Bonding and Finance - for Construction Companies

Bonding and Finance

By Tiffany Wright

This month, the finance article will take a different perspective. We will focus on bonding and how it affects financing. Next month we will discuss the impact of bonding and its requirements on an acquisition.

Bonding is NOT insurance. The purpose of bonding is to ensure that the project continues on or near schedule despite issues with performance or payment. The bond is there to provide assurance to the owner or general contractor that your company can and will fulfill its obligations as contracted. In the event that the bond is utilized, the bonding company expects full repayment for the amount utilized.

Bond companies need 10% equity (or higher) on the balance sheet. In order to show this, a company must retain a portion of its earnings each year. This retention is shown in the Stockholder’s Equity section of the balance sheet. If your firm has not previously retained earnings due to past losses or large shareholder distributions, one way to shore up the balance sheet is to inject your company with equity capital. This injection will show under Contributed Capital in this section. If you’ve made a Shareholder’s Loan to the company, you can quickly shore up your balance sheet by converting that loan to equity. Check with your accountant and attorney to make sure you document the conversion properly.

Bond companies also like to see 5-10% of the revenues in a line of credit (LOC) for a program. That way if you encounter a hiccup – cost overruns, slow payment by the owner or general contractor, disputed work – the surety can be assured that you have access to funding above and beyond your operational cash flow. This LOC will help you complete the work as contracted, thus reducing the risk that any use of the bond will be necessary.

It can get a little tricky here. Banks and other financial institutions will not provide an LOC against “bonded receivables”. Bonded receivables are those accounts receivables that are generated from contracts that required bonds. Why won’t banks lend against these? Because banks place liens on accounts receivables as collateral for the LOC and in doing so mandate that they are in the first position to obtain these receivables in the event of a default. However, with “bonded receivables” the bond company is in the first position. How do construction companies get around this? Most companies do not have 100% bonded contracts so those non-bonded receivables make good collateral. In addition, companies may utilize equipment, property, or other collateral or strong personal guarantees by its management to obtain or increase its LOC.

Many of you understand what a “bonding program” is but some don’t fully understand precisely how it works. Following are two examples to best illustrate what bonding agents mean when they discuss a “program”.

Example 1: Company A has $12 million in annual sales and that revenue is generated from two large $6 million projects. Project 1 yields $6 million for the January – June period and Project 2 yields $6 million for the July – December period.  Assuming that both jobs/projects are fully bonded, this equates to a $6 million bond program. (This $6 million is the per project maximum bonding capacity.)

Example 2: Company B also makes $12 million in annual sales. However, that revenue is generated from a number of small jobs with an average size of $150,000 - $300,000. In any given month projects are beginning and ending, with the overwhelming majority of jobs lasting only 3-4 weeks. The average monthly revenue from these jobs is $1 million. Assuming all jobs are fully bonded, this equates to a $1 million bond program. (This $1 million is the per project maximum bonding capacity.)

A complete program is typically denoted as “per project maximum” over “aggregate bonding” program. I.e., a “2 over 4 program” would be as follows: per project maximum of $2 million; aggregate bonding of $4 million. Aggregate bonding refers to the maximum amount in total outstanding bonds the company can have. Remember that, as a project is completed the exposure decreases and accordingly, the bonding required for that project decreases.

Other things bonding companies look at to determine the bonding program are the list of jobs on hand and the year in perspective. Does the company average jobs of $200,000-$300,000 but occasionally garner projects of $1.5 million? Is there a large job that’s scheduled to commence in a couple of months? Assuming the larger projects are also fully bonded, the bonding program should reflect this pattern otherwise the construction company would have insufficient bonding capacity on a per project basis to cover the larger projects. Consequently, bonding agents look at the spectrum of jobs performed and anticipated for the year and those from the previous year, the contract value of each job, and the length of each job.

Bonding companies seek a 3:1 debt ratio on the balance sheet. Therefore, whatever you can do to decrease your debt will improve your ratio. As stated previously, you or an investor or partner can inject equity capital. You can pay off a term loan. You can restructure existing loans. However, bonding companies can tailor the bonding program to fit the balance sheet. If all your jobs are fully bonded, this could pose a problem. If only some of your projects are bonded, the tailored bonding program may meet your needs.

In addition to SBA-guaranteed bonds, another way for up and coming companies who have had difficulty procuring bonding to obtain some bonding capacity is through 3^rd party indemnities. These can be provided by the seller if you are buying a company, by an investor, or by a joint venture or other partner.

Bonding companies strongly prefer reviewed financials. Of course, if they can get audited financials, that is the strongest preference but bonding companies understand that the cost difference between audited and reviewed financials is significant – often several thousand dollars. For a long-term customer, bonding companies may take CPA-compiled statements. However, when that customer seeks more steady bonding or presents a weaker balance sheet, the bonding company will want to switch to reviewed financials. With reviewed financials, the bonding company can be certain that the financials presented to them are accurate and reflective of the company’s true condition. Why audited or reviewed? With Quickbooks only data, a company’s owner or CFO may add false data, delete information, or manipulate timing to make their statements look better. Or they may simply make mistakes due to unfamiliarity with generally accepted accounting principles (GAAP). With no credible outside source (CPA) reviewing the information, the bonding company cannot be certain. CPAs and their accounting activities are regulated. Private company owners and CFOs are not. (Of course, outright fraud is always illegal but can be difficult to prove unless glaring.)

Most bonding companies like personal guarantees or other guarantees to 100% of the bond. Remember, bonding is NOT insurance. Bonding, unlike insurance, is not a risk product. Bonding’s purpose is to ensure that the project continues with minimal hiccups as smoothly as possible. In the rare instance that the bond is called upon to pay, the bonding company expects full reimbursement of their payouts, up to the bond limit. In general practice, if the bond company must pay out, to the extent that it was their customer’s fault through overt negligence or fraud, the bond company will pursue full repayment. To the extent that it was not their customer’s fault AND the customer helps them as much as possible to mitigate the payouts, the bond company will pursue only partial repayment.

All rights reserved.© Tiffany Wright is President of Toca Family Business Services, a strategic advisory firm that provides interim CEO and CFO services, and the publisher of Equal Construction Record. She is the author of Solving the Financial Equation: Financing Solutions for Small Businesses, available at Amazon.com or  www.tocafamilypublishing.com. Please contact her at twright@equalconstruction.com.