The buyer or employer requires this type of protection for two reasons. The first reason is to financial protection to help ensure that the work gets done. If the supplier or contractor fails to complete the work, the buyer has those monies retained to complete it before needing to claim breach and pursue damages. The second reason is for some types of work (mainly construction)
laws provide subcontractors and material suppliers with protection in the event they do not get paid. That protection is called a mechanic’s or materialman’s lien that they can file against the property where their work was performed or their materials delivered. A lien against the property prevents the property from being sold and may prevent financing on the property until such time as the lien has been removed.
If you required bonds, a performance bond is to protect against the additional cost of completing the work if the supplier failed to. When you have a performance bond, the party that issued the bond has the option of completing the work or if it would cost more than the bond amount to complete the work, they may simply pay the recipient of the bond the amount of the bond. If you require a payment bond, the issuer of that bond would need to have any liens removed by paying the unpaid amounts up to the amount of the bond. If you don’t require bonds, your retainage may need to cover both risks.
Most of the time retainage is based upon a percentage of the amount to be paid. Over time as more payments are made the amount of the retainage grows. For large projects over extended periods of time the amount of retainage may be substantial. From my own perspective establishing the amount being withheld and any reductions or caps to the amount needs to weight the value of that protection against two things 1) the cost of that protection and 2) the financial impact the amount may have on the supplier’s performance. There is a value to the amount of money that is being retained that the supplier may include in their cost of performing the work. Similarly there is a significant value the supplier would get if you agree to release any amounts earlier than agreed. You also do not want to be holding so much that it is impacting the supplier’s cash that can in-turn impact their performance.
I’ve always preferred retainage over bonds as bonds cost more and if you have a problem and need to collect on the bond, what you want up with is a party whose sole goal is to minimize the costs they have to pay out under the bond. The other reason I prefer to use retainage is I don’t need to involve a third party. I can hire who I want to finish the work. I can manage the release of the liens. The cost of doing that becomes a receivable in which I can use the common law right of offset to set off my payables (the retainage) against my receivables. As the laws of locations can always be different, I would always investigate the laws concerning liens, and set off.
Another reason why I prefer retainage is I’ve always been of the opinion that from an owner’s perspective the last percentage of work is usually the hardest to get done. Individuals may have moved on to other work and the best way to retain the Supplier or Contractor’s attention is to be holding enough money so they provide you everything that’s due.