What is backlog and why is it different to your surety bond company? My experience has taught me that in order to be a good surety bond agent, you need to be able to translate. Unfortunately this has nothing to do with those foreign languages classes I took in High School. No I’m talking about being able to speak the language of both contractors and surety bond underwriters. One great example of this is talking about backlog. Backlog means different things to different people and we’re going to discuss how your surety bond underwriter looks at backlog and how you can use it to maximize your surety bond capacity.
Most of the time when I talk to contractors, they refer to backlog as the total dollar amount of projects under contract but not completed. Some contractors include both projects under contract and projects in the pipeline, which can be problematic. I have had contractors talk about having $100 million in backlog when in reality they were awarded a very small percentage of that work. That is a great way to scare off a surety bond underwriter. Most surety bond companies however, refer to backlog as either Cost to Complete (CTC) or Left to Bill (LTB). Although these may not sounds like big distinctions, they can have a serious impact on your surety bond credit. Let’s look at the example below:
Let’s assume a contractor has $500,000 of working capital, makes 5% gross profit, has $10 million of uncompleted contracts that have not started and is on a 5% case with the surety bond company. How much additional work will they be allowed to take on?
- Contractor Definition – By the contractor’s definition, they are full. $500,000 of working capital x 20 = $10 million. They have no room to add new work.
- Cost to Complete – By this definition, the contractor can still add another $500,000 in work because we can subtract their profit from the backlog. The reason being is that it is not a cost.
- Left to Bill – Left to Bill can be a method for contractors with good billing practices. Although more difficult to illustrate, assume that a general contractor has a good practice of overbilling at the start of the project. This would reduce backlog and therefore allow them to get more surety bond credit. When surety bond capacity is tight, this small difference can make a significant impact. However, the inverse can also be true. A subcontractor who routinely under bills may be hurt by this method. Their costs have decreased but their billings have not caught up so they would have less surety credit.
Tricks of the Trade
Bonded vs. Unbonded Backlog
Now let us take a minute to talk about bonded backlog and non bonded backlog. Most surety bond companies will look at your total backlog using one of the methods discussed above. However, some will give you surety bond credit for bonded work only. The thinking with these companies is that if a problem arises, the contractor will make sure the bonded work is taken care of first. This makes sense given that the contractor is responsible for indemnifying the surety bond company for a loss. This philosophy has even more teeth when the owner(s) are personally indemnifying. So how can contractor use this to their benefit? Let’s use the example above. Let’s say the contractor wants to add an additional $5 million project. That would not be possible if we are counting all Cost to Complete or Left to Bill backlog. However, if much of that work were negotiated or unbonded, a surety bond company that looks only at bonded work may be willing to support the additional work.
A good bond agent should be able show run off to maximize your surety bond credit. For example let us say in the example above that the contractor is full on work at $10 million. It would be great if they could simply replace the work as it runs off. Unfortunately, we all know that is not reality. They may want to bid that $5 million job right now. What if it does not start for 6 months though? Your bond agent should be able to translate your runoff to the surety bond underwriter so that you can squeeze this job in your program.
I am often asked how surety bond companies look at bonded subcontractors. The answer unfortunately is not straight forward. Of course they like to see contractors get performance bonds and payment bonds back from subcontractors and suppliers. It is a great risk management tool. In my career I have seen countless great construction companies get hurt by subcontractors who were having difficulties. These subcontractors can quickly turn great jobs into bad ones. It only makes sense to consider how much of your backlog is bonded back to you. The truth is that it matters but it is not dollar for dollar. In other words, you typically will not pick up another dollar in surety bond capacity for each dollar in subcontract that you bond back. It will however, play a significant role in the surety bond underwriter’s decision to stretch the program and approve additional work or a large project. My experience shows that a contractor that regularly requires bonds from their subcontractors will not only build a lot of trust with the surety bond company, but they also get significantly more surety bond capacity.
Effectively understanding backlog and translating it between contractor and underwriter is key to providing a great surety bond program. The more contractors understand about this process, the better they can present their companies. I will not give away all my strategies but good bond agents can be an invaluable resources when trying to maximize surety bond capacity and opportunities.