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What to Know About Surety Bonds for Businesses

If you are an entrepreneur or small business owner and have learned you need to purchase a surety bond, you might not fully understand your bonding requirements, the purposes of surety bonds, or how they work. Surety bonds help to ensure that businesses will follow the law and complete the work they have been hired to do. If your business breaks the rules and regulations that govern your industry or fails to perform its contractual obligations, claims can be filed against your bond. Here’s some important information you should know about surety bonds as a small business owner.

What Surety Bonds Are

Surety bonds are legal agreements between the following three parties:

• Principal – The company or individual who must obtain a surety bond
• Surety – The bond company that approves the bond and guarantees the principal’s performance and compliance with the law
• Obligee – The private party or government agency that requires the surety bond

Surety bonds differ from insurance. Unlike insurance policies, surety bonds do not protect the principal from liability when claims are filed. Instead, when your bond application is approved, the surety company will require you to sign an indemnity agreement through which you will agree to hold the surety harmless if any bond claims are filed.

If you violate your bond terms, break the law, or engage in malfeasance, the government or the party that you harmed can file a bond claim. While your bond company will pay the bond claim up to your bond’s maximum amount, you will have to reimburse the surety or face legal liability through the court process. Because of the way in which bonds work, they function as a type of credit rather than a form of insurance.

Types of Businesses Requiring Surety Bonds

Many different types of businesses are required to purchase surety bonds for licensing or permitting purposes or to ensure their performance under contracts. Some examples of the types of businesses that are generally required to purchase surety bonds include the following:

• Auto dealers – Required to purchase an auto dealer bond by state licensing authorities
• Freight brokers – Required to purchase a freight broker bond by the Federal Motor Carrier Safety Administration (FMCSA)
• Construction contractors – Might be required to purchase a contractor license bond under state law and performance, payment, or bid bonds by state agencies, federal agencies, or private project owners
• Mortgage brokers – Required to purchase a mortgage broker bond as a licensing requirement
• Auctioneers – Required to purchase an auctioneer bond as a licensing requirement

These are just a few of the types of businesses with bonding requirements. Surety bonds are basic requirements for many industries as a basic cost of entry.

Why Surety Bonds Are Required

Surety bonds serve as a prequalification showing the bondholders are financially stable, ethical, and have the capacity to follow the law and complete their work as called for under their contracts. They are required to ensure the businesses will adhere to legal requirements and avoid engaging in malfeasance during the course of doing business. They protect the public and the government against violations you might commit while operating your business.

While you might think that surety bonds are simply yet another cost to add to the list of expenses you must incur to operate your business, surety bond requirements also provide some benefits to businesses. When you are bonded, you can compete for contracts that might otherwise be unavailable to you. You might also have to purchase a surety bond before you can legally operate, so having a surety bond might allow you to legally run your company. Surety bonds also demonstrate that your company has met the qualification standards of the surety company, making your business more attractive to others for contracting purposes.

Common Types of Bonds

While there are thousands of different types of surety bonds based on local, state, and federal laws and various industry regulations, there are several that are common types of bonds for small businesses. Some of the most common types are described below.

1. Contract or Construction Bonds

Contract or construction bonds are bonds that are required for work on construction projects. The obligee might be a state or federal agency or a private project owner. Common construction bonds include the following:

• Bid bonds – Bonds that are required before contractors can submit bids to perform work on projects and guarantee the contractors will follow through if they win the bid.

• Performance bonds – Bonds that guarantee a contractor’s performance under the contract

• Payment bonds – Bonds that guarantee the contractor will pay its suppliers and subcontractors to protect project owners from mechanic’s liens

2. Commercial Bonds

Commercial bonds are typically required by government agencies to ensure that businesses will operate lawfully and adhere to industry regulations or to protect the interests of the public. The most common type of commercial bond is a license and permit bond. These are bonds that must be purchased as licensing requirements before licenses or permits will be issued by local, state, or federal licensing authorities.

How Do You Get a Surety Bond?

You can get a surety bond by submitting an application to a surety company. The bond company might ask for you to submit additional documents so that it can evaluate your and your company’s credit and financial stability, including bank records, profit and loss statements, and others.

Once you submit your application together with the required documents, your application will be sent for evaluation in underwriting. Some of the most important factors that will be considered include your credit, your company’s available working capital and finances, and your reputation.

If the underwriters determine your business poses a low risk, they will provide you with a free bond quote. This quote will be for the premium you will have to pay to purchase the bond. You will not have to pay the entire bond amount to purchase the bond. The premium will depend on the underwriting factors and can range from as little as 1% up to 10% or higher.

If you accept the quote, you will pay the premium and sign the indemnity agreement. The bond company will then issue the bond and a certificate showing you are bonded.

Many businesses will encounter surety bonds during the course of doing business. If you are required to purchase a surety bond, keeping your credit in good shape and following the law can help you secure the lowest premiums. Once you are bonded, make sure to always follow the regulations and laws that apply to your business and avoid misconduct to build a good relationship with your customers, the licensing authority, and your bond company.