Which is better for a solar contractor’s business, a bond vs. letter of credit? Both a surety bond and a letter of credit can provide a performance guarantee in a solar project, but a surety bond is friendlier for the guarantor.
If you’re asked to provide a letter of credit it helps to know the difference so you can request a change to a surety bond, if needed.
What Is A Solar Surety Bond?
First things first, what is a solar surety bond? A solar surety bond is an agreement between three parties to provide a performance or financial guarantee:
- Principal: The guarantor. This is the company doing the work (solar contractor, solar developer, EPC, etc.) that has the obligation to pay or perform under the contract with the obligee.
- Surety: The bonding company providing the surety/guarantee that the project or work will be completed according to the contract between the obligee and the principal.
- Obligee: This is the party requiring the guaranty or requiring the work to be completed (solar project buyer, solar offtaker, lender, etc.) that is owed the obligation by the principal.
Types of solar surety bonds may include a power purchase agreement (PPA) bond, interconnection agreement bond, construction bond, performance bond, decommissioning bond or bid bond.
Surety bonds may be used as a credit enhancement strategy in solar development projects to help reduce – or eliminate – the risk of default in the payment stream to a lender or equity investor.
How Does A Surety Bond Work?
In the diagram above, the principal completes an application and provides financial information on the company and/or the owners to the surety for underwriting.
During the underwriting process the surety will consider your business’s work history, credit score and business and/or personal financial records to determine your reliability.
If the bond is approved, the principal pays a fee to issue the bond and the surety guarantees that the work will be done according to the agreement between the principal and the obligee.
If the principal fails to perform according to the terms of the contract, or the work is not completed, the obligee will notify the surety who will investigate and step in to make sure the work is completed.
The principal is required to reimburse the surety for any costs associated with the completing the project.
What Are Types of Solar Surety Bonds?
Solar surety bonds can guarantee important aspects of the solar development project, including:
- Interconnection agreements
- Power purchase agreement performance
- Subscription manager bond (aka “community solar subscriber bond“)
Other types of solar surety bonds may include a performance bond, payment bond or bid bond.
How Much Does A Surety Bond Cost?
It costs nothing to apply for a surety bond.
However, you will pay a fee (premium) to issue the bond. The fee can range from 1-3% of the total bond amount depending on the financial risk profile of the principal and the type of bond.
If your business has good credit, you will generally pay less for your bond. However impaired credit and perceived risk in a project may raise the cost of the bond premium to as much as 15%.
For example if you pay 3% for a $100,000 bond, you will pay $3,000. New business owners may have to pay more for their bonds depending on the extent of their financial history… A new business owner with a good credit score and otherwise sound financial history should pay less for the bond than a new business that has no credit or a poor credit history.
If you are a new business owner in need help with a bond, you can schedule an appointment with me.
What Is A Letter Of Credit?
What is a letter of credit? There are important differences to know between a bond vs. letter of credit.
Like a surety bond, a letter of credit (“LOC”) is also an agreement between three parties that provides a performance or financial guarantee:
- Applicant: The guarantor. The company doing the work (solar contractor, solar developer, EPC, etc.)
- Bank: The bank (issuer) issues the letter of credit and receives a promissory note from the applicant. The bank is required to honor the letter of credit if/when the obligee presents documents requesting to draw down funds from the letter of credit.
- Obligee: The beneficiary of the letter of credit. This is the organization requiring the work to be completed (a municipal agency, government entity, solar project buyer, solar offtaker, lender, etc.)
The applicant/guarantor pledges funds to guarantee the letter of credit. The LOC is issued by the bank for the benefit of the obligee in the event of a default by the applicant.
The bank and the guarantor agree to issue a lien (either a UCC lien or UCP lien) in the amount of the LOC. This sets aside working capital in the amount of the LOC which appears as a liability on the balance sheet of your business. This liability means that you will not have access to this capital during the term of the LOC and that the business’s credit and borrowing capacity may be impaired.
A Letter Of Credit Is A “Demand Instrument”
Unlike a surety bond, a letter of credit is a “demand instrument” operating under contract doctrine.
This means that the bank’s obligation to pay the obligee is separate and independent of the agreement between the applicant and the obligee.
In other words, the obligee may demand the money without having to prove a breach of the underlying contract. The letter of credit does not look to the terms of the contract between the obligee and the applicant, it only looks to the requirement to pay between the bank and the obligee.
The bank must honor the request, regardless of whether the applicant (i.e. you, the solar developer or contractor) actually defaulted on their agreement.
How Much Does A Letter Of Credit Cost?
A letter of credit typically costs 1% of the guaranteed amount, plus additional fees. However, the up front costs should be considered with the totality of costs associated with the LOC and the potential loss of access to working capital, etc.
Bond vs. Letter of Credit: Which Is Better For A Solar Contractor?
IMHO, when choosing a bond vs. letter of credit, a surety bond is preferable to your business as a solar developer.
This is because a surety bond provides the guarantee of performance for the obligee, but is less restrictive to your business and includes reasonable checks and balances in terms of performance of the contract.
Obligees may prefer a LOC because it’s easier for them to demand the money.
However, in the event of a dispute between you and the obligee, the surety verifies the situation and the end result would be the same, the project would be completed and/or the obligee would be paid1.
- Photo by Renovus Solar