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Performance Bond and Payment Bond Case Study

Performance and Payment Bond Case Study. This is an image with a house under construction with Performance and Payment Bond Case Study on It.

Although residential construction is rarely bonded, we are going to look at a case study of what it may look like to provide a performance bond and a payment bond for a high end home build. Our completely made-up couple, “The Bradys” are looking to build a very expensive custom house and will require the contractor to post surety bonds. This case study is for educational and entertainment purposes only. The companies, underwriting information and figures presented in this case study are completely made up for the benefit and education of the readers. Satire is intended.

This is meant to be a real case study into how professional surety bond brokers and their customers can work together to obtain surety bonds. I hope it is educational to contractors, students and other parties interested in learning more about contract surety.

The Customer:

 

Gronk Builders has approached MG Surety Bonds about building a house for Mr. and Mrs. Brady. The contract price of the home is $40 million and the Bradys are requiring a performance bond and payment bond on the project. The project will start in June and it is currently March. Gronk Builders has been told by his bond company and agent that he does not meet their qualifications for a contract of this size based on the company’s working capital and experience. Gronk knows this would be an excellent project for their company. They know the Bradys well and would be embarrassed to tell them that they cannot bond the project. We ask Gronk for standard underwriting information that include 3 years of CPA prepared financial statements for the company, a contractor questionnaire, resumes on key people, a copy of their bank line of credit and a personal financial statement. Gronk happily complies. Let’s look at Gronk Builder’s Balance Sheet.

This is the first balance sheet in our performance and payment bond case study for Gronk Builders

A quick review of the balance sheet shows that Gronk Builders is a strong company. They have strong cash balances and very little interest-bearing debt. They do have a significant portion of their assets in Accounts Receivable, Inventory and Underbillings, however. Now let’s look at the income statement provided by Gronk Builders.

This is the income statement for our performance and payment bond case study

We see from the income statement that Gronk is profitable and makes money on their work. They can handle a large workload. However, they are asking for a $40 million bond which is larger than their entire revenue for last year. This will scare off many surety bond companies. Next let’s look at the work schedules. Gronk Builders had no completed projects last year.

Work In Progress Schedule for Surety Bond Case Study

Finally, Gronk Builders has informed us that they have a $500,000 line of credit with their bank. It is secured by receivables and all company assets. They have been with the same bank since the company started and enjoy a great relationship. The owners of Gronk Builders do not sign personally for the bank and their preference would be to keep bonding the same. As such, no personal financial statements were provided. You can read more about the importance of bank lines here.

The Problems:

Working Capital – If you remember, Gronk Builders was turned down by their agent and surety bond company because of lack of working capital and lack of experience. Let us look at why this is a common problem with underwriters and unsophisticated surety bond agents.
Working Capital: Back to Gronk’s balance sheet. I am adding a column to the right that shows how a surety underwriter analyzes these line items.

This is the first balance sheet in the case study as analyzed by a surety underwriter

Most underwriters will eliminate or discount items that cannot be easily converted to cash. They will eliminate Accounts Receivables over 90 days old because they may not be collectible. They will also remove Accounts Receivables from Owners of the Company. Inventory is usually discounted by 50%. The thought process is that it may either be obsolete or must be sold at a discount, if liquidated. Underbillings are often severely discounted or written off completely as contractors often hide losses in their underbillings. These are often unapproved change orders. If contractors have earned the money, they should bill for it. You can read more about that here. You will notice that no discounts were applied to the liabilities as those are obligations that will be due.

Working Capital is simply a company’s current assets minus the company’s current liabilities. It is an indication of how easily a company can satisfy its immediate obligations. Most surety bond companies are working capital oriented. That means they will base a contractor’s bond capacity of a multiple of analyzed working capital. Often, standard practice for a general contractor is to multiply analyzed working capital times twenty. Notice what happens to working capital in our analysis. Gronk Builders’ CPA statement shows working capital of $1,750,000 (Current Assets of $2,400,000 – current liabilities of $650,000). However, in the surety’s analysis, that number drops to $1,300,000 ($1,950,000-$650,000). That is a significant drop for our contractor and their bond capacity. If we use the twenty times rule, Gronk Builders qualifies for about $26,000,000 in bond capacity ($1,300,000 x 20). This is far short of the $40,000,000 they need to bond the Brady’s house. There is another problem as well. Gronk Builders already has existing work it needs to complete. This backlog needs working capital too. A bond company will factor in their current cost to complete in addition to the new work. Looking at the Work in Progress schedule provided by their CPA, we see that they already have $5,900,000 in backlog.

