In February of 2016, I finished up working at an oil and gas startup. The decline in oil prices turned the business from a high growth company to one running out of cash. As a result, the business sold its assets and I along others were out of a job.
Not two months before the collapse in the oil industry, the company needed to raise capital, and I took all the cash I could scrape up to invest further in the business, valuations were high and the market was hot so why not double down?!
The crash left our saving account empty, no steady paycheck and our family dependent on my wife’s income as a style consultant and book author. She was doing OK, given she had started the business a few years earlier and now that our twin boys were older and she had more time.
I spent months interviewing for another full-time gig but preferred to concentrate on my own consulting work and independent publishing. I was at a loss for how we could support the household while my wife and I both ramped up our businesses. That is when my wife introduced me our current financial advisor, who helped me to understand that I had access to low-cost capital that did not require me to go through any approval process. This concept was so successful that felt it important to share how you can tap into capital now and get your new business started or pursue a writing career full-time.
Setting the stage
Most small business startups are founder -funded and under-capitalized. The research in the “Business Owner’s Compendium” shows the debt-to-equity ratio, for most businesses, is between 1:1 to 1:2 with $1,500 to $3,000 of debt and over 80% of that funded by the owner’s personal credit cards. Credit cards are the most common and expensive start-up capital.
Back to the Story…
We could not use credit cards we would need those for emergencies and the amount of money needed to float a family of four for six months exceeded our credit limit. Dory reviewed our financial situation and offered a solution.
My wife and I had set up our business as an LLC, so we could create a 401K plan for the company then transfer funds from an IRA we had into the 401K plan. Dory set up the 401K plan with an outsourced administrator and then arranged a $50,000 loan to give us the cushion we needed to get our businesses up and running. If you are in a similar situation, thrust into an opportunity to start your dream business or you have been thinking about how to fund it, you now have access to an easy option within your control.
You as Your Own Venture Capitalist
If you have a 401k, you can borrow from the fund, in the amount of 10% up to fifty-thousand dollars whichever is less. For most single employee businesses this is plenty of capital. If you were to go raise capital from friends and family you would spend time and effort to secure the funds that are better spent on the business. The real downside of venture capital isn’t the onerous terms you may receive but the time to raise this money; a fundraising treadmill you find yourself on, a massive joy- sucking distraction.
You can be the venture capitalist and invest in yourself.
How do you do this? I will get into the detail of using an existing 401K from your current employer and how to create one for a new or existing business. When it comes to the loan, you should write out a term sheet. This is your personal commitment from the business owner part of you to the investor part of you to make sure you get a return.
The initial terms are the loan repayment plus interest. Next, you should make a minimum threshold commitment of putting money in the 401k after the loan is paid off. Think of this as if you sold preferred equity or warrants to your 401K which will have an ongoing claim on the profits of the business. Since these contributions can be as high as $72,000 a year and 100% tax-deferred, you have an outstanding investment instrument.
Why this makes sense
- Low cost of capital–the interest rate is 1% to 2% above the prime rate, you pay the interest back to your 401k investment account.
- You need not go through a bank approval for a loan or credit check, and your interest rate might end up being lower than what you could get at a bank.
- You pay yourself back with interest – immediate return on investment!
- It’s the most efficient tax shelter a small business owner has for a profitable venture.
The Other Advantage Tax Deferral
The reason you’re starting a business is to build a successful company that will one day generate profits. By using a 401K, you can contribute up to $18,000 a year as salary deferment( an additional $6,000 if you’re 50 years of age or older), meaning you do not pay taxes until the money comes out of the plan.
Your “company” can match funds. The rules need to be set during the formation of your 401K plan, so discuss with your financial planner.
With liberal company matching and profit sharing in place your company can contribute either $36,000 or up to 100% of your salary whatever is less. If you had the cash, you could contribute $54,000 a year on a tax-deferred basis. NOT TAX-FREE. You will pay income tax when you draw on funds, but this should be done after you retire when tax rates are lower. These types of contributions by yourself and your employer can also be done in SEP plans, however, you cannot borrow from a SEP plan. That’s the advantage of the 401K.
What You Should Know About Using a 401K Loan
You don’t have to set up a company if your current 401K is with your employer.
