Most contractors obtain their first bonds through “Fast Bond” programs that are based largely on the owner’s personal credit score. These programs are great for newer companies or those that only obtain bonds infrequently.
Contractors can obtain single bonds up to $500,000 with these programs, however they come with a relatively high rate (2.5% to 3%).
To grow the size of bonds you can obtain and also lower your rate, you will need to transition to a standard surety program. Each surety carrier has a different approach to this process, but there are some common steps that will help improve your bonding program, and ultimately make your company more resilient.
Financial Reporting
The biggest hurdle, but also the most impactful step, is to continually improve your financial reporting. Most contractors start off with a part-time bookkeeper that may only have a basic understanding of construction accounting. This is understandable, as it is expensive and difficult to hire a controller or CFO, but unless your bookkeeper can reliably produce monthly financial statements that utilize the percentage of completion method of accounting, your bonding program will be limited.
Instead of struggling with in-house accounting, we recommend hiring a third-party bookkeeping service or a fractional CFO. These firms/individuals can produce accurate balance sheets and income statements, and provide consultation on your work-in-progress schedule.
Separately, you should engage a construction-oriented CPA firm that will provide an independent assurance of your year-end statements. There are three levels of assurance: compilation, review, and audit. Companies with revenue under $5 million should have compilation statements, and between $5 million and $50 million, reviewed statements will suffice.
This is a stopping point for many contractors. They see the price tag of a bookkeeping service and CPA-prepared financials but cannot rationalize the cost. There are significant benefits however.
Your bonding rate will drop, costs for software can be avoided/deferred, and your bank will also provide better terms on loans and lines of credit (see below). Most importantly however, the management team will be able to make better strategic decisions with consistently produced financial statements. Your company can improve on many levels, including hiring/firing, job selection, risk management, and identification of growth opportunities. Finally, when you look to sell or transition your company to key employees, financial statements will be essential for proper valuation.
Bank Support
What does your banking relationship look like? You have a corporate checking account, and you may even have a business savings account, but is that the extent of your relationship with your bank? To move beyond fast bond programs, establishing a strong banking relationship is crucial.
Your next step should be obtaining a working capital line of credit. Having a reliable line of credit in place can make your company more resilient during challenging times and also demonstrate your financial strength to surety underwriters. We recommend having an available balance of approximately 10% of your total revenue. It can take 90 to 120 days for banks to underwrite and process a line of credit application, so the time to start is now.
Efficient cash management is another aspect where your bank can play a pivotal role. With the right banking tools and services, you can streamline your cash flow, and optimize the use of your funds. With money-market rates around 5%, it is possible to generate positive returns from overbilling your clients while still adhering to your vendor payment terms.
Key Performance Indicators (KPIs)
Lastly, it’s essential to develop a set of Key Performance Indicators (KPIs) specific to your construction business. These are the metrics and financial indicators that will help you assess your company’s financial health and performance. Common KPIs in the construction industry include current ratio, debt-to-equity ratio, and profit margins (and fades) on various project types. Tracking these KPIs will not only help you manage your business more effectively but will also demonstrate your financial stability to surety underwriters.
Most surety underwriters place the largest emphasis on analyzed working capital. This figure is calculated by subtracting Current Liabilities from Current Assets, less Prepaid Expenses, A/R over 90 days, and a portion of Underbillings. As a general rule, your analyzed working capital position should be more than 10% of your total outstanding bonded liability.
That said, some underwriters focus more on Equity, and include the owners’ personal net worth in their analysis. Also, how your underwriter calculates your outstanding bonded liability (e.g., Cost to Complete) can differ. Understanding your underwriter’s specific approach to assessing your KPI’s can help you improve your program.
In conclusion, transitioning from fast bond programs to standard surety programs involves improving your financial reporting, establishing a robust banking relationship, and understanding the KPIs that demonstrate your company’s financial stability. While these steps may involve some upfront costs and effort, the long-term benefits, including lower bonding rates, increased capacity, improved decision-making, and enhanced business resilience, are well worth the investment.
