Bonding capacity refers to the maximum amount of surety credit that a surety company will provide to a builder per project and in the aggregate, based upon its evaluation of the builder’s financial stability and performance record. In this article, we will explain why bonding is an essential element of many large projects (especially in construction), how bonding agreements work, what it takes to qualify for bonding and how builders can increase their bonding capacity.
What is bonding?
A bond agreement is a contract with three parties: a principal, an obligee and a surety. In the construction industry, the principal is the builder who has been hired to complete the project, the obligee is the project owner and the surety is the financial guarantor of the bond.
Based on the Value of the Project
Surety companies are specialized departments of banks or insurance companies that use their capital to underwrite the performance of the principal for the protection of the obligee.
The principal pays a premium to the surety company as fee for underwriting the value of the bond, which is based on the overall value of the project.
Bonds Protect the Project Owner
The idea is that if the principal can’t complete the project, does a bad job or otherwise fails to fulfill the obligations, the obligee can claim the bond, and the surety agency will provide funds to hire another contractor or to compensate the project owner for the losses.
In this regard, bonding is similar to insurance, except that the coverage being purchased by the principal is for the protection of the obligee.
Why Project Owners Require Bonds
Bonds became a standard feature of government contracting with the Heard and Miller Acts of the U.S. Congress. Prior to these requirements, contractors would sometimes bid low to win a job and then demand more money to finish.
Other builders would sometimes take payment for the project and fail to pay their suppliers, subcontractors or employees, leaving taxpayers on the hook for their compensation.
By requiring contractors to purchase performance and payment bonds, government project managers shifted these risks from the taxpayers to the builders. Construction bonds are now a common requirement for state, local and private projects.
Required Qualifications for Bonding
Before underwriting a construction bond, a surety company will conduct a thorough evaluation of the builder’s qualifications for bonding. These will include audited financial statements of the business, the number and value of projects successfully completed and the builder’s personal credit rating and assets.
These details provide assurance to the surety underwriter on three concerns: First, does the builder have the business acumen and financial wherewithal to complete the subject project successfully; and second, does the builder have the resources to reimburse the surety if the bond must be paid to the obligee; and third, does the builder have a good reputation in the market.
The Importance of Bonding Capacity
Based on its evaluation, the surety will determine the bonding capacity of the builder, expressed simply in two figures. The single job limit is the largest single project the surety company would be willing to underwrite. The aggregate limit is the maximum amount of contract backlog in bonded projects the contractor can carry while maintaining credit with the surety.
For example, a principal who is qualified for a bonding capacity of $5 million single/$20 million aggregate can be assured that the surety agency will readily approve for a bond of up to $5 million on a particular project, as long as they are within the aggregate limits of $20 million or less in other bonded work or backlog.
If a new job would expand the contractor’s contract backlog over the aggregate limit of $20 million, the surety might still approve a new bond, but not without a separate underwriting review.
This shows that a company’s bonding capacity is not set in stone, but rather is potentially flexible based on the judgement of a professional surety agent.
Factors Determining Bonding Capacity
To determine the bonding capacity of a particular builder, surety companies consider the builder’s financial stability and business experience, but at a deeper level, they also judge the quality of the builder’s organization, team members, work practices and recent project results.
Financial Stability
The surety will study the contractor’s financials from every angle, but with particular emphasis on appropriate net worth, book value, flexible liquidity and modest debt, all of which indicate lower risk.
As a general rule, a well-capitalized builder will have a business an aggregate backlog of at least 10 times balance sheet equity or working capital, with debt less than two times equity.
Most surety companies regard liquidity as critical to a builder because construction involves laying out large amounts of working capital to suppliers, subcontractors and employees, while lenders release working funds in conservative segments, and project owners hold back percentages against completion.
Debt Warning Signs
When determining a contractor’s bonding capacity, the surety does not want to see bank lines of credit that are fully utilized or applied, bank debt greater than two times equity, or any indications of weak credit or poor performance on meeting loan payments.
Business Experience
Surety underwriters know that past performance is the best indicator of future results. The surety will evaluate the work history of the builder, looking for satisfied customers, job profitability and subcontractors who are eager to work with the builder again. A track record of finishing jobs on time and under budget is highly desirable.
The contractor’s experience must also be relevant to the project which is the subject of a new application for bonding. A successful track record of building luxury homes with a $1 million single job limit and $10 million aggregate limits is no guarantee of good results if the proposed future job is a $10 million office building.
Professional Conduct
During an evaluation of bonding capacity, the surety will meet with team members at various levels of the builder’s organization, with an opportunity to observe their conduct and examine the quality of their work.
Surety firms work at all levels with industry-leading organizations, so they are well qualified to judge whether a management team is highly competent or otherwise.
They will expect to see accurate, detailed financial reports based on current information, reflecting an operation that is run with integrity, high energy and competitive skill.
Work Practices
Builders seeking to improve their company’s bonding capacity should ensure that their work practices equal or exceed those of their best competitors. Current construction management software keeps schedules, budgets and tasks up-to-date and communicated to all team members.
Bids can be more accurately rolled into proposals. Spending can be managed more closely to budgets. When a surety sees a builder managing data for performance improvement, the result is more confidence in the applicant.
An Opportunity for Partnership
A campaign to earn a larger bonding capacity is mostly a matter of objective business data but may also depend on the contractor’s ability to present an opportunity for a desirable partnership. Surety agents want to invest their capital in a winning organization with exciting projects, dynamic employees and a mission for the company team.
Builders should share openly with the surety. Organize visits to job sites. Invite the surety agent to planning sessions. Show why particular subs were chosen. Share Gantt charts to show a project in clearly defined steps. Show how the team will control overhead costs and how risks will be mitigated.
The bottom line: a builder’s bonding capacity can be steadily increased by concentrating on building a competent team, a solid financial statement showing profits are kept within the company and a track record of finishing jobs on time and under budget.
