Understanding Why Small Businesses Need to Be Bonded

Most people have seen advertisements for small businesses that state they are licensed, bonded, and insured. If you have a small business, you might not understand what a bond is or whether you need one. Many new small business owners also confuse insurance with bonds and do not understand why having both a bond and insurance are important.

Licensing, bonding, and insurance are common among various types of professionals that provide construction services, including HVAC professionals, roofing contractors, electricians, and others. They are also common requirements for many other types of businesses. Depending on your industry, you might be legally required to obtain a license in your state, and a common condition of licensing is having a surety bond. Here is some information about these types of requirements and why bonds are important for small businesses.

Are Bonds a Type of Insurance?

Many entrepreneurs confuse bonds with insurance, but there are distinct differences. Insurance and bonds play different essential functions for businesses and their customers. All businesses need to have at least some form of insurance to provide coverage for property damage, damage caused by employees and others, and liability coverage to protect your business from losses caused by injuries on your premises. If your business routinely works on the property of others, your customers will likely want to make certain that you are insured to protect them from losses if you cause damage or injuries on their property. For example, if you have a tree-trimming business, your customers will likely want to make sure you are fully insured to protect against losses caused by falling branches or limbs.

While insurance protects you against liability in the event of an accident by covering the damages, a surety bond does not. Surety bonds do not protect the businesses that have them and instead are meant to protect the public from misconduct or legal violations committed by the bondholders. You will have to sign an indemnity agreement with your surety at the time you purchase a bond through which you will agree to hold the surety harmless for any filed claims. This means that if a valid claim is filed against your bond, you will have to pay it in full or risk legal liability through court action.

What Is a Surety Bond?

A surety bond is a legal contract that involves three parties, including the following:

• Principal- Business or individual who needs the bond
• Obligee – Party that requires the bond and is typically a government agency
• Surety – Bonding company that guarantees the principal’s legal compliance and ethical business practices by issuing the bond

When a surety company issues a bond to you, it is extending a type of credit to you. As a result, bond applications undergo an underwriting process through which the surety company evaluates you, your business, your credit, and your character to determine how much risk the bonding company would face by issuing you a bond. If you are approved for a bond, the surety company will provide a premium quote to you. The premium is a percentage of the bond’s maximum value that you must pay to secure the bond.

For example, auto dealers must be licensed to operate their businesses. As a condition of obtaining an auto dealer license, states require them to purchase an auto dealer bond. If your state requires you to purchase an auto dealer bond as a licensing condition of $10,000, you will not have to pay $10,000 upfront to purchase it. Instead, you will pay a percentage of the total based on your underwriting factors. For example, if you have great credit and a strong business reputation, you might be charged a premium of 1% or $100. By contrast, if you have poor credit or a spotty record, you might have to pay as much as 10% to 15% of the bond amount to secure your bond or $1,000 to $1,500.

If you commit legal or ethical violations, the state or the customer you harmed can file a bond claim. While your bond company will pay up to the maximum bond amount to cover the claimant’s losses, you will have to pay the surety company in full for all of the amounts it paid. If you don’t, the surety company can pursue legal action against you, forcing you to pay everything the surety paid the claimant as well as the surety’s legal costs.

Why Are Bonds Needed by Small Businesses?

Small businesses might need bonds for several reasons. As discussed in the previous example, certain types of businesses are required to purchase bonds as a condition of licensure. Some of the common types of businesses that are legally required to purchase surety bonds include the following:

• Auto dealers
• Car dealerships
• Construction contractors
• Auctioneers
• Notaries public
• Mortgage brokerages
• Real estate agents
• Travel agencies
• Freight brokers

This list is not comprehensive. You should check the laws in your state to determine your bonding requirements.

In addition to being required for licensure, bonding is important for small businesses for several other reasons. Bonding serves as a prequalification because of the underwriting process you must undergo to secure a bond. This makes it likelier that other businesses and customers will want to do business with you. Many savvy consumers also will not do business with companies that do not have bonds, so being bonded might help to increase your customer base.

If you are a general contractor, a surety bond might also be required if you want to bid on public projects or perform work on them. Purchasing a payment bond might also make private project owners, subcontractors, and suppliers more willing to do business with you. Payment bonds protect project owners from mechanic’s liens subcontractors or suppliers might file against the titles to their property since they guarantee the subcontractors and suppliers will be paid for their work. Suppliers and subcontractors might also be more willing to do business with you because they know that they will be paid for their work.

Regardless of the type of business you have, you might need to get a surety bond. While a surety bond might not protect you against liability, it could be a legal requirement for you to operate your business. Being bonded might also provide some other benefits and provide you with more business opportunities.