As a contractor, understanding the role of collateral within bond facility agreements is essential, especially when securing or maintaining bonding support, or when accessing contracts that go beyond a surety’s usual comfort level. Collateral is more than just a procedural formality; it’s a fundamental element of the bonding process, acting as a crucial safeguard that protects the interests of the surety and underscores your commitment to project completion and financial integrity.
However, it’s important to be cautious about how tying up collateral can affect your business. Locking valuable corporate or personal assets into long-term agreements can restrict your financial flexibility and limit your ability to pursue other opportunities. This reality leads some contractors to circumvent traditional bonding routes, a topic we’ll explore further ahead, providing insights into why alternative strategies might sometimes be necessary.
What is Collateral?
In surety bonds, collateral refers to the monetary assets you may be asked to pledge to a surety to secure your company’s performance in bonding support. This financial security is critical as it is essentially on-demand security the surety may immediately seize to protect themselves from a default, bankruptcy, or other bonding-related loss the contractor suffers.
Common Types of Collateral
In Canada, the most accepted forms of collateral within the bonding industry are irrevocable letters of credit (ILOC) and collateral mortgages, each serving distinct purposes and offering unique benefits:
Irrevocable Letters of Credit: These are the industry standard in accepted security. ILOCs are formal financial commitments that banks issue to guarantee payment up to a specified amount. They are highly regarded in scenarios where immediate liquidity is necessary, such as settling claims or fulfilling financial obligations quickly without asset liquidation. Irrevocable letters of credit enhance contractors’ credibility by demonstrating their financial backing and capacity to meet contractual commitments efficiently. The downside of an ILOC is that banks can take up to 3 weeks to issue them, and they act like a bank draft or certified cheque – the cash is tied up and held by the bank to issue the ILOC.
Collateral Mortgages: This form of collateral involves pledging real property as security. It is a preferred choice for many contractors due to the circumvention of tying up liquid cash via an ILOC. Real estate’s inherent value and stability make a collateral mortgage appealing to a surety and can move faster than a financial institution may take in issuing an ILOC. Real estate generally appreciates over time and provides a substantial equity cushion, which reduces the risk of sureties in the event of a contractor’s default. This makes collateral mortgages a reliable and attractive option for both parties.
The Realities of Tying Up Security
While utilizing security to access bonding support is a decision many contractors follow through with, the realities of tying up security with collateral in bond facilities have profound implications for contractors. Typically, the security you provide will be held for an extended period. This duration often extends through a bonding facility until corporate financial benchmarks have been met consistently over time or well beyond a project’s completion for which collateral security was conditioned, usually until after the expired warranty period.
This tie-up of valuable assets can significantly restrict your ability to leverage these resources for other business ventures. For example, suppose your liquid assets are locked up as security. In that case, you may need help to secure additional financing or to invest in other projects that could propel your business forward. This limitation can strain your financial flexibility, making it difficult to adapt to new opportunities or to respond proactively to market demands.
Furthermore, it may affect your capacity to take on new projects, as the inability to access or liquidate assets quickly can impede cash flow needed to initiate other work, and ongoing operations.
Why Some Contractors Circumvent Bonding with Direct Collateral
Collaterals placed to secure bonding facilities often negatively impact contractors, mainly when the demands are too restrictive or significantly affect cash flow. This is especially true for smaller contractors with limited assets or reserves. Providing collateral directly to a project owner is another option; however, this can become increasingly difficult as the value of the contract increases. Security can critically affect your operational capacity, leaving you vulnerable to risks associated with project changes, delays, or financial issues.
For instance, consider the 50% direct security to a particular bonded contract valued at only $100,000. It is only $50,000.00. A small contractor may be comfortable securing that number directly with the owner if collateral conditions for support via the surety are too steep or unavailable.
However, if a contract is valued at $500,000 and 50% direct security is required, a $250,000 security placed with the project owner may become impossible for the same contractor, as they don’t have that much liquidity available.
While this approach may be feasible for larger contractors with robust cash flows and substantial assets, it presents considerable risks for smaller contractors, potentially leading to greater financial instability.
Dusty’s Tip: To manage and mitigate the challenges associated with any collateral conditioned in bond facilities, consider stepping away and reapplying for bonding once the company is in a stronger position. While this may seem discouraging, it may be best, for now, to pursue unbonded contracts and correct your company’s short-term health issues before entering the long-term practice of bonding support and contracts.
Understanding and effectively managing the role of collateral in bond facilities is essential for success in the construction surety industry. While collateral provides security for sureties and project owners, it also poses significant challenges that can impact your ability to operate. By carefully considering the implications of collateral, you can strike a balance between meeting surety requirements and preserving your operational agility, ensuring the long-term success of your business.
Dustin SanVido, Surety Bond Expert
As a dedicated #SuretyBroker, Dustin understands the unique challenges you face in the construction industry. Whether you are new or experienced, Dustin offers guidance through the complexities of bonding requirements. He’ll help you secure contracts and grow your business. Dustin covers everything from bid bonds to performance bonds. His dedication to client satisfaction and extensive industry knowledge distinguishes him, ensuring a smooth and stress-free surety journey for you. Dustin SanVido works with clients across Canada and internationally. He also facilitates contract surety and bonding needs for individuals and contractors in the private sector. Dustin leverages a network of strong market partnerships to secure the best and most affordable bonds for clients, even those with non-traditional needs. His unmatched expertise and unparalleled knowledge of surety bond products make him invaluable in the surety world. For any surety bond needs, Dustin should be your first contact.
Dustin SanVido holds a Registered Insurance Broker of Ontario (RIBO). He also holds a Canadian Accredited Insurance Broker (CAIB) license and designation, and Associateship in Canadian Surety Bonding (ACSB) professional designation through the Surety Association of Canada (SAC).
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