Work In Progress Schedule for Surety Bond Case Study

Contractors and surety bond underwriters look at backlog differently. Bond companies look at either cost to complete or left to bill. However, the majority look at cost to complete so that is our assumption here. We get the cost to complete by taking the Total Cost and subtracting Cost to Date. In our example above, that means Gronk Builders has $5,900,000 in backlog already before adding the Brady home. Using our twenty times rule, many bond companies will want Gronk Builders to have $295,000 of working capital for the work they already have under contract in addition to what they will need for the new work.

Experience:

Gronk Builders tells us that the largest project they have previously completed is an $17 million home for the Marinos in Miami. This is a challenge for a couple of reasons. First, many surety bond companies are only willing to bond a project 2 times as large as the biggest project a contractor has previously completed. A lot of extra risk comes in managing larger projects. It requires more cash, often more subcontractors and supervision. Bond companies prefer to see a gradual increase in a contractor’s project size. They like to see completed projects schedules showing success and profits on such projects. The second problem that we discussed earlier, is that the $40 million Brady project would be significantly larger than Gronk Builders’ total income from last year. Many surety bond companies will balk at this. They view it as a big risk and a contractor putting all their eggs in one basket. One problem could put the company out of business.

The Surety Bond Underwriting:

At this point, MG Surety calls Gronk Builders to tell them we have looked at the information and we have questions. We ask Gronk for the following:

  • We need a job cost breakdown of the Brady project. This should include estimated overhead, profit, labor, subcontract amount, material and any equipment needed. It should also include a list of estimated subcontract amounts.
  • We ask Gronk about the project. How long until completion? Who will run the job? Will you need to add any additional labor? Are there any damages? Retainage? Is the financing in place? How does this job compare to the Mahomes project and other projects they have done?
  • We ask Gronk what he used to bid the project and if a bid bond or letter of credit was required.
  • We ask Gronk about the contract and bond forms required by the Brady’s.
  • We ask Gronk about his bank line. How much is currently borrowed and available? Would the bank be willing to increase his bank line of credit? This could be important for financing the project until he gets paid by the Brady’s or could give them cushion if there is a problem.
  • We ask Gronk about his current projects. Are Rodgers and Manning now complete? Did profits hold up? How is Mahomes going? Why was there an underbilling on the Manning project and has it been billed and collected? How much of the Mahomes project will be left in June when the Brady project starts?
  • We ask Gronk about other work that he will need in addition to the Brady project.
  • We notice that Gronk Builders has a high-quality Reviewed Financial Statement from a reputable construction CPA. We ask Gronk about his internal systems for estimating and accounting. Further, we ask Gronk if we can get an internal statement for the current year.
  • We ask Gronk about his $500,000 in inventory and what it is.

Gronk’s Response:

  • Gronk tells us the project should take 18 months to complete and that Liquidated Damages of $500 per calendar day are assessed after that. He said they will have no problems hitting that time frame and depending on the weather could be done 60 days sooner. Gronk told us that retainage is 5% and they will use cash or their bank line to finance their part. He told us they would also hold 5% on their subcontractors. Gronk says that the Bradys are using bank financing and that the loan has been approved and is in place.
  • Gronk tells us that the house is similar in size to the Mahomes project. He said the project has some very specialized items that have added to the cost. He said the Bradys have specified that all cabinets and wood products be made of avocado wood. It is very expensive as most carpenters do not use it. Gronk also said the Bradys have a full-size football field in the backyard which is adding to the extra cost. He has also specified a large trophy room to hold his championship trophies. This room will have high end security and twenty-four-hour surveillance. Finally, Gronk said another difference is the secondary guest house that includes a very high-end yoga studio. Gronk does not have much experience with this and they will sub out this scope of work. Other than these items, the other construction is in line with the high-end homes that Gronk normally builds.
  • Gronk says his key superintendent Wes Edelman will be on the project along with senior project manager Julian Welker. They have been with Gronk for years and have plenty of experience dealing with high-end projects and tough conditions. They will self-perform the lumber and provide supervision. They do not anticipate needing to add any additional labor for this project. Gronk plans to have all his crew on this project until it gets to the trim stage.
  • Gronk says that this project was negotiated like all his projects. There were no other bidders and no bid security such as a bid bond was required.
  • Gronk sends over a copy of the contract and bonds forms. We are pleased to see that they are standard AIA bond forms. There is a one year warranty period.
  • Gronk tells us that they have paid down the bank line since year-end and currently owe nothing on it. He tells us that they have enjoyed a long-time relationship with the bank, and he believes they can increase the line if needed. In fact, his bank is always asking how they can do more business together.
  • Gronk tells us that both Manning and Rodgers are now complete. Both projects turned out to be very good for Gronk and the profits held on both. Gronk tells us that The Manning project specified a recording studio with some specialty equipment. Although Gronk had purchased and installed the equipment, they were not allowed to bill for it until the project was completed and it could be tested. Gronk tells us that it has since been billed and collected with no issues. The Mahomes project is going well and has about $3 million in cost left and will be down to about $1 million when the Brady project starts.
  • Gronk tells us that this project will keep his people and crews busy for at least 12 months. At that point, they may look to add another project while The Brady house is finishing up. The Brady project will cover his overhead for next year and they will be looking for work to cover the following at that time.
  • Gronk says they have good systems. They use a reputable estimating and project management software system. Their head estimator has been with Gronk since the company started and Gronk’s president reviews major bids for accuracy as well. Gronk’s controller is well versed in construction accounting. He came from a major CPA firm before Gronk hired him away. Gronk utilizes a construction specialist in Vinatieri Accounting for their CPA review and Vinatieri has long been known for their accuracy.
  • Gronk tells us that they do not normally keep inventory. He tells us that he got a year-end discount and therefore went ahead and purchased the lumber for the Brady home.

