Surety Basics 2013 Construction Opportunities Conference Phil Condra- Bonds Southeast, Inc. 2013 Construction Opportunities Conference Tennessee Small Business Development Centers February 26th, 2013 Oak Ridge, Tennessee

What is Surety Bonding? Principal Obligee Surety (Contractor) (Owner) A surety bond is a three-party agreement where the surety company assures the obligee (typically the project owner) that the principal (most often the contractor) will perform a construction contract. Surety bonds in construction are referred to as contract surety bonds. Surety bonding is a careful, rigorous, and professional process in which surety companies prequalify contractors and then assure project owners that these contractors are capable of performing the contract according to its terms and conditions and that they will pay certain laborers, subcontractors, and suppliers associated with the project.

Suretyship vs. Insurance Principal / Insured Insurer Policy = Two Party Contract Surety Principal Obligee Bond = Three Party Agreement Contract/Obligation Page 3

Insurance vs. Suretyship Premium paid by Principal and the Obligee derives the benefit Bond obligation dictated by law or underlying agreement Underwrite to zero loss ratio Premium covers expenses not losses Non-payment of premium does not negate coverage/bond still in force Similar to obtaining bank credit Risk is NOT transferred from Contractor / INDEMNITY CERTAINTY “Hope it’s not covered” Insurance Premium paid by Insured (Principal) and the Insured derives the benefit Coverage drafted by Insurer and filed in various states Law of large numbers Expect premiums to cover losses Non-payment of premium may terminate policy CHANCE/ PROBABILITY “Hope it’s covered” Page 4

Types of Surety Bonds Bid Bond Performance Bond Payment Bond There are three basic types of contract surety bonds. The first is the bid bond which provides financial assurance that the bid has been submitted in good faith, that the contractor intends to enter into the contract at the price bid, and that the contractor will provide the required performance and payment bonds.

Types of Contract Bonds- Bid Bonds Guarantees that the bidder will actually enter into the contract at the proposed price and provide the required performance and payment bonds. Performance Bonds Indemnifies the owner for financial loss caused by the contractor's failure to perform the contract in accordance with all the terms and conditions of the contract. Payment Bonds Guarantees that the surety will pay for certain labor, material, and supply bills and subcontractors associated with the project if the contractor fails to pay these costs. Supply Bonds Guarantees that the supplier will provide a specified amount materials in a specified time frame. Page 6

Functions of Bonds REQUIRED BY LAW No liens Smooth transition from construction to permanent financing Provide support to contractor Project completion Surety Bonds Surety bonds relieve the private project owner from risk of financial loss arising from liens filed by unpaid subs & suppliers and protect taxpayer dollars on public projects. In the absence of liens, the transition from construction to permanent financing is much smoother. If the contractor requests help, the surety may offer technical, managerial, or financial assistance. This may help the project move forward and significantly reduce the likelihood of default. Should the contractor default, the surety arranges for project completion.

Underwriting- (The YES or NO’s) _ Capital Financial Statements Indemnity Working Capital Work-in-Progress Capacity Resumes Experience/ Previous Project Contingency Plan Business Plan Equipment Character Reputation Relationships References In terms of character, the surety wants contractors with good reputations. The surety expects the contractor to have established, positive, and ethical relationships with subcontractors and suppliers, owners, and lenders. In addition, the surety underwriter may look closely at the project’s contract terms and the contractor’s contract review process, liquidated damages, warranty requirements, and the owner’s performance history. The underwriter may also review the contractor’s subcontractor and supplier selection criteria. Successful contractors leave nothing to chance. They have a clearly defined business plan, know their costs, have financial controls in place, and can compile accurate forward-looking financial projections. Sureties check references with bankers, CPAs, owners, architects, suppliers, and subcontractors.

