Many budding entrepreneurs want to know about the realities of funding their business by tapping into nonsavings areas of their personal assets, such as life insurance policies, certificates of deposit, home mortgages, individual retirement accounts and pension plans. Be careful to recognize upfront that this type of funding strategy is definitely going to blur the lines between personal wealth and enterprise development. Ideally, it is best to keep clear distinctions intact for individual assets and the objectives for these funds, compared to capital raised for the business. However, when a funding strategy with these kinds of assets is executed within a comprehensive plan for both the business and the personal assets, it can provide much-needed cash for the venture without completely throwing personal common sense aside.
The first rule is to understand that if funds are diverted from these traditional products to a business, it should be viewed as either a temporary or intermediate-term remedy for funding. This kind of funding does not constitute a good long-term approach to venture capital. There must be a plan in place to return these funds to these other financial products, or to replace these products at a later date once the venture is producing solid revenue and positive cash flow. I cannot emphasize this enough. There are tremendous risks involved in funding a business. Bringing personal assets into the picture only adds to that risk exposure, because it can further complicate personal risks by reducing insurance or retirement benefits or jeopardizing the status of one's primary residence.
The place to begin is with some brief qualifications on these products. Today, most people buy term life insurance, and very few, if any, individuals purchase traditional whole life insurance. Term life insurance simply provides a cash payment to beneficiaries. Whole life insurance is more expensive and accumulates a "cash value" over the long term (like a traditional savings account). Whole life policies allow the owners to borrow cash value for personal use (i.e. funding a business), but the funds borrowed must be paid back. Whatever is not paid at time of death will reduce the death benefit by that amount. And interest must be paid (typically monthly or quarterly) on the outstanding principal balance until it is paid back. Interest rates tend to be relatively low, so that an entrepreneur could access the funds for one to three years and pay interest only on the outstanding loan, and then pay back the cash value in full once the company becomes profitable and regular compensation can be drawn. Term insurance has a much less expensive premium compared to whole life and accumulates no cash value over time, so there are no funds to borrow against such a policy.
This same general format holds true for pension plans as well. The fund value for a 401(k) or 403(b) retirement account can be typically borrowed for the short term to midterm without penalty, but must be paid back, and interest charges will be incurred during the loan period. The same holds true for IRAs. One major concern is that if funds are borrowed on insurance or retirement funds and the business goes bust, interest must still be paid on the outstanding loan balance. The death benefit will be reduced by that outstanding loan, and of course in the case of the pension funds or IRA, the retirement benefit will be reduced proportionate to the borrowed funds still not paid back.
A certificate of deposit is a midterm to longer-term savings vehicle, where the bank agrees to pay a stated contractual interest rate for a specified time period of the deposit. Banks offer higher rates when funds are kept on deposit for a longer period of time (and lower rates when the term is shorter). Pulling money out of a CD prior to its maturity generally incurs significant penalty fees. However, some institutions will allow a CD balance to serve as collateral on a short-term to midterm loan. If interest is paid regularly on the loan, funds remain in the CD accumulating interest. When the loan is paid back in full, there is no effect on the CD's balance or interest earned. But if the business had difficulties and the loan could not be paid back, the bank would liquidate all or a portion of the CD to cover the loan, and that would include penalty fees for early withdrawal.
When the entrepreneur's primary residence has accumulated sufficient equity (the difference between the home's market value and the outstanding balance on the first mortgage), it is possible to borrow some or all of this equity with either a home equity line of credit or a second mortgage. The lender will have a secondary lien on the residence and typically requires interest only paid each month or quarter. And in many cases, this interest is tax-deductible on the individual's personal tax form. The word of caution, again, is that if the business fails, the interest payments on the second or equity line are still due, and the equity in the house has been reduced by the amount of that loan outstanding.
If a venture idea needs some funding for the near term, borrowing against personal savings, retirement plans and a primary residence can be an easy way to access much-needed cash. When the business begins to generate positive cash flow, then is the time to begin paying back these outstanding principal balances. Remember, too, that it is important to have a legal written loan document between the company and the entrepreneur lending the funds. If the funds are invested into equity, then stock certificates should be issued, as these funds are not a loan. If the business needs money for a longer term, or if the risks are significant, it would probably still be prudent to obtain funding through banks and/or capital investors and leave the lines of distinction in place between personal assets and the company's funding needs.
David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.