>> May 2011
>> Surety Requirements 101: Best Practices to Guarantee Bonding
As the competition becomes smarter, construction firms must position themselves financially to capture surety support in order to grow organically or through partnering with large firms. Fine-tuning this strategy is critical in the current marketplace, especially given the increasing amount of requests for proposals (RFPs) that are being issued with small businesses in mind.
But, these RFPs often contain high undercurrents of risk—“Catch 22s” such as design-build exposure, consequential damages or steep liquidated damages—that force small businesses to team with large businesses to gain manpower and capital to qualify for surety support.
Construction firms should embrace several best practices to be guaranteed the bonding they need. These best practices include retaining a construction-oriented certified public accountant (CPA), establishing a continuity plan funded by life insurance, maintaining adequate insurance coverage, and implementing job-cost accounting software to accurately track all job progress and data for financial statements.
Setting these best practices into motion can significantly boost surety support and respect for a company—not only by the surety, but by any team partner.
Hire a Construction-Oriented CPA
The prequalification process for surety bonding is more rigorous than ever. Retaining a construction-oriented accounting firm can help companies obtain the desired bonding credit. CPAs can provide insights into the industry and the required accrual-based percentage of completion financial statements. They know the key players and can educate contractors on the pitfalls of profit fade, which happens when a contract is complete or near completion, yet continues to incur additional costs not factored into the overall cost of the project.
Profit fade is a red flag for sureties. Contractors usually need to provide CPA-prepared financial statements to the surety when a job exceeds $350,000. Through an express-bond application, a surety may approve a bond from $250,000 to $500,000 based on a contractor’s personal credit score and history with little or no requirement for financial information.
However, only very small businesses can use express-bond programs. Barring qualification under an express program, CPA-compiled financial statements are required to gain bonding credit for projects ranging from $350,000 to $500,000. Sureties still look at personal credit scores, as well as PAYDEX scores, which rate how a business pays its invoices. Until a company is strong and is receiving surety support of $10 million or higher, personal credit scores will be evaluated.
When seeking bonds for projects exceeding $500,000, a contractor likely will be required to produce a CPA-reviewed statement on the percentage-of-completion basis. Such statements usually are prepared at year-end, although one-time exceptions are granted if the first job requested is not well timed with year-end reporting.
This method is not defined as the percentage left to bill on outstanding contracts; rather, it is derived by dividing cost to date by total cost. This determines if the job is under-billed (cost and estimated earnings in excess of billings) or over-billed (billings in excess of cost and estimated earnings). The CPA will reflect any over-billing (a liability) and under-billing (an asset) as line items on the balance sheet.
These line items are two areas of great concern for the surety and are highly scrutinized during the underwriting process. Accounting guidelines only allow a contractor to show the additional costs associated with change orders until they are approved. Once approved, the financial statement can include the profit associated with each change order. Updated work-on-hand schedules to track the backlog and progress of all work usually are requested on a quarterly basis.
While each surety has its own guidelines with regard to CPA financial reporting, most sureties will accept CPA-reviewed financial statements for jobs up to $15 million and aggregate bond programs up to $30 million. On or around this mark, a contractor most likely will be required to upgrade to audited financial statements.
Team with a Financially Stronger Contractor
The financial condition presented in the contractor’s statement is not the only qualifier for bonding. Typically, sureties only extend bonding credit up to one and a half times the largest job completed. The amount of work a contractor can finance at any one time is called bond capacity or aggregate backlog, and it often is defined as remaining costs to complete all jobs (bonded and unbonded).
Because general contractors finance little of the overall work, sureties typically extend more capacity—about 20 times the working capital. For subcontractors that finance most of the work, sureties extend less capacity—about 10 times the working capital.
Exceptions exist, and often allowances are made for larger jobs and programs if there is a teaming agreement or if joint-venture partners present greater experience and cash flow. Some sureties provide bonding capacity for an under-capitalized small business if it teams with a financially stronger contractor. The teaming partner would be the subcontractor to the small business prime contractor.
Often, an escrow agent controls the funds from projects structured with teaming arrangements. The escrow agent receives the funds from the project owner, pays all subcontractors and suppliers first, and then pays the prime contractor its earned income. (Over-billings will not be paid until earned.) Such funds held in escrow are protected from outside claims.
If the teaming subcontractor elects to indemnify for the prime contractor in lieu of posting a bond for its portion of work, the surety will want to disclose the indemnity to the contracting officer if the project is part of any federally certified program, such as 8(a)
As for joint ventures, some sureties only provide bonding support if they bond both partners. Otherwise, sureties enter a co-surety relationship, and each partner bonds its own portion of work.
The joint-venture agreement should spell out the work to be performed by each party. For example, one joint-venture partner builds the shell and the other performs the interior work. Often the best joint venture is one that is organized as an LLC. Here, the equity in the joint venture will be reflected on the balance sheets of the participating companies as a line item called “equity in joint venture(s).”
However, under the rules of the U.S. Financial Accounting Standards Board’s
Generally Accepted Accounting Principles, if one joint-venture partner actually controls the joint venture, and the joint venture is deemed to be a variable-interest entity, the activities of the joint venture should be consolidated by the controlling partner, rather than accounted for under the equity method. Consider the SBA Bond Guarantee Program
An alternative surety resource for contractors is the Small Business Administration's (SBA) bond guarantee program, which is designed to enable bonding credit for all small business contractors by guaranteeing up to 90 percent of the bonded risk. Small businesses do not have to be a participant in the SBA’s 8(a) or small disadvantaged business programs to participate in the surety bond guarantee program.
The program now considers bonding joint ventures as long as the small business contractor performs 40 percent of the work. The SBA can only consider jobs of $2 million or less, and the sales volume cannot exceed the contractor’s NAICS code for small business. Under the American Recovery and Reinvestment Act of 2009, the SBA could consider projects as high as $5 million and up to $10 million if funded by the stimulus bill.
There are two types of SBA plans. The Prior Approval Program (Plan A) requires the bond account to be submitted to both the corporate surety and the SBA for approval. The Preferred Surety Bond program (Plan B) is for corporate sureties that maintain, underwrite and approve bonds on the SBA’s behalf.
Although the website www.sba.gov
provides examples and insights into teaming agreements, this type of agreement is not yet included in the SBA’s regulation. Therefore, the prime contractor must demonstrate past performance and be financially strong enough to support the project, or enter a joint-venture relationship.
Until the SBA program can consider larger jobs, small businesses will need to team and joint venture with large businesses. A small business will find it difficult to obtain its own bonding given the sizeable backlog large business partners may have accumulated. Until RFPs are issued with less onerous conditions and in a size small businesses can handle, it will be difficult for small businesses to break through the “Catch 22” and obtain adequate bonding support on their own.