Resources abound for individuals looking to start a new business for a second-act career, from multiple loans options to crowdfunding, etc. But the Rollovers for Business Start-ups (ROBS) strategy stands out as a unique opportunity for older business owners who are looking to manage the risk associated with a new start-up.
At first blush, I have to admit that the concept of taking cash out of my retirement funds to start a second-act career sounded risky. I had read a lot of advice from financial advisers warning people against such practices to start businesses. On the other hand, particularly in the wake of the Great Recession, it was clear to me that the big financial institutions weren’t necessarily taking such great care of our money, either.
Most of us who were affected by the Great Recession have, by now, gained back a significant percentage of our losses. Our houses are above-water, and our investments have recovered somewhat as well. Still, we’re not ready to retire just yet, and many of us still have entrepreneurial dreams we want to fulfill. But, depending on the start-up requirements for the business we want to own, we’re looking at a significant initial investment that is usually beyond what we have saved up, or what we’re comfortable parting with. We may be OK with taking the risk and believing in ourselves enough to take the plunge into a new business, but we also want to be prudent and strategic with our money. So where do we go to raise that cash?
Business Funding Options for Baby Boomers
What’s the best, most effective way to raise start-up capital for a second-act career business? Should we borrow, whether from family or friends or the Small Business Administration? Should we take out a mortgage (or a second mortgage) on our house? Or should we invest our own hard-earned cash to seed the business? Equity, after all, is powerful, both personally and professionally. Having ‘skin in the game’ is likely the first test of a business owner’s commitment to their business. Being able to invest in one’s own business establishes authority, and it commands respect. It also denotes leadership. While it doesn’t guarantee success, equity counterbalances debt and gives the new business owner a firmer foundation for their business.
While we might not have a lot of cash on hand, we probably have something tied up in a retirement account, whether a 401(k), traditional IRA or similar. The problem with pulling money out of our retirement accounts is that the cash is subject to taxation (plus an additional 10 percent penalty if we’re younger than 59 ½), so we’ll pay a penalty just to get our business off the ground — not a great incentive.
Here’s where the ROBS strategy makes sense. While there are other aspects that may make ROBS attractive to a new business venture, the single most important aspect is that the rollover from an existing 401(k) or other qualifying retirement account is 100 percent tax-free. Of course, the IRS will eventually get their slice when you pay taxes as a business owner, but just not now, when you need every cent to launch your business.
Whatever investment level you’re comfortable making to seed your business — whether it’s 20 percent or 100 percent of your retirement funds — doing it through the ROBS financing vehicle means that every dollar will go towards investing in and supporting your business. Even if you use ROBS as a down payment on a business loan – including those from the SBA – you’re leveraging your buying power and preserving your existing personal savings. You could also consider using ROBS as a vehicle to partner with other investors for your new business. Whatever your plan, you will reap the advantages of the tax-free rollover.
Best Practices with ROBS
Before we jump into best practices, here’s how the ROBS process works:
ROBS transactions are carefully monitored by the IRS and DOL, meaning there are very specific guidelines that must be met. This process may seem complicated, but the operational guidelines make good common sense and are in line with other organizational practices we’re all familiar with. Some of the key considerations are:
- Fiduciary requirements for ROBS are intended to prevent conflicts of interest that could undermine the integrity of the business. This should be a no-brainer, as we all want to build businesses that are sound and sustainable. This ROBS guideline can actually ensure we’re not tempted or distracted by bad practices that could damage our business.
- A ROBS-funded business must be an “operating” business that is investing in commerce, not a hobby, nor a vehicle that is intended to simply pay the owner a salary or help out a friend or family member. Again, this requirement helps avoid making an unwise business decision and forces us to scrutinize our venture thoroughly before making the investment.
- Management of the new retirement plan established to fund the business must be fair and transparent, allowing proportional participation by all qualifying employees without giving undue advantage to corporate officers and/or leadership. This is another incentive for us to regard the business as a real entity and to act responsibly.
Business Impact of ROBS
Research firm FRANdata has studied the ROBS phenomenon and found that for every 500 ROBS transactions, 7,648 jobs and $1 billion are created in economic output. In 2009 alone, businesses launched using ROBS funding had an $8.3 billion impact on the U.S. economy.
Despite uncertainties and volatility in the global economy, the opportunity to start a new business as a second-act career remains compelling. This is perhaps more true than ever, as small business owners can respond more quickly and more effectively to market changes and disruptions that are inherent in the digital era. As a former start-up founder, if I were starting a new business today as a (soon to be) retiree, I would look very closely at using a portion of my retirement funds to launch that business through a ROBS.
This post first appeared as one of my regular posts for Guidant Financial, a financial services firm focused on providing guidance to entrepreneurs and small-business startups.