A performance bond provides a security to an obligee in a project. During a project, a contractor obtains the bond, which acts as a guarantee that the work will be furnished by adhering to all agreed terms and conditions specified by the client.
A performance bond typically involves three parties, viz., the principal party or the contractor, the obligee who is protected under the bond, and the surety provider who issues the bond. When the obligee, also called the employer demands the performance bond prior to a project from the contractor, it essentially implies that the obligee wants a security that there will be no violation to the terms and conditions and set guidelines.
Apart from structural guidelines, which include design and description of the project, the bond also ensures that the contractor will work within the budget and finish the work within the stipulated time. If the contractor finishes the work without violating any of the terms and conditions, then the performance bond becomes ineffective and has no further significance.
However, if the contractor fails to meet the guidelines and that results in a loss for the owner, the surety company will compensate, either by paying for the financial losses or by hiring another contractor and will ensure that the job is completed.
Performance bonds ensure that the financial standing of the contractor has been evaluated so that the contractor does not declare insolvency in between the project. The surety company will analyze financial statements, cash flow, working capital, and net worth to prequalify the contractor. It also scrutinizes prior works undertaken by the contractor and their completion status, equipment and human resource required to execute the project, and verify the contractor’s relations with suppliers, project owners, and everyone else associated with projects.
A performance bond is not an insurance, it is a three-party agreement that a project will be completed as per the contract documents, and in the event of a violation of terms and conditions, surety company steps in to ensure that it does not impact the project.
It is advisable that the contract details and the terms and conditions are specified clearly prior to the commencement of the project, and the responsibility, understandably, lies with the owner to furnish the details of the project so that the surety company can evaluate every aspect correctly. Performance bonds, in short, are a protection for an obligee against any default by the contractor and it also helps the contractor obtain a project.