A surety bond is a type of contract which is used to hedge against failures to deliver on obligations. Surety bonds involve three parties.
In a surety bond arrangement, one entity (the principal) promises to deliver a pre-agreed service, product or level of performance to a second party (the obligee). A third party (the surety or guarantor) promises to pay the obligee a pre-agreed amount if the principal fails to follow through on their promise.
Example: An investor invests 100,000 Swiss francs in a startup. In a written contract, the startup (the principal) promises the investor (the obligee) that it will reach profitability within 5 years. An insurance company acting as the surety issues a surety bond guaranteeing payment of the 100,000 francs to the investor if the startup fails to reach profitability in 5 years as per the written contract.
If the startup failed to reach profitability at the end of 5 years, the investor could redeem the surety bond issued by the insurance provider for 100,000 francs. If the startup did reach profitability within 5 years, the surety bond would no longer be valid.
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