A bond is similar to insurance; the bonding company provides compensation if certain events covered by the bond occur. In fact, most bonds are written by specialized subsidiaries of the same companies that write business insurance policies. Since a bond fills a different need than an insurance policy, it’s important to know when and if a bond is right for you. Here, we’ll help you identify situations where this form of protection is needed.
Bonding developed from the ancient practice of one party guaranteeing another’s obligation. The bond is the surety company’s guarantee to someone that they will not be harmed by another’s failure to do as he had promised.
For example, if you want to bond an employee, the surety company guarantees that you will not suffer loss if that employee steals from you. If a government agency requires that you present a bond if awarded a contract, this is the surety company’s guarantee to the agency that you will perform as expected. Note that in this case, you are not a party to the two-way agreement between the agency and the bonding company. But, of course, they would not issue the bond for you unless an offsetting agreement existed between you and the surety.
This type of bond protects you from losses caused by dishonest or fraudulent acts by specified employees. You’re taking out protection in case they steal your money, securities, parts, tools or equipment. Employees who handle your company’s books and records may be bonded because of the risk of embezzlement. If this were to occur, you would be compensated for the loss under the bond.
Why not use insurance instead of a bond? Because only bonding companies will undertake the extensive investigation necessary to properly evaluate the risk. That won’t create a guarantee of honesty, but it will give you the comfort of knowing that your employees have nothing in their histories that could post abnormal risk.There are fidelity bonds to cover almost any type of employee and risk. A competent insurance agent can suggest where you are exposed to possible loss and how bonding can cover that risk.
Fidelity bonds don’t prevent crime, they only provide compensation if it occurs. One way to prevent loss through employee theft or other dishonesty is to conduct a thorough investigation of job candidates. Even an occasional loss, and there will be some in the life of every business, may be less expensive in the long run than bonding.
This type of risk makes bonding more complex. Third-party theft involves employee dishonesty in conducting business away from your business location. For example, in a home cleaning business, you will face a claim and possible loss if your employee steals a client’s silverware. The same risk occurs when a delivery employee steals merchandise by not giving your clients the full amount they ordered.
Covering this kind of dishonesty is very complicated. Insurance and surety companies typically don’t want to get involved in these “third-party” situations. For a long time, such coverage was not available for individual small businesses.
In many lines of service work, protection for delivery or transportation activities can be obtained through associations of businesses in those fields. They have joined together to spread such risks over their members, and as a result surety firms have been more willing to extend coverage.
This is a typical form of bond or surety. It can be summed up this way — “We (the surety company) hold ourselves responsible to you (the obligee) if XYZ (you, the principal) does not faithfully fulfill his/her/their obligations to you.”
The most frequent use of contract bonds is in connection with bids submitted to government agencies and the resulting supply of construction contracts. In this case, a contract bond guarantees that you will do what you are supposed to do, as specified in the contract you sign with the agency.
If you don’t, the surety company may take action to see that the contract is completed. They do this by either by getting an outside party to take over where you left off or by paying an amount agreed upon by all concerned to recompense the agency for the unfulfilled contract. Then the surety company will come after you for reimbursement of its costs in making good on its bond.
The surety company is not in the supply or construction business, so the last thing they want is to have to complete a contract. They will examine you very carefully before making a commitment, such as:
- Business track record
- Financial condition
- Expertise and experience
- Strength to weather setbacks
- Ability to perform as contracted
They’re measuring you against the size and difficulty of the contract you want to enter into. Two key points are the conditions governing release of the bond and when this can take place.
In many cases, the surety company will insist on collateral to back up the risk of “going bond” for you. At first glance, it might seem preferable to deposit the collateral directly with the agency instead of paying for a bond. After all, if your liquid assets are going to be immobilized for this purpose, why pay the surety company’s fee?
One answer to this, particularly in the case of construction contracts, is that government agencies and owners can’t resist finding a way to keep your collateral. This may include calling your work incomplete or faulty, or charging you with not meeting the requirements of the contract. Your collateral will be taken as liquidated damages, and fighting this in court can be expensive.
If you are going to be bidding regularly for such contracts, you need to establish your “bondability.” Once you do, you will not be asked to put up collateral except in special circumstances.
Other Types of Bonds
In addition to the contract or performance bonds discussed above, bidders have to submit a bond with their bids. The purpose of a bid bond is to make sure that you accept the contract if you are the successful bidder. This kind of bond is issued for a specified amount of money, usually 10 percent of the contract value. This is paid to the beneficiary if you do not accept the award.
Another kind of bond that small businesses are frequently required to put up covers the issuance of state and local licenses to do certain kinds of business. If you do not abide by the requirements of the license, the bonding company pays the amount specified and comes after you for reimbursement.
A variation of this kind of bond is sometimes required for businesses that collect certain kinds of taxes as agents for the state or locality. These bonds guarantee that you will pay them what you collect.