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What Startups Need to Know about Surety Bonds

No matter the industry, entrepreneurs and small business owners pore over the same general checklist before launching their startup - business plan, revenue model, insurance, legal, needlessly fancy water cooler.

But there's one key risk mitigation tool that often gets lost in the mix: surety bonds.

Who Needs Surety Bonds

Surety bonds are often mistaken for or confused with insurance. They're more like a form of credit - and surety bonds can provide a crucial layer of financial and legal protection for fledgling businesses. In some cases, startups can't get off the ground without them.

Surety bonds provide a guarantee that an individual or a corporate entity will follow a contract or fulfill a duty in accordance with all applicable regulations and laws. They offer fiscal protection for the public, employers and project owners.

At the outset, it's best for entrepreneurs to evaluate their industry and their own unique business. Here are a few types of industries and jobs that will require surety bonds:

Companies that aren't mandated to purchase surety bonds can still benefit from them. For example, accounting firms or research-and-development outfits often purchase Employee Theft Bonds, which provide financial protection in case one of their employees steals or otherwise engages in illegal or immoral activity.

How Surety Bonds Work

Surety bonds are in essence three-party agreements among a surety company, a principal (the employer, individual or company performing work) and the obligee (the project owner, often a state agency). The surety bond provides a financial guarantee that contracts are followed, duties are fulfilled and that laws and regulations are obeyed.

Here's a basic example: Construction companies are required by law to purchase surety bonds when embarking on a public project. When a municipality awards a bid to construct a new police headquarters or a new library, the winning contractor must secure a host of bonds, including a Payment Bond. This bond ensures subcontractors and other workers will get paid in the unlikely event the contractor defaults. That bond also keeps the municipality and the taxpayers insulated against financial harm. Subcontractors would file a claim against the bond, and it would be the contractor's responsibility to cover any losses. If the company goes belly up, then the duty falls to the surety company.

How to get a Surety Bond

Insurance companies for years have issued surety bonds. There are also standalone surety companies that specialize in these unique products.

Surety companies are generally licensed by a state Department of Insurance. Bond applicants will encounter a process similar to a loan approval process - bond underwriters will review an applicant's financial history, credit profile, managerial team and a host of other key indicators.

The Cost of a Surety Bond

Surety bond costs vary depending on the financial status of the applicant, the type of bond and the surety. Those with excellent credit will typically find competitive rates. Those with less than perfect credit may have to find a surety that specializes in high-risk bonds, which will come with higher rates.

Right now, bonds rates tend to range from 1 to 3 percent of the total amount. High-risk applicants could see rates as high as 20 percent depending on the market. Some sureties require that applicants have suitable equity, up to five times the bond amount.

Startups and Bond Rates

Some startups will see higher surety bond rates than traditional applicants because they lack a concrete credit or financial history. But these are competitive, fluctuating rates - entrepreneurs who decide they need a surety bond should take the time to shop around and find the best rate possible.