based on the bond’s size.
The coverage level provided by license and permit bonds typically falls between $5,000 and $100,000, though some, like California’s contractor license bond, are fixed at $25,000. For contract surety, bond amounts vary with project scale and commonly range from $50,000 to several million dollars, especially in major construction markets in California, Florida and Texas.
How do you find a surety provider?
Here are a couple of options if you’re seeking a surety provider:
- National Association of Surety Bond Producers (NASBP): To help you find a surety provider, the NASPB offers the online Surety Pro Locator, where you select your state or country to find bond producers near you.
- Small Business Administration (SBA): The SBA offers a Surety Bond Guarantee Program to help small businesses secure the bonds some jobs require (including bid, performance, payment and ancillary bonds). Similar to how the SBA partners with banks and credit unions to help small businesses get loans, the SBA partners with authorized surety companies to provide sureties to SMBs. It guarantees a portion of the bond to reduce risk to the issuer. To qualify, businesses must meet the SBA’s definition of an SMB and the contract should be no more than $9 million for non-federal contracts and $14 million for federal contracts.
- Insurance providers: Many of the best business insurance providers also offer surety bonds if you’re looking for a one-stop-shop solution.
Surety bond FAQs
- Bonded: You've purchased a surety bond that protects the client if you fail to meet specific obligations, such as completing a job or following agreed-upon standards.
- Insured: You've purchased a business insurance policy, though this doesn't specify what kind or what coverage it provides.
- Licensed: You have the appropriate licenses to operate legally in your state. Typical examples are sole proprietor licenses and construction business licenses.
Kimberlee Leonard contributed to this article.
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