Many NY Construction Companies , and the Accountants that advise them have overlooked a very powerful tool in securing or augmenting bonding capacity. The tool I speak of is Subordinated debt to help secure surety credit. Readers of this article will get a better understanding Subordinated debt, and how it may be a useful tool as you look to get an initial bonding line , or raise an existing one .
If you have been in the bonding market for even a short period of time you have seen NY Surety Underwriting tighten, bonds rates have increased, and bonding capacity has diminished considerably since the financial market meltdown. The good news is that there is some capacity coming back into the market in the form of surplus insurance company capacity, however their appetite for risk in deploying that capital has tighten which is why properly positioning your companies financials is so critical.
Focus On Relationship
In a previous article title THE BASICS OF SURETY CREDIT , I spent a lot of time talking about how important the relationship is between the Surety & Obligee (You). I espoused that the relationship should be viewed like any banking relationship, a silent partnership if you will. A NY Surety , like a bank has the ability to really help propel a well run company by providing the financial fuel necessary for growth. Beyond the numbers, transparency, timely and detailed communication builds trust, which can be critical when your company runs into a tough period.
Increase Your Equity Investment
Let’s assume we have nailed the relationship component of the program , and are on solid footing, however your companies financials aren’t as robust as you would like to support your NY Bonding Line, or NY Surety Line. One option is to infuse the business with additional paid in capital or increasing your equity investment basis in the company by depositing additional funds to give your balance sheet financial muscularity.
Before you do this please consider the following: If you increase your paid in capital through outside investors , you will have in all probability have diluted your current ownership position which may be less than ideal. Additionally if you company is a “C-Corp”, the additional paid in capital will be subject to the double taxation rule, as ‘C Corp'” are taxed at both the corporate level , AND the personal level if capital is paid out in the form of a dividend. Before you pull the trigger and jump to the quick, please consult with your accountant or financial advisor.
Using Subordinated Debt As a Tool To Increase Your NY Bonding Capacity
Thanks for staying with me so far and not jumping over to Utube , so here comes the good stuff. Instead of paying in additional capital to the company to increase the balance sheet, LOAN the company the funds. Don’t stop there as we are not finished; most NY Sureties will treat shareholder loans to the company as both a long term liability, and as a capital investment IF THE LOANS ARE SUBORDINATED TO THE SURETY. Translation if anything goes amiss the Surety has dibs on that “SUBORDINATED LOAN” before you do, which means you lose the “investment”.
By using this financial mechanism you accomplish two goals in short order;
- You increase your balance sheet to a position consistent with your goal of increasing your bonding line.
- You avoid the double taxation if you are a C Corp, diluting your investment.
Preparing The Agreements For A Subordinated Loan
Referencing the Surety Association of America there are 2 standard types of Agreements that may be used to properly execute the transaction. The difference between the two contracts, the “Special” form applies to bonds for a single contract, whereas the “general form” applies to all bonds before and after the effective date of the agreement. It’s been our experience that most sureties prefer the general form as it’s broader applicability contractually makes it a more efficient financial instrument from the NY Surety Underwriting, and NY Surety Claims handling perspective.
Critical Contractual Provisions
- The Creditor ( typically the business owner / person who loaned the money to the NY Construction Company) , subordinates or sits in the 2nd position to the NY Bonding Company, or NY Surety Company. In effect they sign away all primary rights to the loan or capital infusion against the construction company for losses the NY Surety Company may experience as a result of providing the bonding line.
- The Assets of the NY Construction Company are paid out to the NY Surety Company before they are paid to the creditor/ business owner.
- The Contractor & Creditor agree that the debt will not be extinguished until the bonded obligations have been satisfied and released.
- The Creditor assigns to the NY Surety Company it’s rights and claims upon the debt should a bankruptcy or insolvency occur on the part of the NY Construction Company.
- Lastly the creditor agrees that any breach of the subordination agreement all property, cash and cash equivalents received by the creditor will be held in separate trust on behalf of the NY Surety Company.
Surety Decision Points
By no means is this a done deal. Just because it can be done, it’s critical that the Obligee ( NY Construction Company ) , Creditor ( NY Construction Company Owner) , and the NY Surety ( NY Bonding Company) providing the line come to an agreement that IF the Obligee & Creditor take the aforementioned steps , prepare the provisions and agreements that are acceptable to the NY Surety Company , that the goals of the Construction Company are attained, which is either a higher NY Bonding line, or obtaining an initial bonding line in the first place.Additionally the NY Surety Company will also look at the following as critical decision points in determining that Subordination of Debt is an acceptable mechanism.
- Historical Performance of Construction Company - In analyzing the financials of the construction firm it’s revealed that the construction company has not derived a profit from several of the last construction projects they worked on, then the potential solve is not depositing more capital in the company, thus the surety may take a hard view on this and not approve the bond line or additional line.
- Unique Considerations – The NY Surety Company is more likely to look favorably upon the subordinated debt as a means to strengthen the balance sheet where some unique considerations are in play such as a temporary issues like a large backlog of work, investments into equipment which may have eroded the companies financials , stock repurchase, large bonus payouts or expansion of company personnel , or perhaps acquisition.
- Capital Source : Typically loans from banks, or other debt is not looked upon favorably, however excess cash from the Owner Obligee may be. It’s also common that contribution of salary, bonus, profit distributions, sale of assets , or dividends is used to support the subordinated debt position. The NY Surety may also used in their analysis promissory notes , however they don’t love this due to the administrative burden it presents to the NY Surety.
In Summary :
One of the most important variables in the NY Surety underwriting process is that the construction firm have adequate capital At Risk consistent or relative to the scope of work or project specs. Each NY Surety Company defines this ratio differently, some are more aggressive and will allow a larger spread, others are more strict and want to see a much smaller spread in the ratio.
Using subordinate debt as a tool to augment your NY Construction Companies financial position is just one technique. Refer back to this blog periodically for more NY Bonding tips and intuitive ideas to achieve your Surety goals. We also encourage you to speak to a Metropolitan Risk Advisor to assist you in achieving your company’s business goals. To contact a Metropolitan Risk Advisory PLEASE CLICK HERE.
A special thank you to R. Neuschaefer who I met years ago at a NY Bonding conference who shared this idea with me. It made perfect sense. He was happy to share it with me, and I with you, which is what’s it’s all about in the long run.