Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
Definition or Explanation: A 401(k) is a tax-deferred savings account that an employer establishes for its employees. This savings vehicle can be used for almost any kind of investment. The 401(k) stays intact even if the employee leaves the firm. If the employee leaves to start a new business, his or her 401(k) can be used to invest in, or even to finance, the new venture.
Appropriate For: Any company at any stage of development. Since entrepreneurs fund the company with their own retirement savings, they need only convince themselves that the deal is worth the risk.
Supply: This option is for entrepreneurs who have been cut loose from corporate America with their 401(k) plans intact. Beyond the requirement of simply having a 401(k) account, the supply is further influenced by how much of their tax-deferred retirement savings entrepreneurs are willing to put at risk.
Best Use: Financing startups. When startup companies are financed with equity from outside sources, it's the most expensive avenue of financing because the company is worth so little. A round of seed financing can cost 30 percent of the equity. Although 401(k) financing forces a company to surrender equity, it is surrendered to the firm's founders and which means that the ownership is not really lost.
Cost: The fees can run high because several professionals are required to engineer the transaction. However, 401(k) financing does not cost the founders any equity in their business.
Ease of Acquisition: Moderately challenging. There are several legal and accounting issues that must be resolved for this technique to work properly.
Range of Funds Typically Available: $20,000 and greater.
When attempting to cash in your 401(k), you may discover-as the following entrepreneur did-that heavy tax penalties will accompany any funds you get. To avoid that, take heed of Jim Brien's tale.
After nearly 20 years working in sales and sales management for a large manufacturer of printed forms, labels, and electronic printing systems, Jim Brien was growing antsy. The business plan he was writing in his head was getting more and more detailed. And when the future of the company he was working for seemed less certain, Brien, along with five fellow salespeople, formed Print Integration Partners, a company that brokers printing and also offers forms-management services.
Brien's business plan showed that the company needed about $500,000 during the first two years of operation for office equipment, inventory (of forms) and receivables funding. Though Print Integration Partners was up and running, Brien wasn't ready for a grand opening until he knew that the business could be backed financially. "I thought it would be a big mistake for us to launch headlong into the business without any funding," he recalls. "At the time," Brien says, "the biggest asset I had was the 401(k) account from my previous employer, so naturally, my first reaction was to see what could be done with that." In fact, all the newly minted Print Integration Partners had 401(k) accounts, and in the aggregate, there were more than enough assets to fund the business. The trick was unlocking these funds.
Brien and his partners could have liquidated their 401(k) plans. But there was a 10 percent penalty off the top, and the distribution from the liquidation had to be taken as income in the year in which it was received. So for a good-sized distribution, it would push the recipient into the higher end of the thirtysomething tax bracket. No, thank you!
A simple and straightforward approach would be to simply have the 401(k) plans purchase shares directly in Print Integration Partners. This could be easily accomplished despite the widely held though mistaken belief that 401(k) plans can only make investments in publicly held companies.
However, Greg Brown, an attorney specializing in Employee Stock Ownership Plans (ESOPs) with Chicago law firm Seyfarth, Shaw, Fairweather & Geraldson, counseled Brien that there might be a better approach. Specifically, Brown proposed that Brien establish a Print Integration ESOP from which the 401(k)s would purchase their shares in the company. Such a transaction would require a highly specialized team of financial professionals, but the structure would deliver several tax- and estate-planning benefits that most small businesses don't think about until it's too late. This team that Brien would need would include an attorney, an accountant, a valuation specialist and a securities firm.
It took Brien about five months to assemble the team and put together the transaction. By April 1996, about five months after Print Integration Partners was incorporated, all the pieces were in place, and the transaction could be executed. Brien and his partners then instructed Salomon Smith Barney, the custodian of their 401(k) plans, to purchase shares in the Print Integration Partners ESOP, for which Salomon Smith Barney was also custodian. As a result, cash ($427,000 in total) went from the 401(k)s to the ESOP and from the ESOP into the Print Integration Partners bank account. Then stock certificates in Print Integration Partners were issued to the ESOP in the names of each of the employees making the investment.
True, this transaction was tricky. But when it was all said and done, Brien and his partners had successfully tapped their 401(k) plans without any tax consequences, funded their new company without giving up equity or bringing in outsiders and kept the balance of their savings intact.
The success of a 401(k) transaction depends largely on the team that is assembled to help implement it. Here are the principal players:
- Counsel: You need an attorney to draft the documentation for the ESOP and to define and engineer the relationship of the ESOP to the 401(k) plans. Although such a transaction is not beyond the ken of a general law practitioner, its cutting-edge nature probably demands an ESOP specialist.
- Valuation consultant: Since at the end of the day the ESOP is buying stock from a corporation, you need a qualified opinion about the value of the stock being purchased. There are lots of valuation specialists out there, and many concentrate on specific industries. Rather than just finding a specialist who understands a particular industry, it's important to find one who can work with emerging or startup companies. After all, traditional measures of value, such as assets or book value, which is the total value of assets the shareholders would theoretically receive if the company were liquidated, are often not available with startup businesses.
- Stock brokerage: A brokerage firm is needed to act as the custodian for the ESOP stock. Care must be taken to choose a firm with the right size and capabilities. After all, current or future employees who participate in the plan need to establish or roll over their plan with the broker. That means you want a broker who can provide not just service, but also investment options or access to investment options above and beyond the ESOP stock.
- Accountant: Everybody needs good tax advice, but with an ESOP, the tax issues are especially complex. As was mentioned, the company's net income can be managed in part or entirely through the ESOP. In addition, the 401(k) needs an administrator to keep track of stock purchases made by employees. Some accountants, as well as brokerage firms, can fill this role.
Excerpted from Financing Your Small Business.