Gronk provides the following project breakdown. You can find a job cost breakdown form here if you need one.

Job Cost breakdown sheet

MG Surety Bonds’ Observations:

  • We notice that even though Gronk is passing the 5% retainage onto his subcontractors, he will need to finance $450,000 himself. He has a strong cash balance and an open $500,000 bank line. Still, we feel he should ask the bank for an increase in the line to give them more cushion.
  • $500 per Calendar Day is reasonable for Liquidated Damages. Liquidated Damages are preferable to Actual or Consequential Damages. Underwriter also prefer the contract to not be silent on damages so this is a positive. You can read more about damages and other tough contract terms here.
  • We notice that most of the subcontractors can put up subcontractor bonds for Gronk. We encourage Gronk to ask for bonds on all these subcontractors to protect the company and to reduce Gronk’s risk. Additionally, most surety bond companies want to see critical path subcontractors, specialty subcontractors or those with scopes of work over $300,000 to provide subcontract bonds back to the General Contractor. It appears that Kraft Specialty and Belichick A/V cannot put up subcontractor bonds. These are $7,000,000 worth of work and very significant to the project. We ask Gronk about those trades.
  • Gronk seems to have capable systems and people in place to handle the work.
  • We are pleased that the underbilling on the Manning Project has now been billed and collected. We can now add that back to our allowed assets.
  • The bond forms are fair to all parties.
  • We will want a copy of the loan or commitment letter showing that the financing is in place and the money set aside.
  • We are happy to hear about the inventory. Since this will go into the Brady project, it is not obsolete, and we are convinced that the surety bond company will give us credit for all of it.

Gronk’s Response:

  • Gronk says that his bank has agreed to double his bank line of credit to $1 million. Although he does not plan to use it, we feel this gives Gronk some nice cushion.
  • Gronk tells us that Belichick A/V cannot provide a subcontract bond. His previous company had a job go bad in Cleveland and now he cannot get surety bonding. Gronk tells us that since then, he has been nothing but successful. Gronk has called around and done references and he is told that nobody does surveillance like Belichick. He is widely regarded as the best in the business for this type of work and has successfully performed for Gronk on many projects. Gronk says that he can purchase the materials for Belichick and/or joint check if that helps.
  • Gronk then tells us that he has never worked with Kraft Specialty. They are a friend of the Bradys and they were specified as the subcontractor on the yoga studio. Gronk tells us that he has made some reference calls and Kraft Specialty has done a lot of this work in Florida. However, his references were not spectacular.

MG Surety Bonds’ Response:

  • We are very pleased about the bank.
  • We think Gronk’s proposal to purchase the material and joint check Belichick is wise.
  • We tell Gronk the subcontract with Kraft Specialty is very risky. It appears that part of the project could be separated nicely without impacting the rest of the project. We ask Gronk if the Bradys would consider making that a separate contract and removing it from Gronk’s scope of work. This makes sense given their relationship with the contractor and the easy separation. Gronk likes this idea.

Gronk’s Response:

Gronk reports back that the Bradys will separate the yoga studio into a separate contract with Kraft. This will be removed from Gronk’s contract.

