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General contractors (GCs) require the help of subcontractors to help them finish a project on time, especially when there are limited resources available and strict deadlines to meet. Hiring subcontractors allows GCs to streamline their work and boost the efficiency of a project through effective delegation and more achievable milestones. While this is quite favorable in theory, there is always the risk of a subcontractor abandoning the project mid-way, refusing to provide services, not complying with safety or quality standards, or simply failing to turn up at work. For this reason, a subcontractor bond is required to buffer the GC – and in turn, the project owner – from unforeseen financial impacts. Here is how these subcontractor bonds work.
Construction Bonds And Their Importance
All residential, commercial, and industrial projects require various construction bonds (also known as surety bonds) for both general contractors (GCs) and subcontractors as a guarantee to the project owner or investor that the work will be completed on time and within budget. These construction bonds ensure the payment, performance, and timeliness of a project and secure the owner’s financial standpoint. There are different types of bonds used in construction depending on the audience required to provide bonds as a legal assurance to the project owner, officially stating that they are responsible for finishing their end of the work.
In case of failures or delays, the bond provides a legal alternative for the GC or owner to receive compensation for their investment and even enlist the help of a new team to resume the work as soon as possible.
The general parties involved in surety bonds include the following:
- The principal: a GC or a subcontractor who is required to obtain the surety bond and abide by its terms to deliver their agreed work.
- The obligee: the project owner or investor who is protected by the surety bond and to whom the principal is bound by the contract. The obligee can make claims in case the principal fails to uphold their end of the surety terms.
- The surety: the party that issues the bond, typically an agent or organization acting as the guarantor or sponsor who acknowledges the principal’s ability to uphold their end of the bargain and meet the stated terms. In case of failures, the surety will step in and compensate the owner immediately (and the principal will pay the agent back in installments over time).
In this way, surety bonds prevent the risk of financial losses for the owner and act as a type of insurance to protect their investment. Note that the principal and obligee can change based on who requires whom to get bonded (so you could be the obligee as a general contractor, while your subcontractor would be the principal).
A subcontractor bond is one example of a surety bond in construction. It is required by hiring GCs to safeguard their role and reputation in the project by making sure that the subcontractors working for them actually deliver their services as intended. Otherwise, the general contractor will be accountable for any losses incurred, and this can be very damaging to the owner-contractor relationship. There could be multiple reasons why subcontractors fail to deliver, some of which include timing issues, labor unavailability, conflicts, lack of resources, and non-compliance with safety and quality standards.
As a GC, you want to safeguard your project and your credibility by limiting such damages, and the best way to do so is to establish legal terms that hold your subcontractors accountable for their work. This gives them a legal incentive to complete their work as agreed mutually. If you want your subcontractors to be bonded, you have to mention this requirement clearly in your contract. With the help of a subcontractor bond, the surety guarantor will compensate you for valid claims against the bond, so this creates both a level of trust and financial security while hiring subcontractors.
Types Of Subcontractor Bonds
Subcontractor bonds can be both performance and payment bonds – each type will protect you as the GC.
A subcontractor performance bond acknowledges and confirms that the subcontractors will complete their end of the work on time by meeting the given budgets and quality requirements. In performance bonds, the surety agency provides an alternative means to complete the required work in case the subcontractor fails to deliver. In this scenario, the guarantor takes responsibility for the performance aspects of the project and incurs any financial risks caused by the subcontractors – who are still liable to eventually pay back to the agency. If your subcontractor cannot complete the given assignment, the surety company can:
- Help the existing subcontractor finish the work at no additional cost to you.
- Compensate you with the cost of the unfinished work or the bond’s value.
- Hire replacement subcontractors.
All of the above alternatives protect you from the risk of default on your project and allow work to resume as seamlessly as possible.
In comparison, a subcontractor payment bond protects the lower-tier employees (your subcontractors and suppliers, for example) from non-payment issues and shifts the accountability to you – the GC. With a payment bond, the surety company will step in and ensure that the necessary expenses for your labor and materials get covered in case of any crisis or non-payments from you. You can then pay the agency back at a later date.
In this way, the use of performance and payment bonds provides a timely solution with the surety company offering some financial respite to keep the project grounded and funded.
This does not set you or your subcontractor free from your financial responsibilities – you do have to pay the company back eventually, or risk going bankrupt.
