Performance bonds are used in construction and commodity contracts to ensure subcontractors get paid and the project gets finished on time.
Construction projects take a long time to complete. It’s tough to estimate the exact time for the completion of the project. Due to this complication, project owners want security of their investment of time and money. Despite proper documentation, there’s still a risk in a construction industry.
Many contractors don’t stay the course, as plenty of construction projects are a failure. A performance bond is a solution to this problem for project owners. A performance bond is an insurance against the risk of contractors not paying their subcontractors and finishing their project on time. It prevents project owners from the risk of being sued by subcontractors.
Besides construction projects, you can find the usefulness of the performance bond in commodity contracts as well.
Why Obligee Wants A Performance Bond?
Contractors might feel it’s unfair to them when they’re asked to place a performance bond. They may already be committed to working till the end. What can go wrong?
Well, there’re plenty of things that can go wrong when it comes to a construction project. Some of them are:
- Contractors can go bankrupt before starting the project.
- An unethical client might only have the objective of keeping the money in their pocket and flee.
- Contractors may fail to adhere to the deadline or face some unexpected financial crisis.
- Contractors might file bankruptcy after the start of the project.
These are some of the problems an investor might face, which is why they want contractors to place a performance bond.
How Does A Performance Bond Work?
It’s mandatory for public contracts of $100k and above to place a performance bond. There are many financial institutions and insurance firms, such as Netsurance Canada offering this service. There’re three parties involved in a performance bond:
- Principal, the one performing the work as a contractor.
- Obligee, the company, investor, or a government who is assigning the task.
- Surety, the institution providing the performance bond.
Both government and private investors make use of performance bonds for their investment security. Performance bonds and payment bonds go side by side. A payment bond is a contract between the obligee and the principal, ensuring the laborers working on the projects get paid. It also comprises sub-contractors and suppliers of materials.
The performance bond also protects the obligee from the bankruptcy. If a contractor files bankruptcy or goes through other financial crises, a performance bond acts as a protection shield for an obligee. It’ll be either a surety company or a contractor who pays for a performance bond.
Documents For Performance Bond
Financial institutions don’t issue a performance bond to anyone quickly. Like other banking and financial transactions, companies need to understand certain factors and present some documents.
Depending on the project’s size, the surety company will do some investigation and require some documents before issuing a performance bond. Here are some of the materials one needs to present for placing a performance bond:
- At least a couple of years of CPA-prepared financial documents.
- A genuine copy of the contract.
- An application of the surety.
- Any piece of real estate or other collateral from the contractor.
Having these documents allow the surety company to minimize the risk posed by the contractor.
How Much Does A Performance Bond Cost?
Contractors, in most cases, must provide a performance bond as part of the contractual agreement. It’s not easy to estimate the cost when you’re bidding for the work. One of the specific expenses is the cost of a performance bond. How much does a performance bond cost?
There’s no fixed rule of estimating the cost of a performance bond. However, you can expect the price of the performance bond to be 1% of the contract. The cost might get higher with the increment in the size of the project. It might increase up to 1.5-2% of the contract. With that said, the contractor’s worthiness also plays a role in the cost of the contract.
Is Performance Bond A Must?
It’s a must for major government projects to have a performance bond in place. However, there’s an exception when it comes to private contracts. But obligee wants the placement of the performance bond, depending on the type of project. A small project might only have a deal in place.
The issuance of a performance bond gives project owners and investors security of their investment. Furthermore, it also assures laborers and sub-contractors they’ll get paid for their value.
However, there are cases when surety might try to settle obligee to agree for a lesser amount. The obligee must be able to accurately estimate the cost of the project, to ensure the performance bond is enough to cover the cost.
Despite a few drawbacks of the performance bond, it’s still the best form of insurance for project owners. And the cost of the performance bond is also not very high, which is a good thing.
Travis Perkins has worked with different companies in the past and is now making a name to be one of the best bloggers in the online community. Travis writes articles on several business industries, with topics suitable for both consumers and entrepreneurs.