What are Surety Bonds?
A Surety Bond is a contract among a minimum of three parties where if the principal defaults or fails to perform an obligation, a surety is obligated to fulfill a duty such as paying a certain amount.
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How Surety Bonds Work
Surety bonds are structured to protect the lender against losses from the main borrower defaulting on its debt obligations.
At a bare minimum, there are three parties required in a surety bond arrangement:
- Principal: The party required to fulfill a specified obligation.
- Surety: The party backing the contractual obligation to perform the task is called the “surety,” or guarantor.
- Obligee: The party protected by the surety’s backing that the principal will uphold the agreement.
If the party responsible for upholding the promise fails to do so, the surety assumes full (or partial) responsibility for helping the obligee recoup all or some of its total losses.
The set amount that the surety must pay to the obligee if the principal breaches the contract – i.e. the “penal sum” – is the maximum amount that the surety is responsible for providing in the event of default.
In short, the purpose of the surety bond is to protect against losses caused by one party not meeting its contractual obligations.
Surety Bond Lending Terms
The maximum commitment amount that the principal can obtain from a surety is determined by its:
- Cash Flow Profile and Profitability
- Net Working Capital (NWC)
- Liquidity Ratios
- Collateral (e.g. Cash & Cash Equivalents, Inventory, Accounts Receivable)
- Managerial Experience
- Historical Performance
- Industry Risk
To obtain the surety bond, the principal (i.e. the local contractor) must pay a premium to the surety, who is typically an insurance company.
For protection against the worst-case scenario, surety bonds come with indemnity agreements in which the principal pledges its assets as collateral to reimburse the surety.
The riskiness of serving as the surety (i.e. risk of default by the principal) determines the pricing on the premium.
The bond premium fee typically ranges from 1% to 15% of the “bonded” amount per the agreement – with the payment ordinarily paid upfront for the entirety of the term.
Lastly, the term of the surety bond normally lasts between one to four years on average.
SBA and Small Businesses Surety Bonds Example
The obligee is most often government agencies (e.g. local or state governments), while the principal can range from small businesses to commercial enterprises.
For example, local contractors can compete for government contracts by negotiating a surety contract to further assure the customer (i.e. the government) that the task will be completed.
In recent years, the Small Business Administration (SBA) has been active in the surety bond market to help local businesses recover from COVID-19.
SBA Surety Bond Program Process (Source: U.S. SBA)
Bonded Surety Claim vs. Insurance Policies
The term “insured” is likely familiar to most. If a certain event occurs, a claim gets filed against the appropriate party’s insurance with no or minimal fees incurred by the policyholder if covered.
By contrast, the principal in surety bonding is expected to reimburse the surety for filled claims.
In the event that the obligee files a claim against the principal, the surety has secured a claim on the principal’s money (and/or assets) and the underwriters will expect full reimbursement for the claims paid.
Therefore, a surety is NOT an insurance policy. The surety is responsible for the agreed-upon payment to the obligee if there is a breach, but the principal must then compensate the surety on the side.
