If you are the owner of a contracting, manufacturing, or small supply business, you undoubtedly have been required as part of the bid process to obtain a surety bond or provide an irrevocable line of credit (ILOC).
Either one is, in effect, a promise to protect your customer in the event the job is not completed to the customer’s satisfaction. But choosing a bond over an ILOC can be confusing.
How do you select which one is right for your particular business?
What is a Surety Bond?
The term bond may be confusing you, since it immediately conjures up ideas about investing.
But in this context, the surety bond is a merely a formal guarantee–made between you, a bond company, and your customer – promising that you will fulfill your obligations.
In short, you will pay a bonding company a premium, typically 1-3% of the job price, and they will in turn will pay the bond amount back to your customer if you fail to perform as expected, or cause your customer to suffer damage or loss.
Bond companies rarely require collateral, meaning your cash assets are not affected beyond the purchase price of the surety bond.
To understand surety bonds even better, the article, “Surety Bond Vs Letter of Credit: Which Is Best For My Business?” allows you to have a better grasp of the situation.
What is an ILOC?
Like the surety bond, the ILOC is meant to protect your customer in the event you do not complete the job per your contract.
In this case, you will arrange with your bank to give your customer a letter stating that if a claim arises, the bank will allow the customer to access the funds set aside as outlined in the ILOC.
During this process, the bank freezes your liquid assets so that they have ready access to the funds should they need to satisfy the claim.
Banks usually charge a fee equal to 1% of the amount covered in the ILOC.
Weighing the Options: Which is Right for My Company?
On the surface, it may appear that the ILOC is a lower-cost option.
A bid using an ILOC that guarantees the customer $50,000 will cost you $500. A surety bond in comparison would cost you $1,500.
Keep in mind that your cash assets will be frozen during the term the bank holds the irrevocable letter of credit. If you own a small business with uncertain cash flow, this most certainly will be a deal breaker. If you own a larger business, access to cash is important for other reasons.
You may very well want easy access to your money in order to invest it in the stock market or otherwise.
You need to keep in mind that though the cost of the bond may seem high at 3%, having money available to invest has the potential to pay back a higher percentage in dividends.
In the end, the choice is up to you.
Keep in mind that both a surety bond and an irrevocable letter of credit are necessary business expenses that will cost you between 1-3% of the contract price.
If you value liquidity of your cash assets, choose the surety bond.
It may cost more on the surface, but choosing the surety bond may very well make your business more money in the long run.
About the Author: Kate Supino writes about best business practices and financial matters.