Performance bonds are a subset of contract bonds and guarantee that a contractor will fulfill the terms of the contract. If they fail to do so, the Surety company is responsible for completing the contract obligations, either by securing a new contractor to complete the job or by financial compensation.

It is a type of contract construction bond that guarantees a contractor will complete a project according to the terms outlined in a contract by the project owner, also called the obligee. The obligee can be a city, state, or local government, as well as the federal government or a private developer. One reason these bonds are often required for public projects is to ensure hired contractors are financially and professionally capable of completing the projects they bid on. Surety bond companies that are willing to bond a particular company for a project are, in essence, vetting the contractors capability of completing the specified project on behalf of the project owner.

How Does a Performance Bond Work?

There are three parties fundamental to a performance bond:

  • Principal – The contractor or business entity performing the construction project. The principal must pay the upfront performance bond cost, pay to have the bond renewed, and repay the surety for settling any claims filed against the bond.
  • Obligee – The party that hires or contracts with the principal to perform the job. This is the party that details the surety bond requirement and the one that benefits from any claims filed against the bond.
  • Surety – The financial institution that guarantees that the principal’s obligations will be performed. The surety company agrees to guarantee payment for valid claims up to the total surety bond amount. Sureties are similar to (sometimes divisions of) insurance companies.

 

Each party described above plays a role in any performance bond claim. For example, a project owner (the obligee) may require that a general contractor (the principal) provide a performance bond to win a contract. If the principal fails to perform their duties, the obligee may call upon the surety to pay compensation out of the performance bond. These payments are for damages up to the bond’s limit.

In the same way, a general contractor obligee may require a subcontractor to provide a performance bond to secure a subcontract. If the principal fails to perform their duties under the subcontract specifications, the obligee may call upon the surety to pay damages out of the performance bond up to its limit. When subcontractors provide performance bonds to general contractors, it is also called “bonding back.”