A performance bond is a financial instrument guaranteed to a project owner. These bonds ensure that a contractor will finish its job as per the terms and conditions mentioned in a contract. This bond also has a collateral property or investment to support the requirements of an agency. Generally, banks or insurance agencies offer these bonds, which act as surety.
The basic aim of a performance bond is to provide financial backing to owners in case of default by a contractor.
Performance Bonds: A Closer Look
A performance bond is issued by one party as a contract to another party. It assures against the contractor’s failure to meet certain obligations mentioned in the signed contract. In other words, these bonds obligate the contractor to deliver a certain level of performance according to such agreement.
Issued by banks and insurance agencies, these bonds are typically paid by the party offering said services under an agreement. These bonds are also essential for private companies that involve general contractors for company operations. Further, these companies can get performance bonds from KredX’s online platform for a seamless experience.
Such instruments are extremely common in industries like real estate development and construction. Instances like commodity transactions also require performance bonds. This is to ensure that such commodity being sold is deliverable and available.
Typically, there are three parties involved in a performance bond:
- Principal: It is the primary entity or any person performing the work. Oftentimes, the principal is a contractor or a similar firm.
- Obligee: In simple words, an obligee is a customer. It is an entity or a company that will be a recipient of a project. For example, a city undergoing road construction will have a performance bond to ensure that a contractor completes work as per agreement.
- Surety: It is a financial institution or insurance company providing the performance bond.
Points to note
Here are some points that one should note with regard to performance bonds:
- Individuals cannot consider performance bonds as insurance. If the obligee claims against the bond, the surety will have to pay the amount. But, the surety will reach the principal to approach the amount paid. Hence, performance bonds are only given to firms with a robust financial structure.
- Sometimes, companies also obtain a payment bond along with a performance bond. A payment bond is an agreement between surety, obligee, and principal to ensure that labourers involved in the projects are paid. This bond is also applicable to sub-contractors and suppliers of materials.
- For private sector companies, it is essential to cover their contractors with a proper insurance plan along with surety or performance bonds. This will ensure various types of financial coverage as well as other business insurances.
How To Get A Performance Bond?
Jobs requiring performance or payment bonds have to go through project or job bidding at first. As soon as the bidding is done for the winning party, performance and payment bonds are awarded to guarantee project completion.
However, one needs to provide certain information to an underwriter to qualify for a performance bond. These are:
- Year-end financial documents that a CA should prepare.
- Listing of company receivables and payables.
- Bank reference letter.
- Financial statements of main shareholders.
- Contactor questionnaire. It is often accompanied by resumes of shareholders or some other information that would help in explaining the type of work a company has done in the past.
Moreover, before submitting a business’s financial statements to a surety, make sure to include the following:
- Balance sheet
- Income statement
- Cash flow statement
- Complete disclosures and work schedules
Also, when one works with bonds, they should associate with KredX with dedicated relationship managers to manage their accounts.
Benefits And Drawbacks Of Performance Bonds:
These bonds entail several benefits, like:
- Assurance of project completion to the owner
- The owner does not need to incur additional cost
- Works as an alternative to a letter of credit and bank bonds
- Enhances liquidity of contractor
- Alleviates bank borrowing pressure
- Improves the ability to respond to more tenders
Whereas a few drawbacks of performance bonds are:
- Sometimes, the surety may try to prove that the owner needs to settle for a less expensive remedy for the issue.
- If somehow the owner underestimates the future cost and losses of the project incompletion, they may not retrieve the shortfall from the lender or insurer (surety).
Performance bonds are also beneficial in other industries. Buyers can ask sellers to provide a performance bond in case of product unavailability. So, these bonds can be extremely beneficial in ensuring that the contractor completes the project as per the agreement.
Frequently Asked Questions:
A. The bond company may do the following in the event of default:
Complete the contract by providing financial assistance to the original contractor.
Re-tender to a new contractor.
Pay the total amount of bond to the owner.
A. Typically, project owners provide their requirements in the contract documents or tender. If the requirement on contact is specified in the contract, it is mandatory to provide a performance bond.
A. Ideally, one can release performance bonds after project completion. However, some public works do require a one-year warranty after the completion of the project.