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.
