I’m not a big fan of using retirement money to start a business – especially not if your plan is to cash in the retirement account and pay income taxes and potentially penalty taxes. But there is a solution that enables you to fund a business with retirement money without cashing in.
I learned of this solution by speaking with David Nilssen, CEO and co-founder of Guidant Financial, a company that helps new and existing entrepreneurs find capital they need by using a variety of debt and equity solutions. David described Guidant as "maniacally focused" on increasing the success of small businesses.
One service Guidant offers is providing SBA (Small Business Association) loan packaging services which help show why you are a bankable asset - but their primary service is assisting start-up companies set up a 401k plan that allows the owner to use his or her own retirement money to invest in the company’s stock.
Let’s look at how this works, because I think it can be a great solution in the right situation.
How does it work?
Normally your own retirement money cannot be invested in your business – this is considered a prohibited transaction. But with qualified plans there is an exemption for the acquisition and holding of qualified employer securities. Large companies offer their employees the option of buying company stock through an ESOP. And, smaller company can utilize a “similar” process to raise capital
What are the steps needed to set it up?
Company sponsored plans, called qualified plans, are highly regulated. You need to set things up correctly for this business funding strategy to work. Here are the broad steps that need to be taken.
1. You must create a corporation which serves as the operating business entity.
2. This business sets up its own 401k plan.
3. You rollover all or part of your IRA or old 401k money into your company’s 401k.
4. One of the investment options you offer inside your 401k plan is company stock.
5. You then allocate all or a portion of your 401k money to buy company stock, and thus invest in your business.
What does an operating business entity mean?
You can’t be a passive owner and it can’t be a hobby business. You need to own and operate the business and be considered an eligible employee of your business - which means you work at least a 1000 hours a year. Your business must be actively engaged in the sale of a product or service and you need to pay yourself a fair market value salary (best to work with a CPA to figure out what this number is).
What types of people are using this solution?
This solution is best for higher income/higher wage earners who aren’t risking their entire life savings and have previous experience in the business world.
David says that over 60% of the people they work with are buying into a franchise concept of some sort. Less than 30% are starting a business from scratch. The average IRA rollover of their clients is $180,000, and the businesses each employ 6.8 employees on average.
Guidant also finds that 55% of their customers use some form of subsequent financing, with the largest portion using their own cash, and about 19% using SBA financing.
How much does it cost to set this up?
Setting this up isn’t cheap, but then raising capital for a business is never cheap. With Guidant you pay about $4,995 up front which includes two consultations with an outside tax attorney, setting up the corporation, and designing the plan.
You also have to have a third party administrator for the plan. They are responsible for all the reporting that must be done when you have a qualified plan. Pricing is $119 a month and increases when you have over 10 employees. It is also important to remember that as an employer, you have a fiduciary obligation to your qualified plan and its participants.
How successful are the businesses that have worked with Guidant?
Dun & Brad Street reports that after four years only 39% of new business are still operating; Guidant has found that among the business owners they have assisted after four years over 80% are still operating.
The success may be attributed to people who are willing to outsource. Most successful business owners try to avoid working on things that don’t fall into their sweet spot. Using a packaged capital raising solution can help them focus their time on things most important to growing the business.