If you are employed and have a 401k plan with that employer, you can inquire about taking a loan. Every retirement plan has a document describing the rules.
- There could be an early payback penalty. If a participant with a loan balance leaves his or her employer, the entire balance of the loan must be paid back — usually immediately or could be considered a distribution from the retirement plan, rather than a loan.
Therefore, if you are starting a business and your objective is to leave a present employer where you have a 401k plan, it might make sense to create your own individual 401k plan and see if your employer plan allows for in-service rollovers.
What if you have an existing business and SEP plans? Talk with your financial planner on converting and rolling over that money into a 401K plan to set up the new company. It’s a great way to consolidate, remember that your financial advisor can construct just about any investment strategy to match your risk tolerance.
Planning and Examples
If you will quit your job and rollover the 401k into a new business, there are costs associated with this process that you will need to build into your plan. There are fees to set up the company, figure on $200 to $ 500 (learn more about incorporating here). Then there is the plan cost $125-$200 a year to administer your company 401K plan. You can discuss this with your financial planner or if you don’t have one and have questions please reach out to Dory.
New Business Startup:
This will work for any business startup you might be contemplating. If you can get the business off the ground for less than fifty thousand dollars, it makes sense to use a loan to buy the tools of the trade and provide working capital while you work to become cash flow positive. You will have 100% ownership while avoiding spending tons of time raising money from others. Putting the fund-raising effort into the business will deliver results faster than delays or distraction by fundraising. The key here is to develop a plan that will get you cash flow positive on the loan you take out, otherwise you will end up having to go back to the well for more money.
If you have been thinking about starting a fulfillment business on Amazon, a 401K loan is a good way to get the capital to source your inventory and have the working capital to get through startup. Most overseas suppliers require a deposit and the larger quantity of product you order, the lower your unit price is. Given that FBA (fulfillment by Amazon) does everything else, you can run a large operation with little overhead.
You want to write full-time. One way to do this is plan out leaving your day job, using your loan for living expenses and coverage for free time to finish your book series. You will need a solid plan to receive revenue levels you need – the 401K loan fills the gap. Maybe you are not prepared to go full-time but want to do your book launch right by using an editor, book cover designers, and have a marketing budget. This could add up to $3,000 – $5,000.
If this sounds like a road map to your dream of self-employment or full-time writing keep this in mind:
Plan first! Given the risk you’re taking, your plan should deliver a return that exceeds the performance of the S&P 500 by at least by fifty percent. If you can’t do as good as the S&P 500 the best place for your money is to remain invested in the market.
You should be able to pay back the loan with an understanding that in the beginning, you may use the proceeds to pay back the loan while you get started. Any funds not paid back will be treated as a distribution and you will pay income tax and an early withdrawal penalty.
How To Steps
Step 1: Make a plan
Write up a one-page plan with numbers outlining the uses of the funds. If this is an exit strategy from a day job, you need to account for living expenses including loan repayment for three to six months. A good rule of thumb to follow: consider what sum is needed to make the money you need, and double it.
If this money is to fund the business, then create a cash flow for the business. If you are unsure how to this check out Business Owner’s Compendium.
Step 2: Review your plan and the 401K Plan
Review the 401K plan with HR, get a copy of the plan documents and understand how the rollover process works. You want to ensure that if you quit, you know the repayment policy and your vesting schedule for profit sharing. Most plans no longer have vesting, but if yours does then make sure you know when your money vests. Waiting a few months may be the difference in thousands of dollars.
Step 3: Patience
Prior to rolling over to a new company you need to set up that company and establish a plan. This will take longer than just setting up a typical LLC or S Corp and establishing an EIN. Once the plan is in place the funds can move, and the loan issued. Having patience is helpful in getting the parts in place for a successful exit.
This is not a one size fits all solution. It made sense for me and has worked well to date. If this sounds like something you want to do, meet with a financial planner.
You may have a trusted advisor already and all you need to do is share with them what you are thinking about. They may not have suggested this option if they did n’t know your plan to start a new business and therefore suggested fewer complex strategies delivering the savings plan you need at the lowest cost.
Joe Solari is an Author and Business Consultant.
Authors can learn more at the Business of Writing
Or from his book “The Business Owner’s Compendium”