The construction sector is one of the most valuable industries globally. It is valued at over $10 trillion. Economic growth and development worldwide greatly influence what happens in the construction industry. However, when there is financial distress in the economy, it is one of the sectors that get hit hard the most.
That is why performance bonds are prevalent in construction. Would you like to know what performance bonds are? Do you ever wonder, “how does performance bond work?” This article will provide all the answers to such questions and also share with you four important things about performance bonds.
This is a type of bond issued to safeguard project owners against failure by contractors to meet specific obligations under a contract. Examples of duties or responsibilities may include the time frame for contractors to complete a project. Different jurisdictions have varying conditions under which performance bonds are required. However, it is more common in government infrastructure projects like roads and railways.
The performance bond is also commonly referred to as a contract bond. It is also issued in commodity contracts, where sellers are required to provide performance bonds to guarantee the delivery of goods according to the terms of the agreement.
Who Are the Parties Involved in a Performance Bond?
There are three parties involved whenever a performance bond is issued: the owner of the project, the surety, and the contractor.
The project’s owner is the party the bond seeks to protect; it may be a government agency or private organization. The contractor (also referred to as the obligee) is the party responsible for fulfilling specific contract obligations. The surety is the party that acts as the guarantor on behalf of the contractor. If the contractor fails to meet their commitment, the surety has to make up for the expenses as per the terms of the bond.
Benefits of a Performance Bond
- Project owners can rest assured their projects will be completed as stipulated in the contract. The project owner gets compensated when a contractor fails to meet their obligations.
- Government agencies are protected from unscrupulous bidders. The performance bond ensures that any contractor that wins the bid will do the project as promised.
- It allows small and new contractors to compete for government and private projects. Contractors are required to present performance bonds when bidding for specific projects.
- Contractors don’t have to depend on bank loans which are painstaking to process and sometimes come with stringent rules.
How Does a Performance Bond Work?
General contractors are required to present performance bonds on specific projects. It may be public or private. To get a performance bond, a contractor contacts a surety company and finds out if it is in a position to offer the bond. However, there are several surety companies, and it may be challenging to choose one. It is safe to go with one with experience in your project.
The bond provider performs necessary due diligence. It may involve looking into the financial and technical background of the contractor. The goal is to determine if the contractor has the ability or capacity to perform said project according to the terms of the contract.
When a surety is satisfied that the contractor can meet contractual obligations, they issue a bond guaranteeing the same. The surety and contractor agree on the terms of the bond before it is given.
When a contractor fails to meet their obligation, the surety pays necessary penalties, but in some cases, they can take over the project.
Four Critical Things You Should Know About Performance Bonds
- Performance bonds work hand in hand with payment bonds. Payment bonds protect other parties involved in the contract, such as suppliers and subcontractors.
- Most contracts that require performance and payment bonds go through bidding processes. Different contractors compete for an agreement, and the one who offers the most desirable bid wins the contract.
- These bonds are sometimes required to safeguard the total amount of the contract. However, contractors pay anywhere between 1 and 3% of the contract amount for the performance bond.
- It is more commonly used in construction projects.
To better understand performance bonds, it’s prudent to be aware of the workings of surety bonds for small businesses.
Although performance bonds are required in construction projects, they are also used in other sectors, for example, in commodity contracts. The above-mentioned information can help you understand how does a performance bond work. It is an essential component in any construction project. It protects the owner of the project but also gives the contractor the ability to compete for projects. If you are into the construction business, it is best to consider investing in performance bonds with a reputable surety company to improve your business operations in the market.