Legal Advice

Insurance:
Taking the Mystery Out of Bonding

John L. Cramer, AAI
TriSure Corporation
Cary, N.C.

"Performance and Payment Bond required of successful bidder."

More than any other language in the bid specs, these eight words probably affect the decision of most masonry contractors whether or not they will bid a job. Many contractors will consider this wording as an absolute reason to pass on a job, while a smaller group of contractors are waiting for the specs that have this wording in it. Understanding the basics of bonding will help demystify the concerns that most contractors have about bonding and possibly help them understand that that being "bonded" can be a significant advantage when selecting which jobs they want to bid on.

One of the most common issues that confuse people about bonds is that they do not work like insurance. Bonding is a financial guarantee that requires you to indemnify and pay back the bonding company all monies, costs and expenses incurred if you fail to perform as outlined in the construction contract and a demand is made. Bonding is an Indemnity Contract and you will most likely be required to sign an Indemnification Agreement both corporately and personally, stating that you will be responsible for any funds paid.

Bonds for masonry contractors are mostly composed of two basic kinds; Bid Bonds and Performance/Payment Bonds. A Bid Bond is presented with the masons bid package on bid day. The Bid Bond usually specifies a penalty of five percent of the amount bid. This penalty is levied against the successful bidder if, and only if, the successful bidder withdraws their bid, for any reason, other than a qualified reason such as a scope omission or math error, and requires the bonded party to pay that penalty if they fail to agree to perform the work. In rare cases, some contractors who find their bid is substantially less than the closest competitor, elect to pay the penalty versus taking a job they suddenly suspect will cost them far more in losses than five percent of their bid amount. Oftentimes, these are tactically very good business decisions when you realize that your best competitors were 20 percent or higher than you on their bids and you might have made a serious mistake estimating.

When a contractor is awarded the contract, a Performance and Payment Bond (P&P) is required before work progresses. This is paid for by the owner or general contractor, referred to as the Obligee, on the initial draw of the contract. This P&P bond essentially guarantees that the sub will perform the full scope of the work outlined in the contract documents, that the work will be performed with proper workmanship, according to acceptable standards, and perform the work on schedule and in the time allowed by the contract. Once the work is performed and completed, it will be turned over to the Obligee free of any liens, debt or encumbrance. In short, a Performance and Payment bond states that you will do what you agreed to do, in a quality manner, and ensure all of your bills are paid.

Establishing a Bond Line is a paperwork intensive project. Understanding what the Bond Company is looking for and how they underwrite makes the project a lot simpler. In simplest terms, a bond company evaluates a potential client on the basis of the three "C's": Character, Capability and Capital. Character is essentially reputation and references. This is based on checking references of suppliers, people for whom the sub has completed work for in the past, bankers, insurance agents, Dunn and Bradstreet reports, etc. Capability is evaluating what type and size of jobs the contractor has successfully completed in the past. As a general rule of thumb, most bonding companies, referred to as Surety, will only issue a bond on a job less than two times the size of the largest successful job the contractor has completed. This will include bonded and un-bonded jobs. Capability will also evaluate such things as the strength of your management and staff and if you have a formal arrangement in place for the continuation and completion of your work should a key owner or manager die or become disabled. The final, and most complicated part of the surety underwriting process, is the Capital portion. Capital refers to evaluating the financial strength of the contractor.

Evaluating the financial strength and weaknesses is a complicated process with a variety of formulas, analyses, and statements. Every bond company evaluates your financials slightly different. A good surety agent can review your financial statements and work with your CPA to help develop a long-term strategy and formula for building a strong bonding relationship. For the purposes of this article, we will only review the basic rules. The first rule is always the "Golden Rule." Cash is key and the more "gold" a contractor has — in terms of short term, liquid assets — the better. Your financial strength is primarily determined by evaluating your Profit and Loss Statement for Net Working Capital and your Balance Sheet for New Worth/Retained Earnings.

Selecting the best CPA and Surety Agent is key to building and developing a strong bond line. The CPA should be familiar with construction and the various challenges associated with your industry. In addition, the CPA should coordinate with your bonding agent to present the complete information that will be required by your bonding company at a reasonable expense. There are three levels of financial statements that can be prepared by the CPA. A Compilation Report, a Review Report, or an Audited Statement. The Compilation is simply a properly presented form of your internal records, with minimal verification. A Review is more detailed, and the CPA is required to verify certain items such as cash balances and receivables. An Audited Statement is extremely detailed with the CPA acting as an independent verification of all information presented. The cost of each statement increases substantially as you progress from a Compilation up to full Audited Statement. On smaller bond lines and in certain circumstances, some bond companies will only require a Compilation or a Review. Larger bond lines will always require an Audited Statement. Before you spend the money with your CPA, make sure you have a Surety Agent who knows exactly what is required and what type of statement will be needed. Your Surety Agent should also speak to your CPA and discuss what schedules need to be attached, such as completed contracts, and a schedule that breaks out all under- and over-billing on work in progress.

