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This Alternative Financing Avenue Allows You to Tap Into Retirement Funds

As the U.S. economy continues to show signs of improvement, many people will make 2015 the year they start the process of buying a small business or franchise. But startups still face challenges gaining access to capital. In fact, although large-business loans are now 24 percent higher than pre-2008 levels, small-business loans of under $1 million still lag 17 percent below the pre-recession peak.

The challenges in small-business lending have made way for other alternatives, especially rollovers as business startups (ROBS). ROBS allow an individual to invest up to 100 percent (but generally much less) of their eligible retirement funds into a small business or franchise without taking a taxable distribution or getting a loan.

Related: Is Seeking Angel Investment a Realistic Goal for Your Startup?

The legal foundation of the ROBS arrangement is the ability of a 401(k) to hold both publicly and privately held stock. Here’s how the general process works:

  1. The entrepreneur creates a new business entity as a C corporation.
  2. The entrepreneur creates a new qualified retirement plan -- generally a 401(k).
  3. Funds from an eligible retirement account are rolled into the new retirement plan.
  4. This new plan invests in the stock of the corporation, becoming a shareholder.
  5. The corporation then acquires or starts up a small business utilizing the funds -- debt free.

This process, although straightforward, is complex. Mistakes or shortcuts in setup, or in ongoing operations, can have serious consequences for the business and the entrepreneur. Some important things to keep in mind as you work with your professional advisers on setting up ROBS are:

  • The new entity must be a C corporation. S corporations and LLCs are not legitimate structures for ROBS. LLCs don’t qualify because stock in the new entity must be made available for purchase. An S corporation in which any “shareholder-employee” owns more than 5 percent of the company will lose the prohibited exemption that ROBS operate under.
  • The new 401(k) plan must explicitly allow the trustee to acquire and hold employer stock in a private business.
  • The 401(k) plan must begin and remain in compliance with ERISA rules. This means that participation is available to all eligible (and only bona fide) employees, and owner-employees must begin making ongoing contributions as soon as they are able.
  • Don’t pay “promoter fees” to any advisory entity using plan assets or proceeds from the sale of the employer stock. Pay the fees personally to avoid any appearance of violating ROBS guidelines.
  • It’s best for the entrepreneur to wait until the business is generating revenue before drawing a salary through ROBS. This avoids any possible risk of breaching ERISA fiduciary responsibility, as well as making better sense from a tax perspective.
  • Administer the plan properly, including good recordkeeping and prompt annual filing of IRS Form 5500.

Related: 5 Essentials for Raising Your Growth Round of Funding

Used properly, ROBS can be a very sound capitalization strategy, and it’s already proven successful for tens of thousands of U.S. entrepreneurs. They’ve obtained funding without using their home or personal credit as collateral and launched businesses free of financing debt. They’ve invested in themselves and are building their retirement wealth while growing their business.  And rollovers for business startups can be used in combination with SBA loans too.

But as with any investment, there’s risk. It’s essential that anyone considering the ROBS approach consults trusted financial advisers and evaluates their own tolerance for risking the loss of retirement funds. This is not a process that any entrepreneur should attempt alone. Setting up and maintaining a C corporation, establishing a compliant 401(k) plan and managing the ROBS process requires expert support to avoid the kind of mistakes that can derail the business.

Once the entrepreneur has made their decision to use ROBS, the process takes four to five weeks to complete. It’s a journey many have already found rewarding. Todd and Suzie Ford opened the NoDa Brewing Company in North Carolina in 2011 using ROBS. Their thriving business now employs 24 people. Christopher Villa purchased an i9 Sports franchise in the Seattle area with his retirement fund, and its continued success has allowed him to found a mobile gaming truck franchise business.

If you’re pursuing a new business this year, be sure to consider all your alternatives. ROBS isn’t for everyone, but it may be right for you.

Related: Great Idea But Little Capital? Don't Let That Hold You Back.