A performance bond is a financial instrument that helps ensure the successful completion of a large project in areas like road construction or real estate development.
What Is a Performance Bond?
A performance bond is issued by one party to contract to the other party as a guarantee against the issuing party's failure to meet their obligations under the contract, or to delivery on the level of performance specified in the agreement. Performance bonds are typically provided by a financial institution such as a bank or an insurance company. The bond would be paid for by the party providing the services under the agreement.
Performance bonds are common in industries like construction and real estate development. A performance bond may also be required for some commodities transactions. The performance bond in that case is to ensure that the commodity being sold is actually available and will be delivered if the buyer indeed wants to take delivery.
There are three parties to a performance bond:
- The principal is the primary entity or person who will be doing the work. Often this is a contractor or similar type of firm.
- The obligee is the customer, so to speak. It is the company, individual or governmental entity who will be the recipient of the work. A city who will be having roadwork done by a contractor might have a performance bond to make sure the work is finished to specifications.
- The surety is the financial institution providing the performance bond.
A performance bond is not insurance. If there is a claim against the bond by the obligee, the surety will pay the amount of the bond to the obligee, but they will look to the principal to make good on the amount paid out. Performance bonds are only given to financially stable firms.
A payment bond is often obtained along with a performance bond. A payment bond is essentially an agreement between the obligee, the principal and the surety to ensure that laborers on the project get paid. This also extends to any sub-contractors used, as well as suppliers of materials.
Private sector companies or governmental entities who hire contractors for major projects should, of course, be sure the contractor has proper insurance coverage in addition to any type of performance or surety bond coverage they might provide. This would include various types of liability coverage and other applicable types of business insurance.
How Does a Performance Bond Work?
Performance bonds are usually required for government-related projects such as building a bridge or for road constructions. They are common for private sector construction projects as well.
The performance bond protects against a contractor failing to deliver the work as specified in the contract. The contract must be specific about the work to be performed, the results expected and the timing.
A performance bond can also protect against a situation in which the contractor declares bankruptcy or encounters other financial issues that would preclude the contractor from completing the work.
Payment of the performance bond can only be made to the obligee, such as a property owner or governmental entity who commissioned the work, in the case of road construction or other public-works type project.
When applying for a performance bond, the surety will require information from the contractor such as:
- At least two years' worth of financial statements prepared or reviewed by a CPA.
- A copy of the contract that the performance bond is tied to.
- An application with the surety company.
- Real estate or other collateral that is owned by the contractor.
Overall, the surety will want to ensure that the principal of the bond is financially stable. Again, a performance bond is not insurance.
In the event the contractor does not complete the work, the surety may either cover the cost of hiring a new contractor to complete the project or provide compensation to the obligee and allow them to use the money to complete the project as they deem fit.
When Do You Need a Performance Bond?
Typically, a performance bond will be required by law or by rule for major public construction projects. Private construction projects may also require a performance bond, this will depend on the terms of the contract and the preferences of the party commissioning the work.
What Are the Benefits and Drawbacks of a Performance Bond?
A performance bond has both benefits and drawbacks.
Benefits of using a performance bond can include:
- The obligee is assured that the project will be completed even if the principal can't or won't meet their performance obligations.
- The obligee will not be out additional funds to get the work completed.
There are some potential drawbacks that can be associated with a performance bond as well:
- The surety may try to claim that the obligee did not comply with all of the terms and conditions detailed in the bond in order to avoid paying some or all of the amount of the bond.
- The surety might try to get the obligee to settle on a lesser amount or less expensive remedy to the principal's underperformance under the contract.
- Depending upon the terms of the performance bond, it will be up to the obligee to quantify the financial losses they've suffered based on the principal's total or partial failure to perform under the terms of the contract.
- If the obligee initially underestimates the cost of the principal's underperformance and they incur a greater cost to complete the project than initially thought, they may not be able to recover these additional costs from the surety.
How Much Does a Performance Bond Cost?
The cost of a performance bond can vary, but in general it tends to be about 1% of the value of the contract. On larger contracts in excess of $1 million, the cost might go up to 1.5% or even 2%. Every surety's terms will be a bit different. The creditworthiness and financial strength of the principal will also be a factor in the ultimate cost.