Both performance and payment bonds are mutually exclusive agreements and require separate surety companies. The guarantor of a performance bond cannot resolve the claims made against payment bonds, so your choice of bond entirely depends on your project standpoint and who needs to be protected the most. You might even require both types of surety bonds in most projects. Usually, GCs prefer subcontractor performance bonds because of the performance and financial securities they offer to keep the project going – and these bonds also keep your subcontractors liable for their work, which is great if you are hiring new subs for the first time.
Reasons To Require Bonds
Subcontractor bonds are mostly required by government-controlled public projects, but some private projects might also require specific bonds to ensure the owner’s financial security. If your chosen subcontractor is the only specialized subcontractor in town, has a major contribution to the project, or brings valuable skills and efficiencies to the table, then this makes them a huge priority for the project. Take this lead subcontractor out of the equation, and the failure domino effect will be unstoppable. So, requiring such a subcontractor to be bonded will legally reinforce their key contribution to the work and minimize the risk of default, allowing you to resume work as soon as possible with the help of the surety company.
You also need subcontractor bonds when hiring a new sub for your project, since you have not worked with them before and cannot be sure of their commitment yet. The main benefit here is that surety companies thoroughly check the credibility, experience level, and financial stability of subcontractors before guaranteeing their performance. This streamlines the overall subcontractor selection process with the GC relying on the guarantor to do the required background research, especially for new subs. Surety companies have to be very careful with who they choose to sponsor because, in the end, they are the ones who will compensate the GC in case the subcontractor fails to deliver – so it is easy for a GC to trust the surety company for its legal power and human resource screening.
To get a subcontractor bond, you can refer your subcontractors to a surety agency that will issue the bonds to be purchased – based on what type of bond (performance or payment) is needed.
Subcontractors often take multiple sponsor quotes before selecting the one with the most competitive pricing. The process then begins with filling out an application form to provide all relevant details like your profile information, financial statements, work experience, references, performance with previous contracts, current project details and contracts, applicable construction documents, and so on.
Once the application is submitted with relevant supporting documents, the surety company will probe your subcontractors’ background and experience to determine the feasibility of hiring these subs for your project. This is where subcontractors get pre-qualified with a thorough screening of their past works and behavior, making it easy for you to rule out candidates with too many red flags. This process does not necessarily determine 100% reliable candidates to choose from. Instead, the results of the investigation help you understand your chances of recovery in case your sub defaults – which is great for narrowing down on the best possible subcontractor option.
Benefits Of Subcontractor Bonds
To sum up, here are the top benefits of using subcontractor or surety bonds in construction:
- Performance bonds ensure work completion by offering alternatives to keep the work going. Financing the subcontractor, compensating the GC, and finding new subs all help GCs stay covered if the subs default on their work.
- Performance bonds allow GCs to make valid claims and receive project support at no extra costs on their end.
- Payment bonds ensure that the subcontractors, laborers, and suppliers receive their wages on time, which prevents project delays and potential lawsuits against the GC.
- Payment bonds in turn protect the owner or investor from liens against their properties by initiating timely payments to the respective parties.
- Surety bonds also assist with subcontractor pre-qualification to help GCs find reliable, qualified subcontractors and rule out those with high-risk feedback.
- Implementing such subcontractor bonds creates a serious, legal incentive for both the GC and subcontractor to perform their best and work towards their mutual interests for the project.
- The presence of a third party (the surety) is great for offering an unbiased review of the subcontractor’s past work and financial perspective. This highlights the GC’s chances of recovery from a potential default and allows them to take calculated risks accordingly.
- Prequalification is also a smart precaution for those subcontractors that a GC frequently works with, as the process digs into and reveals details that even the GC might not know yet, so this ultimately secures your project’s future.
Subcontractor bonds also come with drawbacks that can vary depending on your specific application. Some major drawbacks of using these bonds are:
- Subcontractor performance bonds are often quite expensive.
- Their strict quality control requirements can make it difficult for some subcontractors to pass the investigation and get bonded. This is also because surety agencies want to minimize their own risks of working with subcontractors, so they tend to set the bar too high during candidate screening.
- These high costs and tough eligibility standards can seriously limit the number of bonded subcontractors you can hire. You might receive just a handful of bids from subcontractors willing to provide bonds, as most of the others will simply not bid on projects requiring subcontractor bonds.
- Prequalifying each and every one of your subcontractors will take time.
Despite the tough eligibility criteria and the time it takes to prequalify potential candidates, securing subcontractor bonds is worth the effort for large projects and those that rely heavily on their lead subs. Surety bonds offer a sense of security and consistency in a project, giving you all the peace of mind you need to focus on your work, knowing that the guarantor has got you covered.