By Dan Huckabay, President
Commercial Surety Bond Agency
For many contractors, even those who rely heavily on surety bonds, the general rules that surety companies use to determine bonding capacity can be somewhat of a mystery. And it is hard to play a game when you don’t know the rules.
This article will aim to help you get the most out of your surety program by demystifying the two main areas sureties focus on. First by exploring how the single limit is set and then by outlining how the aggregate threshold is determined.
Establishing the Single Bond Limit – Can you perform the work?
Just like when you are looking to hire an employee, the best proof that they can perform is usually based on the employee’s prior experience. Sureties do the same thing, and when evaluating contractors, sureties are primarily looking at a history of profitability both at the individual contract level and the operation as a whole.
Sureties want to be able to draw comparisons between the work you have done historically and the work you are looking to do to make sure it is similar and the experience you have will translate. Thus, being able to articulate clearly to a surety why a job is like a previous one completed is important. This communication is one of the reasons your surety agent is an important piece of the puzzle, both in understanding your trade and unique business and being able to translate it to the surety in terms they can understand. That is why at CSBA we invest so much time getting to know our contractors.
There are also times when it can make sense for sureties to look at an owner or key employee’s past experience at a prior company. Perhaps, they completed certain types of projects earlier in their career in an area the company is now looking to expand into. This is often how sureties will approach start up contractors, because startups don’t have the experience under their own company yet. While running a big job as an employee and running an entire company isn’t exactly the same, it does give sureties some idea as to the capability of the individuals involved.
Other things sureties look to understand is whether you have the manpower and equipment to complete the work. Also, do you have the internal controls (accounting system and job costing) to properly account for the work and manage it closely?
In the surety industry, it is generally considered best practice for contractors to perform jobs that are within 1.5 to 2 times their largest completed project. There are exceptions to this general rule where sureties will provide bonds 3-4 times a contractor’s largest project.
We draw on our decades of experience and trusted relationships with our sureties to make sure our contractors can capitalize on opportunities.
Establishing the Aggregate Bond Limit – Can you cash flow the work?
There is a saying that contractors generally don’t go broke because they can’t do the work, it’s because they run out of cash. Most contractors I have met are keenly aware of the importance of cash flow, but they usually think of it in different terms than sureties do. It’s helpful to understand the surety’s perspective, because it will give you a useful benchmark to increase your bond program, but also another metric by which to successfully run your business.
The main cash flow metric for sureties is working capital. Put simply, working capital equals:
Current Assets (Cash + Accounts Receivable (AR) less than 90 days) – Current Liabilities (Accounts Payable (AP) + Bank Debt)
Example: ($100,000 cash + $400,000 AR less than 90 days) – ($200,000 AP + $100,000 Bank Debt) = $300,000 Working Capital
There are some other adjustments that sureties will make, but these encompass the bulk of it. Working capital is an indication of a company’s ability to pay their short-term obligations.
Sureties compare working capital to the cost to complete the contractor’s backlog of work (bonded and unbonded) to make sure there is adequate cash flow. They do this by applying a multiple to the working capital to determine the maximum backlog they will bond. The general multiple range that sureties use is 10 to20 times a contractor’s working capital based on the type work a contractor performs. For example, $1 million in working capital can equate to $10 to $20 million in total aggregate bonding capacity.
In addition to the type of work, many other factors such as timing of work, amount of material or subbed (especially if the subs provide bonds to you), equipment, size and sophistication of the contractor, complexity of the work, and personal net worth of the owners all influence the capacity a surety will provide. Again, there are definitely exceptions to these general guidelines, and this is where an experienced surety agent like CSBA can make the difference compared to a general insurance agent that just dabbles in bonding for contractors.
As a contractor, you don’t have to be experts in the surety business, because after all, that’s why they hire agents. However, it is important to understand what sureties look for in order to position your company to maximize your surety credit and to learn from the best practices that sureties have developed over decades. Part of your surety agent’s value is to not only advocate on your behalf but to educate you on how surety works.
Contact us today to talk to one of our surety experts and find out how we can help improve your surety capacity.