Don’t make the same mistake as many other small business owners: misunderstanding a surety bond. Numerous small businesses need to have a bond before they can operate legally. Unfortunately, too few take the time to learn how a bond works and what it means for their business prospects. Stay ahead of the curve with this quick guide to surety bonds for the small business owner.
Most small businesses need a surety bond either to obtain a business license or to finalize a contact for work. Bond requirements apply to businesses in many industries: auto sales, contacting, education, fitness and many more. A business may need a bond to get up and running or to secure additional work. In either case, it’s essential to understand what the bond requirement entails – and then to seek out a bond ASAP.
The details vary depending on the type of surety bond and the state where it’s issued, but the fundamentals are always the same: A surety company issues a bond valued a at specific amount to a small business owner. That business is now “bonded.” If a client or customer believes a business has broken the law or violated a contract in ways that cause financial losses, they may file a claim against the bond seeking compensation. The surety investigates each claim thoroughly. It rejects any false claims, but it guarantees payment for all valid claims up to the value of the bond. When the surety settles a claim, the bonded business must pay the surety back the full amount of the claim plus interest and fees. Essentially, surety bonds are a way to hold a small business financially responsible when it breaks state laws or breaches contractual obligations.
It starts by filling out a standard bond application. This document will ask for information about the applicant’s finances, background, and business interests. Typically, everyone with an ownership interest in the business needs to submit an application. The surety will also need a copy of the bond requirements. Some applicant’s will need to submit additional documentation or provide collateral. Underwriters at the surety will look over this information to evaluate an applicant’s risk based on how likely they are to do something that causes a claim, and how likely they are to pay the surety back for any claims it settles. Applicant’s will then receive a quote for the bond price (called the premium). Paying the premium instantly activates the bond.
In every surety bond agreement, the small business is known as the principal, and the party that creates the bond requirement (either state regulators or contractual partners) is known as the obligee. Since the obligee requires the bond and dictates the terms, it decides a minimum value for the bond. The cost is a small fraction of that value. For example, if a used car dealership needs a bond valued at $25,000, the cost could be less than $1,000. Two small businesses applying for the same bond will pay different amounts because the exact cost depends on the applicant’s credit score and financial history. Applicants with a score below 700 or something like a bankruptcy on their record will likely pay more. In some cases, they will even be denied, which is why it pays to work with a surety bond provider eager to help every small business get the bonds it needs regardless of credit.
Some do, others don’t. When a small business needs a surety bond to get a business license, it will need to keep that bond active for as long as the license is active. In that case, the business will need to renew the bond every 12 months. Underwriters recalculate the bond price every time it renews. The price could go up or down depending on changes to the applicant’s credit. Beware that failing to renew and letting a bond lapse may invalidate a business license and make it illegal to continue operating, and expensive if it results in fines and fees. When renewal isn’t necessary (as is the case with many contract bonds) the bonds requirement ends once the contract completes or after a date specified in the bond agreement.
Small business can’t get around the bond requirement, and they should budget for bond costs on a yearly basis. Much more expensive than those costs are claims, which can range from thousands to hundreds of thousands of dollars depending on the bond and claim. Fortunately, claims are avoidable. Small businesses can lower the risk of expensive, unexpected claims by putting policies/practices in place that prevent behavior that could lead to claims. That starts by first understanding what’s either prohibited by law or required under contract, then aligning the business goals around that. The good news is that when a contractor or car dealership work to consistently avoid claims, they become stronger operations with happier customers and a reputation for reliability. In that way, surety bonds are good for small businesses.