1 C = CAPITAL Working Capital Net Worth Debt : Equity Bank- Line of Credit Aging of Accounts Receivable

Financial Statement Analysis Opinion Page Balance Sheet Income Statement Financial Statement Analysis Cash Flow Statement Background Investigation Account Schedules Financial statements are vital to any business that grants credit, and sureties are no exception. Depending on how long the contractor has been in business, the surety will want to see fiscal year-end statements for the past 3 to 5 years. The financial statement should include: Accountant’s opinion page, which discloses whether the statements were prepared according to audit, review, or compilation standards. Balance sheet, which shows assets, liabilities. and net worth of the company. This helps the surety assess the working capital and overall financial condition of the construction company. Income statement, which measures how well the business performed. The surety will asses gross profit on contracts, operating profit, and net profit before and after tax provisions. Statement of cash flow, which discloses the cash flow movements from operating, investing, and financing activities. Accounts receivable and payable schedules Schedules of work in progress and contracts completed, which show the financial performance of each contract and provides insight into the potential for future earnings from contracts in progress. A schedule of general and administrative expenses, which reveal how well overhead expenses are controlled and managed. Explanatory notes that the accountant may have included with the financial statement. Explanatory Notes Contract Schedules Financial Statement Page 10

2 Different Surety Approaches WORKING CAPITAL Underwriting (Majority View) Vs. NET WORTH Underwriting

Surety Evaluation Good character Experience matching contract requirements Necessary equipment Financial strength History of paying subs and suppliers on time Bank relationship Established line of credit

SOURCES for Surety Bonds Traditional sureties Traditional Underwriting OR (Short form applications/ credit based) Smaller bond size Specialized sureties (Collateral based/ Funds Control) SBA program (Surety Company backed by government for majority of any loss)

Underwriter’s Warning Signs Slow Accounts Receivable Inability to Forecast Cash Flow Past Due Bills PROFIT FADE Bank Lines of Credit Exhausted/ Non- renewed Continued Operating Losses Bid SPREADS New (expanded) Geographic Territory / Scope of Work

Advice for Today's Market Contract terms Bond forms Construction CPA Adjust overhead Bank line of credit Conserve capital Bond subcontractors CPA, Surety, Legal Contractors Understand the contract and look for effective and equitable contract language Read the bond forms and watch for onerous terms. Use a construction-oriented CPA Don’t “buy” a job to keep employees busy – adjust overhead and maintain profit margins. Bid the job, not the competition. Have a bank line of credit available to support the company’s business plan Conserve capital – stay liquid Do what you do best. Protect your top talent, who will manage projects well no matter what the market conditions are Procure materials and lock in prices whenever possible Bond subcontractors – requiring bonds on subs is an effective way for contractors to manage risk on projects. Subcontractor bonding policies should also be established – especially in today’s economic climate. Subs should be bonded when: they represent a key trade to the project or a significant portion of the work; they are the sole source for anything; or when the contractor is unfamiliar with the subcontractor. Qualify the surety by contacting your state insurance department.

Advice for Today's Market Know rights & responsibilities Stay within capabilities Show Me The Money Manage growth & overhead Learn why contractors fail Communicate & Communicate & Communicate “DRIVE THE BOAT” Prepare for the next “Boom” Contractors Contractors do have rights and responsibilities to owners, creditors, and others. In addition, contractors need to understand the surety’s rights and responsibilities toward them and the owner. Accurately assessing one’s capabilities speaks for itself. It’s important to look at operating profitability and completing contract profitability. Construction accountants typically use percentage-of-completion accounting, which allows contractors to take accruing profit on work that has not been completed. When you take the completed contract profitability of a company over a four- or five-year period and subtract the overhead that has been incurred during that same period of time, it really shows the true growth the company is achieving, what type of real enhancements in their retained earnings are taking place, and whether they’re making money at the business that they’ve chosen. Learn causes and warning signs of contractor failure. The Surety Information Office’s free brochure , “Why Do Contractors Fail?” is available at www.sio.org by selecting “Free Brochures & CDs.” Communicate good and bad news to the surety bond producer and company underwriter if or when problems begin. The most important thing a contractor can do is keep the surety informed when problems arise. Many surety companies will work with the contractor to help him/her through the problem if possible. Construction is cyclical and contractors should prepare for the pent-up demand that will build during recession. As world demand creates materials and equipment shortages and we face domestic labor shortages, contractors need to protect their core resources and be ready to bid work when the economy rebounds. The surety is a critical partner through good times and bad and can help owners and contractors manage the changing economic climate.