In reality, we would ask for an updated internal statement but from a learning perspective, we will say that we have to use the 12-31 Balance Sheet Information.
Notice the changes:

Second Analyzed Balance Sheet Showing How a Surety Bond Underwriter will look at the account

Notice that that working capital (current assets – current liabilities) increased to $1,850,000. This is because we were able to add back the underbillings, 50% of inventory and the bank line was paid down. Also important from earlier is that the Manning and Rodgers projects are complete. Gronk only has $3 million currently in backlog and we can make the argument that it will be down to $1 million when the Brady project starts. We’ve also subtracted $5 million from the project by removing the Kraft portion. We see from the Job Cost Breakdown that Gronk has about $4 million on profit on this project so we will also subtract that from his cost to complete. The math looks something like this $40 million – $4 million (Gronk Profit) – $5 million (Kraft) + $1 million (Mahomes) = $32 million cost to complete. Remember, we said a good rule of thumb for a surety program is twenty times working capital. $1,850,000 X 20 = $37 million. Gronk now has the working capital to qualify with most sureties.

Now we must get by the experience issue. Because Manning is the largest project Gronk has completed, the Brady project is a little bit of a stretch. However, Gronk has given us plenty of reasons to believe that he can do it. First, he is very close to completing the $28 million Mahomes project which is similar in size but does not have the specialty items. Secondly, he has great systems and experience people capable of doing the work. Finally, he is significantly reducing his risk by bonding back most of the work. The only unbonded subcontractor is Belichick and Gronk will manage his portion through a joint check agreement. We decide it is time to submit to the surety bond company.

The Surety Bond Company’s Response:

The bond company sees the merit in Gronk. They feel like he is a qualified account deserving of surety bond credit. They have decided to approve the project with the following conditions:

  • A meeting with Gronk prior to issuing the Performance and Payment Bonds.
  • All subcontractors except Belichick provide subcontract bonds back to Gronk.
  • Gronk will buy Belichick’s material and establish a joint check agreement for the payment of his labor. Additionally, they would like to run a background and credit report on Belichick to make sure there are no other outstanding issues.
  • The surety bond company will require a copy of the Brady’s commitment letter from their bank showing that financing has been approved and is in place.
  • The bond company would like a current internal statement and Work in Progress report before releasing the Performance and Payment Bonds.
  • The bond company would like Gronk to agree to a $10.00 rate which is as follows:

Bond Rate Sheet Example

Based on the rates, the cost of the performance and payment bonds would be: $186,250 The calculation is below:

($500,000/1,000) x $10.00 = $5,000
($2,000,000/1,000) x $7.50 = $15,000
($2,500,000/1,000) x $6.50 = $16,250
($2,500,000/1,000) x $5.00 = $12,500
($27,500,000/1,000) x $5.00 = $137,500
Add These All Together = $186,250 Total
We also provide an easy bond premium calculator which can be found here. An example of this is below:

 Bond Premium Calculator for our case study

 

Our contract included one year of warranty. This is included by most surety bond companies at no cost. If the warranty or maintenance period exceeded twelve months, we would use the same formula above and substitute our maintenance rates. This would be added to the base premium.

Additionally, this project will take 18 months to complete. Most bond companies have a completion time surcharge. Some start this on projects over 24 months and some on projects over 12 months. Usually this is something close to 1% surcharge for each month over the given period. For our case study, we did not include a completion surcharge. IF there were a 1% surcharge over 12 months, it would be calculated as such:

18 months – 12 months = 6 months. 6 mo. x 1% = 6% surcharge. Total premium (‘$186,250) x 1.06 = $197,425.

Conclusions and Takeaways:

We were able to get Gronk Builders approved for performance and payment bonds on the Brady House project. Fortunately, everything fell into place easily, but that is rarely the case in contract surety. What if it had not? Are there other things we could have done? My mentor, teacher and friend always told me, “Surety is an art, not a science.” This is true because there are so many variables and ways to accomplish an approval. A few examples include:

  • Gronk had a lot of room on their bank line of credit. Could we have asked them to borrow against this and loan it to the company to create working capital?
  • Gronk shows no building or office on their balance sheet. Is it possible that another company exists that holds this asset? Could we have included that on our indemnity package to strengthen the case?
  • Gronk does not sign personally for the bank and asked not to for the bond company. Could we have asked for limited person indemnity until he completed this project?
  • Could this project have been phased to allow us to bond smaller amounts more in line with Gronk’s experience?
  • This was Gronk’s largest project, could we have asked for funds control, collateral or other “tools” to reduce the risk to the bond company?

The point is there are many ways to find bond solutions for both contractors and surety bond companies. The key is working with an experienced bond broker who understands construction, finance and surety bond underwriting. These bond professionals are more rare than you might think. We hope you have enjoyed this case study and found it useful. We are always happy to educate contractors, students and others on surety bonding. Please feel free to reach out to MG Surety Bonds anytime.