As an electrical contractor, your experience with bonding may be limited to the unpleasant task of making a claim against a payment bond; surety bonding is often confused with insurance. While both are risk-protection vehicles, the insurance company uses its own assets to cover claims, but the surety expects to recover payments from the bonded contractor or obligee. For this reason, the underwriting process for prequalifying bonded contractors is much more rigorous than for obtaining insurance coverage.
The good news is that bonding rates are reasonable, and claims are less frequent and severe in the current market. Surety company executives attribute these factors to a strong construction economy, the use of credit scoring in underwriting and improved selection of contractors for bonding.
Why wouldn’t you want to be bonded?
Building a relationship with a bonding agent can often provide benefits beyond risk protection for your customers. Being bonded marks you as a well-managed, reliable company with the financial and technical capacity to complete projects on time and on budget. Also, the depth of the analysis may help you impress your banker. Finally, the discipline required to maintain a bonding limit promotes a corporate culture of strategic thinking and careful planning that supports future profitability.
Because they invest considerable time and resources in the prequalification process, bonding agents and sureties often guard customer relationships carefully, and you may find that they become valuable professional advisers similar to accountants and attorneys. For example, they can assist with contract review, flag possible financial pitfalls and advise against bidding projects that are underfinanced or incompatible with your capabilities.
Whether you require bid, performance or payment bonds, they all provide assurance to the project owner that you will meet performance and financial obligations. The bonding agent helps to prepare prequalification documents and ensures that you receive the best possible rate with a licensed, qualified surety company. Although there are alternatives to the well-known companies, the most reliable and credible bond issuers are part of the “T-List,” the U.S. Department of the Treasury’s Department Circular 570. Bond rates are calculated on a tiered scale based on each $1,000 in contract value. The rates vary from standard to preferred to super-preferred. Your agent may charge a fee in lieu of, or in addition to, the commission earned from the surety company that writes the final bond.
The surety evaluates the criteria, rates the contractor’s ability to honor commitments, and a bond is issued based on the conclusion that the contractor runs a well-managed business, performs obligations as agreed, deals fairly with others and has strong financial capacity and profitability over time. Because of the heavy investment of resources by the surety and the agent in the underwriting process, the risk/reward aspect of the process parallels the bid/award ratio of the contracts they evaluate.
The underwriting process
The surety relationship is based on good faith, and the three C’s—character, capacity and capitalization—are the same for sureties as for lenders. In this context, character relates to your willingness to meet your obligations, capacity measures the assets available to support completion of the work, and capitalization includes working capital, various forms of debt and the total available resources of the company over time.
The prequalification process will most likely require you to produce the following records:
- Company history and resumes of key personnel
- Audited financial statements (3 to 4 years) and current year interim statement
- Personal financial statements of all shareholdersDisclosure of any affiliated entities and all loan agreements
- Descriptions of all systems related to job costing, accounting and estimating
- Descriptions of your largest projects, including final profit calculations
- A business plan, containing market assessment, projected work and job size, asset allocation, and perpetuation or succession details
Once you qualify, your bonding agent will need updated financial information, including work in progress, on a regular basis. Most denials of bond requests result from the contractor’s failure to provide updated information, so make sure to agree on reporting formats and timetables for providing future updates. A good agent or broker will want to build relationships with members of your staff, such as estimators, accountants and project managers, as well as your professional advisers such as bankers and CPAs.
In preparing financial reports for surety companies, your CPA will be careful to confirm and review your cash balances with banks or other financial entities, confirm accounts receivable and trace the collection of the cash payments, and test your payables against unrecorded liabilities. The CPA’s assurance, combined with an annual audit, can reduce your bonding rates.
Once you have established a bonding relationship, you will find your own comfort level, and you may find some overlap between the bonding agent and surety representative in their interactions. Your agent’s job is to get you the best rate available with the most reliable company. Some surety representatives become more involved with day-to-day details than others, but generally, the table above shows the ongoing services each will provide.
