Fritz Archerd is surety practice leader at Lykes Insurance, a Florida-based commercial insurance firm. A former CPA, he is also a commercial risk consultant with focus specialties in real estate/construction, architects, engineers and financial entities including community banking, private equity and M&A transactional products. Visit lykesinsurance.com.
Yes, surety bonds can be a hassle. But the likely reason some contractors dislike them is that they can’t get them.
Think about it. Contracting is a risky endeavor with many opportunities for something to go wrong that can create a negative impact on cash flow. Maybe the project or conditions are not what was anticipated, or the contractor needs more resources than expected.
Challenges like this increased as the economy came out of the Great Recession, when we saw an increased portion of risk passed on to subcontractors by risk-averse general contractors. As a result, some subcontractors took on too much work at too low a margin and were stretched beyond their credit capacity. Some of them tightened their belts, but others experienced long-term difficulties with bonding.
In addition, unfortunately, some contractors don’t retain enough of their profits in the business, perhaps preferring the immediate gratification of spending on a big house or vacations. Later, instead of being able to self-finance, they must rely on bank debt to finance their work. That may work out fine if everything goes right on the job, but even one overrun job can wreak havoc if the contractor doesn’t have the financial strength and stability to get through it.
How to Avoid Default
The most basic advice is to take the time to understand the contractual obligations, particularly when dealing with an owner or prime contractor for the first time. At times, something as simple as a personality conflict can lead to default. Some owners are sticklers for detail, and others need to have their expectations managed, so understanding them as well as the specific contractual obligations can make all the difference. In other situations, some prime contractors make a habit of transferring much of the risk to their subcontractors.
Taking the time for a careful review of the contract and evaluation of the risk makes it easier to avoid the need for repricing and can alert contractors to elements that they should recognize as deal breakers. This is a role your agent should perform as your advisor. A common philosophy is that the profitability of the contract often hinges on how well the contract was negotiated in the beginning.
How to Be Bondable
Let’s take a look at 13 things contractors need to have to qualify for surety bonding:
- A track record of profitability—Financial strength is the single most important factor. Even for those who have experienced tough times, it is possible to demonstrate improvement by rebuilding the working capital structure.
- A record of on-time job performance
- CPA-prepared financial statements—It’s well worth the time and money to work with a good CPA who understands the construction business.
- A good accounting system and smart job costing
- A consistent banking relationship and the ability to borrow as necessary
- Adequate insurance
- A succession plan—Sureties want to know what the company will do if something happens to the owner.
- No history of bankruptcy
- Good cash liquidity
- Good working capital
- Low debt to equity ratio
- Good and fair contracts—Good agents and sureties have experience in reviewing contracts and identifying potential pitfalls.
- Strong personal financial statement
Look at the situation from the point of view of the surety. Which contractor would you choose—the one who meets these criteria or the one with the fast boat and vacation home whose business is only surviving from one job to the next? It’s just good business to go with the one who is bondable.
Sureties also take into consideration the contractor’s relationship with the agent. They realize the importance of bonding a contractor who develops long-term relationships and listens to the agent’s advice. They don’t like to see contractors who agent-shop and bounce from agent to agent.
How to Use This Advice in Your Company
Most sureties will look favorably on your bond application as long as the 3 Cs are present: character, capital and capability. Look to your agent for assistance. The best agents help their clients by building and maintaining durable surety relationships. They do that by being the contractor’s translator, business consultant and matchmaker.
As a translator, your agent takes what you do and translates it into the surety’s language. Conversely, the agent interprets the surety’s needs and communicates them to the contractor in understandable, actionable terms.
As a business consultant, the agent brings solutions to your business and surety issues. The best agents draw on years of experience to make suggestions about balance sheet structuring alternatives to maximize bonding capacity. Share what sureties want to see in financial statement disclosures, and then advise on how to negotiate fee structures and general indemnification agreements.
As a matchmaker, the agent knows the surety market, surety appetites and capabilities—as well as the various underwriters’ perspectives and biases. When the right match is found, the bond gets written.
So, when you really look at the big picture, surety bonding doesn’t have to be difficult. It’s a discipline of thought and action that helps each contractor build a platform for growth and enhanced profitability. Who doesn’t want that? Isn’t it worth the effort?