On most major construction projects, work is awarded through a process known as bidding. Here, contractors submit prices for the job to the project owner. The contractor with the lowest price is typically awarded the job. Many owners will request that a bid bond be submitted along with the proposed bids. This bid bond acts as a guarantee that the contractor will honor their bid, and will sign a contract for the project at that amount if they are the low bidder. Bid bonds are backed by financial and insurance brokers, and typically cost the contractor a small percentage of the full contract amount.
How Bid Bonds Work
During bidding, various contractors estimate what the job will cost to complete. They submit this price to the owner in the form of a bid. The lowest bidder will be awarded a contract for the job. If this bidder realizes they made a mistake with their bid, or refuses to sign the contract for any reason, the bonding company will ensure the owner suffers no financial loss. This usually means that the bonding company will pay the owner the difference between the lowest and next lowest bids. Sometimes, the bonding company may sue the contractor to recover these costs. The possibility of lawsuits depends on the terms of the bond.
Purpose of a Bid Bond
The purpose of the bid bond is to minimize risk to the owner during bidding. It helps keep contractors from submitting frivolous bids, because they would be obligated to perform the job, or to at least pay the bond premiums. Bonding also ensures that all bidders are financially sound. This is because bond-issuing companies perform comprehensive credit and financial reviews before agreeing to provide bonds for a company. Bid bonds keep contractors without strong financial backgrounds from bidding.
Bid Bond Requirements
Construction bonding became widespread during the late 19th century. During this time, the federal government found that many contractors who were hired for projects were going out of business before the project was complete. In 1894, Congress passed the Heard Act, which authorized the use of bid bonds on federal projects. This Act was updated in 1935 with the passage of the Miller Act. Under the Miller Act, which is still the standard today, all bidders are required to submit bid bonds on any federal project. Many private firms have copied this trend to protect themselves from risk during the bid process.
How Bid Bonds Effect Contractors
Bid bonds can have a significant effect on contracting companies. Most companies are rated by their bond-issuers for a certain amount of bonding. The value of this rating, called "bonding capacity," is based on financial strength, company history, and credit information. A company must carefully monitor its bonding capacity when determining which jobs to bid, as bidding multiple jobs at once may mean the company will not be able to provide bonds. In addition, it can be hard for newer contracting companies to obtain any type of bonding, as they have too little time in the industry to show historical performance. To allow newer companies to bid when bonds are not available, the Miller Act allows the company to post a cash deposit of 20 percent of the bid in lieu of a bid bond. All bid bonds or cash deposits are returned after bid opening, or once a contract is signed.
Other Types of Bonds
It's important to understand the differences between bid bonds and other types of construction bonds. The Miller Act requires that all contractors on federal projects provide bid bonds, performance bonds, and payment bonds. Most private owners will also require these same three bonds from contractors. Bid bonds guarantee only that the contractor will sign a contract for the job, not that they will complete the project. Performance bonds guarantee that the contractor will complete the project according to the contract, using agreed upon materials, methods, and schedules. Payment bonds protect both the owner and subcontractors. These bonds guarantee that subcontractors will be paid even if the general contractor goes bankrupt, or fails to complete the job. These payment bonds are necessary because they protect the owner from liens and lawsuits if the general contractor fails. They are also vital on federal jobs, because liens cannot be placed on government property or projects.