Performance bond

How a performance bond works

A performance bond involves three parties. The principal is the contractor. The obligee is the owner, or sometimes a general contractor that requires a bond from a sub. The surety is the company that guarantees the principal will perform the contract. The bond amount, called the penal sum, is set by the contract and is often equal to the full contract price.

The bond is tied to the contract, so it covers what the contract requires: completing the work, following the plans and specifications, and, depending on the bond’s wording, warranty obligations after completion. Check how the bond treats change orders, since a large increase in contract value may call for a matching increase in the bond.

When things go wrong, there’s a process. The owner usually has to declare the contractor in default, notify the surety and follow the steps the bond sets out. The surety investigates, and the contractor gets to respond, because a contractor who stopped work over unpaid invoices may not be in default at all. If the claim is valid, the surety typically chooses one of several paths:

• Finance or support the original contractor so it can finish.
• Take over the work and hire a completion contractor.
• Arrange a new contractor for the owner to sign with directly.
• Pay the owner, up to the penal sum, and let the owner finish the job.

The owner has obligations too. An owner that stops paying for completed work, changes the contract heavily without telling the surety, or skips the bond’s notice steps may weaken its own claim. Sureties review those facts closely before they pay.

Whatever the surety spends, it expects the contractor to repay. A performance bond isn’t insurance for the contractor: when you get bonded, you, and often the company’s owners personally, sign an indemnity agreement promising to reimburse the surety for losses and costs.

Performance bonds and the other construction bonds

A performance bond is usually one of a set. Each bond guarantees something different and protects a different party.

Federal construction contracts above a threshold set by the Miller Act generally require performance and payment bonds, and most states have similar laws for state and local public work. Private owners, lenders and general contractors require them too, especially on larger jobs.

Why performance bonds matter to each party

For contractors

Bonding opens up public work and larger private projects, but it puts your company, and often your personal assets, behind every bonded job. Your bonding capacity, meaning the size of job and total backlog a surety will support, grows with clean financial statements, steady profits and a record of finishing work.

For owners and clients

A performance bond means a third party has looked at the contractor’s finances and experience and is willing to stand behind the job. If the contractor fails, the owner has someone to call besides a lawyer. Recovery isn’t instant, though: the claim process takes time, and the owner has to follow the bond’s notice steps.

For subcontractors and suppliers

A performance bond protects the owner, not you. If you’re unpaid on a bonded job, your claim usually belongs on the payment bond, with its own notice deadlines.

How to get and keep a performance bond

1. Work with a surety agent who specializes in contractors, and start before you bid bonded work.
2. Prepare financial statements, ideally reviewed or audited by a CPA for larger programs, along with a work-in-progress schedule.
3. Expect to sign an indemnity agreement, and read who it binds, including spouses or personal assets.
4. Get the premium quote from your surety and build it into your bid wherever bonds are required.
5. Read the bond form with the contract, noting notice requirements, warranty coverage and how change orders affect it.
6. Keep the surety informed about large change orders, disputes and slow-paying owners.
7. If an owner threatens default, respond in writing, document your side, and call your surety and a construction attorney early.

Sureties dislike surprises more than bad news. A contractor who reports problems early usually gets more help than one whose surety first hears about trouble from the owner’s default notice.

Performance bond claim example with numbers

Say a contractor has a $900,000 contract to build a small community center, with a performance bond for the full $900,000. The owner has paid $540,000 for work completed when the contractor runs into financial trouble and abandons the job. The owner declares a default and notifies the surety.

The surety investigates, agrees the claim is valid, and gets a price from a completion contractor to finish the work: $470,000. The owner still owes the unpaid contract balance, so that money goes toward finishing the job.

The math: $900,000 − $540,000 = $360,000 left in the contract. Finishing costs $470,000, so the shortfall is $470,000 − $360,000 = $110,000, well within the $900,000 penal sum. The owner pays $540,000 + $360,000 = $900,000 in total, the original contract price, though delays and its own extra costs may lead to further claims depending on the contract.

The surety then turns to the original contractor and its indemnitors for the $110,000, plus the surety’s investigation and legal costs as the indemnity agreement allows. That’s why a bond claim can be more damaging to a contractor than a lost lawsuit.

Common performance bond mistakes

• Treating the bond as insurance and assuming the surety absorbs any loss.
• Signing the indemnity agreement without reading who and what it binds.
• Leaving the bond premium out of the bid on a job that requires one.
• Taking on more bonded work than your cash and crews can support.
• Ignoring an owner’s default notice or missing its response deadline.
• Keeping the surety in the dark about disputes until a claim arrives.

For owners, the matching mistake is skipping the bond’s notice steps. A claim that doesn’t follow the bond’s procedure can be delayed or denied, so read the bond before declaring a default.