6 Important Things Entrepreneurs Need to Know About Surety Bonds

If you are an entrepreneur in the process of starting a new business, you are likely trying to deal with all of the various steps necessary to open your company. Opening a new business requires you to find a business location, deal with zoning issues, determine the right entity structure, register your company, open a business bank account, and more. Depending on your industry, you might also be required to obtain a license from your state or local government before you can lawfully operate your business. A common licensing condition required for businesses is to secure surety bonds. Even if you are not required to be licensed and bonded, you will still likely encounter different types of surety bonds while operating your company. Here are six important things to know about surety bonds and how they work.

Surety bonds are legal agreements between these three parties:

• Principal - The business that must get bonded

• Obligee - The project owner or government agency that mandates the bond

• Surety - The surety or bond company that serves as a guarantor of the principal's performance and compliance with the law

The surety bond is a guarantee that the bondholder will follow the regulations and laws and meet its obligations to customers. Since the surety acts as a guarantor, it will evaluate the risk it would face by agreeing to issue a bond to the principal. The surety will require the principal to sign an indemnity agreement before it will issue a bond. The indemnity agreement is legally enforceable, and the principal will be ultimately responsible for paying any valid claims that might be filed against the bond. If the principal fails to pay a valid claim, the surety company can enforce the indemnity agreement through the litigation process to recover what it is owed.

A common misconception held by entrepreneurs is that surety bonds are another type of insurance coverage. However, bonds are not insurance and do not protect the bondholders against potential liability. Instead, they protect consumers and the public against risk. By contrast, insurance policies protect the policyholders in case of an unfortunate event and cover their losses. In the case of a surety bond, the bondholder will be liable for losses caused by their failure to adhere to their bond conditions and the law. The surety premium serves as a guarantee that the principal will meet its obligations instead of covering potential losses.

There are many different types of surety bonds, but most fall into the following three categories:

• License/permit bonds - These are bonds that are required before a license or permit will be issued to a business to legally operate.

• Contractor/construction bonds - These are bonds that are required for contractors that want to perform work on public construction projects. Some private project owners also require contractors to secure construction bonds before they will agree to contract with them.

• Court bonds - These are bonds that a judge might require the parties to a civil case to secure to ensure they will fulfill their legal responsibilities in court.

Many different types of businesses require license or permit bonds as a condition of licensing, including the following common examples:

• Auto dealers/dealerships

• Auctioneers

• Freight brokers

• Travel agencies

• Health clubs

• Mortgage brokers

• Notaries public

• Medical equipment companies that contract with Medicare/Medicaid

• Construction contractors

• Collection agencies

Other types of companies might also require bonds. You should check with your jurisdiction to determine your licensing and bonding requirements.

In addition to license bonds, construction contractors might also need to secure several types of construction bonds for work on public projects or when required by private project owners. The three most common types of construction bonds you might encounter include the following:

• Bid bonds - Bonds that guarantee you will follow through on a contract if you have the winning bid

• Performance bonds - Bonds that guarantee you will perform your obligations under a contract

• Payment bonds - Bonds that guarantee you will pay your subcontractors and suppliers to protect the project owner from mechanic's liens

To get a surety bond, you can apply to a surety company. The company will likely require you to submit some documents so that it can evaluate the degree of risk it would face by issuing you a bond. Some of the types of documents you might need to submit include the following:

• Resumes for you and any partner

• Business organization documents

• Profit and loss statements

• Information about past projects

• Income tax returns

• Bank account statements

• Bank reference letter

• References from parties with which you have conducted business in the past

These documents are needed for the surety company to assess your company's finances and stability. The surety company will want to see that your business is stable and has sufficient capital to cover any potential losses from bond claims. If it decides to approve your application, it will provide you with a free quote for the bond premium. If you agree, you will pay the premium and sign the indemnity agreement to get your bond.

While you might be required to purchase a bond with a high face value, you won't have to pay the total bond value to purchase your bond. For example, freight brokers are required to secure $75,000 surety bonds to get their freight broker licenses. However, they don't have to pay $75,000 to purchase their bonds.

Instead, the bond premium that must be paid up front will be a small percentage of the maximum bond amount based on the evaluation of your company completed during underwriting. If you have excellent credit, you can expect to receive a rate quote of as little as 1%. By contrast, if your credit is poor or you have little experience, you can expect to receive a higher premium quote.

Some surety companies won't underwrite bonds for people with bad credit. However, you can still get a surety bond with poor credit by going through a bad credit program. You can expect to pay high premium rates of 10% or more. However, if you avoid bond claims and work to build your credit, you might receive lower rates when it is time to renew your bond.

As an entrepreneur, you might think that surety bonds are just one more expense to add to your list. However, you might be required to secure a surety bond before you can legally operate your company. After you are bonded, you should take steps to maintain your bond and avoid claims to build a good relationship with your bond company and grow your business's reputation.