Being an entrepreneur who is preparing to start a new business can be both exciting and anxiety-producing. There are many things you must consider when starting a new business, and you must also make sure to take the right steps to comply with the relevant laws and regulations that govern your industry. Choosing an appropriate business structure, making sure you have the required permits and licenses, and making sure you have all of the necessary types of business insurance can help your business be successful. Another requirement you might have to legally operate your business is to purchase a surety bond. Here are five things you should know as an entrepreneur about surety bonds.
Surety Bonds and How They Work
Surety bonds are sometimes confused with insurance, but they are different. They don’t protect the bondholders from losses. Instead, surety bonds are designed to protect your customers and the government against potential violations of the law or other types of misconduct you might commit while running your business.
Surety bonds are enforceable contracts between three parties:
• principal – the party that must get bonded,
• obligee – the government entity or project owner that requires the bond, and
• surety – the bond company that serves as a third-party guarantor of the principal’s compliance and issues a bond.
Surety bonds aren’t issued automatically. Since they are a type of credit, the surety company will complete underwriting before it will agree to approve your application. If you are approved, you will have to sign an indemnity agreement with the surety company through which you will agree to indemnify the surety against any bond claims that might be filed. If you engage in misconduct, the obligee or a customer can file a claim against your bond. Because of the indemnity agreement, you will be legally obligated to reimburse the surety for any money it pays out on claims on your behalf. If you don’t, the surety can pursue a legal claim against you to recoup what it is owed.
Common Types of Bonds
While there are a variety of different types of surety bonds, most will fall into one of the following three categories:
• License or permit bonds – These bonds are required as a condition of getting a license to operate your business.
• Contract or construction bonds – These bonds are required before you can work on public projects. Many private project owners also require contract bonds before they will agree to hire your company for work on private projects. Contract bonds are particularly common.
• Court bonds – These are bonds that judges might require of civil litigants to ensure their compliance with judicial matters.
If your business operates in construction, you might encounter bid bonds, performance bonds, and payment bonds. Bid bonds ensure that contractors who submit winning bids will follow through on the contracts after they learn what the other parties bid. Performance bonds ensure that the contractors will perform their duties under their contracts. Payment bonds are bonds that ensure contractors will pay their suppliers and subcontractors for their work to protect the project owners from potential mechanic’s liens.
Surety Bond Approval Isn’t Guaranteed
Surety bonds are a form of credit since the surety company financially backs the bond. Because of this, your bond application will have to go through underwriting so the company can evaluate your credit, your business experience, your company’s financial stability, and your reputation. Depending on the surety company’s determination of the risk that you pose, it might either approve your bond application or deny it. If your credit and finances are in great shape, you might expect to receive a lower premium quote. By contrast, if you have marks on your credit record or little experience, you might expect to receive a higher premium quote or potentially be denied.
It Is Possible to Get a Surety Bond With Bad Credit
While having a great credit score makes it much easier for you to get a surety bond, having bad credit doesn’t mean you won’t be able to get a bond. Some surety companies have bad credit programs available for applicants with less-than-stellar credit histories. However, you will need to be prepared to pay a higher bond premium up front to secure a bad credit surety bond.
Surety Bond Cost Calculations
You might learn that you need to get a bond with a high amount. For example, if you learn that you need to purchase a $50,000 surety bond as a condition of obtaining your license, that doesn’t mean that you will have to pay $50,000 for your bond. Instead, the surety company will provide you with a free quote for your bond premium based on the underwriting factors. If you have great credit, your bond premium quote might be as little as 1 percent. If you have poor credit, your bond premium quote might be 10 percent or more. For a $50,000 bond, this means that you might have to pay $500 if you have great credit or $5,000 or more if your credit is less than perfect.
The bond premium is how much you must pay to purchase your bond. If a claim is later made against your bond, the surety will pay up to the bond’s maximum value. However, if that occurs, you will have to repay the surety in full or risk legal action.
While becoming an entrepreneur and opening a business involves multiple moving parts, it is important to take care of all of the legal requirements before opening your business. If you are required to get a surety bond, keep in good standing with your surety company and operate your business ethically to avoid potential claims. Even if your initial rate is higher than you might like, building your credit and running your business lawfully can help you secure lower rates when it’s time to renew your bond.