A good Surety Agent needs to be fully informed about every aspect of your business and be informed of any issues, problems or concerns that could have a significant effect on your company at the earliest possible time. The Surety Agent should have a very strong working knowledge of construction, construction contracts and financial statements. This knowledge, along with a strong background in the surety agreement, can help you deal with problems that may arise with other subs, the owner, architect or the general contractor. The most common dispute will probably arise over change order billings and getting payments resolved. Subcontractors often have problems with the "pay when paid" provision dealing with General Contractors. A good bonding agent can often help mediate these concerns to make sure that all parties work together to keep the work on schedule and prevent as many problems as possible.

When reviewing the Profit and Loss Statement, the bonding company is looking for cash, easily convertible stocks, bonds, short term investments, current accounts receivable, trade receivables, retainage receivables and possibly solid, short term loan receivables. They will not consider most inventory, owner or employee loans as an asset. This number is compared to the total liabilities that the contractor owes. I use the analogy with my customers that if an ax were to fall today, this minute, and all work ceased, how much cash would you have left over if you paid off every single bill you owed in full. This is the same number the bonding company is looking for and this is considered your Net Working Capital. The Bond Company will usually take this number, apply a multiplier of ten, and that will be your total Work Program. For example, if your Net Working Capital after you subtract total liabilities is $50,000, the total amount of work to have on hand at any one time will probably be around $500,000.

Bond companies will evaluate your net worth to determine two basic issues. First, they want to see that you historically have made a profit year after year and secondly, they want to make sure that the profits, at least a significant portion, stay in the company and are not withdrawn by the owners for personal use. The balance sheet is a method for tracking historical profits, as well as making sure the contractor is building up assets so that they can survive during lean times. Most importantly, does the contractor have sufficient funds to carry the cash flow demands of the total work in progress, usually determined on a cost to complete basis, that the contractor desires.

When understanding how bond companies operate and evaluate a contractor, there are a few more "rules of thumbs" that you need to be aware. For example, the bonding company will require a list of all the larger jobs that you have successfully completed and the margin you cleared on each job. Normally, a bond company will allow you to bid and bond only jobs less than two times greater than a similar one you have successfully completed. This helps control the growth of your company, as too rapid of growth often leads to extremely poor cash flow and the possibility of financial failure.

Another good rule of thumb is not to use your construction company to build or develop for yourself. Most bond companies frown on a contractor who uses the resources of their company to float personal development of speculative building investments. If you plan on doing this, set up a separate company, use your personal resources to obtain a separate building loan, and although you may use your own company to do some or all the work, make sure you do not do it below cost, including overhead, and have it show up as a liability.

Personal loans to owners or officers are usually deducted as an allowable asset from your financial statement. Bond companies do not consider a loan to an owner as a collectable receivable. In essence, it is often only paid back if and when the owner solely decides to. This is not considered a secure asset.

As mentioned before, keep in mind that the bond is provided for the benefit of the owner or general contractor. The Bond is a contract that states you will do the work scoped in the contract in a timely, professional and financially responsible manner. The bond is not designed to provide you with any rights or protection, just the obligee. However, bonds are not intended to be used to unfairly or as leverage by the Obligee to "hold your feet to the fire," and disagreements will arise. Coordinating and informing your Surety Agent and your Bonding Company in these issues at the beginning will usually result in a favorable resolution.

Applying for and developing a bond line is usually an on-going and long-term process. The number of jobs will continue to increase in a weaker economy as the owners and lenders are taking additional measures to protect their money from unforeseen problems. 2001 was a horrific year for bonding companies who experienced record losses due to the sheer number of failures of construction companies, large and small, as well as bond losses resulting from some major corporations such as Enron. Although bond underwriting is increasingly strict and cautious, there is capacity for new accounts.

The attraction to bonded work for many contractors is that there are usually fewer bidders. The bids that do come in are from quality, long term companies that realize the importance of bidding and taking work on a profitable basis. Requiring a job to be bonded will eliminate many contractors who are just trying to make payroll and squeak by. If you are willing to do the paperwork, commit to establishing a long-term business strategy based on financial soundness and a quality reputation, you might want to consider becoming a bonded contractor. This could well open the doors for you to an increasingly growing segment of work that you had never considered before.

Specializing in construction, John Cramer, AAI, has twenty-two years experience in commercial insurance and bonding and is a partner/owner of TriSure Corporation, one of the largest privately held insurance brokerages in North Carolina. He also manages one of the largest masons association insurance programs in the country.