What Things Should Entrepreneurs Know About Surety Bonds
Entrepreneurs and Surety Bonds: What You Should Know
As an entrepreneur, you are likely juggling multiple things as you prepare to start your new venture. You must consider many different factors when starting a new business. Depending on your industry, you will need to choose the most appropriate legal entity structure for your business, determine your licensing and permitting requirements, think about zoning, choose the right types of insurance coverage, and more. One thing you shouldn't overlook is a surety bond. Many businesses are required to be bonded for licensing purposes, and you might also encounter several other types of bonds in the course of operating your company. Here are some things you should understand about surety bonds as you prepare to get your new business off the ground.
What Is a Surety Bond?
People sometimes mistakenly believe that surety bonds are another type of business insurance. However, there are some key differences between insurance and surety bonds. Instead of protecting the bondholder against liability, surety bonds protect others, including the party requiring the bond and the public, from the bondholder's malfeasance.
Surety bonds are three-party, enforceable agreements that ensure you will fulfill your contractual obligations and adhere to the laws that govern your business. The three parties involved in the surety bonding agreement include the following:
• Principal - The party that needs a surety bond to operate or contract
• Surety - The surety company that serves as a guarantor and issues the bond
• Obligee - The agency or private party that requires that the principal gets a bond
At the time the principal's bond application is approved, the surety company will ask the principal to sign an indemnity agreement. Through this agreement, the principal will agree to hold the surety harmless in case claims are filed against the bond. The obligee or your customers can file claims against your bond if you commit legal violations or engage in misconduct and cause harm to recover their losses.
If a claim is filed, the surety company will investigate it to determine its validity. The surety company will pay bond claims it determines are valid, but you will be legally obligated to reimburse the surety fully for any money it pays out on claims. If you fail to do so, the bond company can enforce the indemnity agreement and recover both what you owe as well as any legal fees it expends to recover money from you.
How Surety Bonds Work
Since surety bonds function to protect your customers and the government against your potential misconduct, the best-case scenario is that you will never use your bond. Having a surety bond might help you secure more business, however. Surety bond companies prequalify principals before they will guarantee the principals are stable, are equipped to handle their contractual obligations, and will follow the law. Being prequalified as a business owner through the bonding process shows potential customers that they can rely on you. Some project owners refuse to conduct business with companies that are not bonded, so having a surety bond might help broaden your business prospects and customer base.
Industries Requiring License Bonds
Certain industries require surety bonds as a condition of licensure. If your state or locality requires you to be licensed before you can legally operate your business, you will likely be required to get a surety bond as a condition of obtaining your license. You can review your requirements from your state or local government to learn whether you need a license and bond. Some examples of industries that commonly require bonds as a licensing condition include the following:
• Auto dealers and dealerships
• Debt collection agencies
• Construction contractors
• Travel agencies
• Freight brokers
• Mortgage brokers
• Notaries public
• Medical equipment companies that contract with Medicare or Medicaid
• Health clubs
This isn't an exhaustive list. To learn whether your business is required to secure a bond as a licensing condition, you should check with your state and local jurisdictions.
Types of Surety Bonds
There are thousands of different types of surety bonds. However, there are three main categories of surety bonds that you should know.
• License bonds - These are bonds required for certain types of businesses as a condition of getting a license or permit to legally operate.
• Contract/construction bonds - These are bonds that are required for companies that want to engage in public construction contracts and for some that want to engage in private contracts.
• Court bonds - These are bonds that might be required by courts for parties involved in judicial proceedings.
How to Get a Surety Bond
You can apply for a surety bond through a bonding company. When you apply, the surety might ask you to submit some additional documents so that it can evaluate your company's financial strength, stability, credit, and reputation during the underwriting process. If you have good credit and are in good financial shape, the company will likely approve your bond application at a low premium rate. If your credit is poor, your application might be denied, or you might have to pay a higher rate. Once you get your bond, the bond company will provide you with a certificate showing that you are bonded that can be provided to the party requiring your bond.
Cost of a Surety Bond
You will not have to pay the bond's face value to purchase a bond. Instead, you will only have to pay a premium, which is a percentage of the bond's amount. Your cost will depend on the amount of the bond that you need and the factors evaluated during the underwriting process. If your credit is great, your bond premium might be as low as 1% of your bond's maximum amount. If it is poor, you can expect to pay as much as 10% to secure your bond.
As a new business owner, you can expect to pay a higher premium based on your relative lack of experience. However, if you comply with your licensing and bonding requirements and continue keeping good credit, you can anticipate receiving lower bond rates in the future.
Entrepreneurs can expect to encounter surety bonds at some point in conducting their business operations. By understanding how surety bonds work and how to comply with your bond conditions, you might secure any bonds you might need at a low rate. Once you have a bond, make sure you always meet your business obligations and follow the law to facilitate your business's growth.