Warning signs and contractor failure
The bonding qualification process provides opportunities for the contractor to become aware of, and prevent, possible business problems that can affect the future survival and profitability of the company. The Surety & Fidelity Association of America (SFAA) reviewed a number of claims cases and identified the following top five factors related to contractor failure:
- Unrealistic growth—rapid or excessive revenue increases and changes in geographic location, type of work or size of project
- Performance issues—inadequate personnel or training and experience for type and scope of work
- Character issues—changes in leadership or focus; lack of transition planning to ensure continuity of management
- Accounting issues—inadequate systems for costing, project management, or estimating; failure to adhere to accepted accounting practices; insufficient insurance protection
- Management issues—attrition of key staff, inadequate staff knowledge of policies and operations, insufficient or incapable project or top management, failure to maintain tracking systems for costs and billing
Other factors causing failure—such as economic and monetary conditions, weather or site situations, labor or materials shortages, owner inability to pay or egregious contract terms—are usually considered outside of the complete control of the contractor.
The warning signs that a contractor is about to fail are often discovered during the prequalification process. Here are the major areas of concern for sureties:
- Financial management systems are not effective. Cash flow is improperly forecast, or cash flow is too tight. The contractor is on C.O.D. status with vendors, payables are overdue, receivables turnover is slow, or
- Lines of credit with banks are borrowed to the established limit, all credit is fully secured, or credit lines are not being renewed.
- Estimating and/or job costing systems are not working, so revenue and margins are eroding; there are consistent operating losses; jobs are being bid too low; or there is a reduction in bonding capacity.
- Project management is poor. There may be inadequate site supervision, missing or uncollected change orders, failure to complete projects on time, ongoing claims or litigation, increases in backlog without the resources to support performance or inadequate lead time to prepare bids.
- There are communication problems with clients or between the field and the office or management staff.
- There is no overall business plan, resulting in the lack of goals and objectives or contingency plans.
Qualities of a bondable contractor
On the other hand, there are characteristics shared by highly bondable contractors. As you might predict, these fall into similar categories:
1. Financial management and marketing—The company controls cash flow and overhead, makes a profit, pays its bills on time, does not incur excessive debt or retainage, and grows only as fast as its resources will allow. Estimating and cost-control systems are effective. The market niche is well-defined; a multiyear growth plan is in place, customers are happy, and the internal culture is sales and service oriented.
2. Project control—Field managers and supervisors are tracking costs and job site operations and are trained in process-improvement methods. There are early warning systems in place to allow project managers to flag potential problems before they cause irreversible harm. The company is seldom involved in litigation.
3. Strategic planning and vision—The company has created a detailed business plan based on a SWOT (strengths, weaknesses, opportunities and threats) analysis, and emergency procedures are in place. If it is a family business, only qualified and interested family members are given management positions. There is adequate key person life insurance coverage, and shareholder buy-sell agreements are current.
Joint ventures and bankers
More electrical contractors have entered joint-venture relationships in recent years, especially on larger projects. Be careful to closely examine your contractual agreements related to bonding, since recent court cases have often found each partner jointly and severally liable for bond claims, should any partner default on payment and performance obligations. You should be sure to evaluate the financial and business capabilities of any joint venture partners or prepare to assume the cost of reimbursing any bond claims related to such projects.
Also, lenders presume that sureties will have a senior credit position in the event of a default. The lender may be reluctant to advance funds for working capital on a particular project, knowing that the surety will move ahead of other creditors if it is called to act under a bond to complete work on a project.
Despite these potential pitfalls, obtaining a bonding limit and maintaining relationships with an agent and surety company provide a considerable boost to an electrical contractor’s public image. Being prepared, presenting your company in a positive way as managed well and financially solid, and avoiding claims and litigation are all aspects of a strategy that will contribute to your corporate viability and ensure your future survival, no matter what happens to the bonding industry. EC
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached via e-mail at firstname.lastname@example.org.
The Surety & Fidelity Association of America (SFAA)—surety companies;
National Association of Surety Bond Producers (NASBP)—bonding agents and brokers; www.nasbp.org
Department of the Treasury—Department Circular 570; www.fms.gov/c570/index.html