Using Your 401(k) to Buy a Small Business

On June 13, 2012 Barbara Taylor of the New York Times writes

about another way to finance the purchase of a small business

when all the traditional ways of financing are still frozen. How

many small businesses today are still unable to grow or expand?

 

Putting a price on business.

 

Linda Jamerson and her husband financed their purchase of a business with their retirement money.Courtesy of Aluminum Case Linda Jamerson and her husband financed their purchase of a business with their retirement money.

It takes a creative and determined buyer to purchase a small business in today’s lending environment. If there’s any doubt that small-business lending has yet to recover in any meaningful way, look no further than Ami Kassar’s new contribution to this blog: Searching for Capital. While frozen credit markets have made it difficult for small businesses to get loans for expansion and working capital, they have also had a major impact on the business-for-sale marketplace.

Linda Jamerson and her husband, Ken McDonald, are typical of many who have tried to buy an existing small business in the last three years. Like most business buyers the couple wanted to work for themselves. But as high wage earners they also wanted to replace their income as soon as possible, which is why they decided to buy an existing business rather than start one. The couple spent two years looking for the right business — that’s the industry average, by the way — and had two deals fall through before finding an ideal opportunity in Chicago, the Aluminum Case Company.

“Our criteria was a manufacturing company with a good reputation and growth potential that had been ignored,” Ms. Jamerson said. “Aluminum Case Company had a large and varied customer base, a unique product niche, a good reputation and capacity for huge growth. They had no Web presence and had not automated their engineering or equipment, so we felt we could make a quick impact on sales.”

What did not happen quickly was persuading a bank to help them finance the deal. “We were discouraged at how little funding our regular bank — and a few others — were willing to lend,” Ms. Jamerson said. She did a Google search on the keyword term “financing your business” and found Guidant Financial of Bellevue, Wash. — a company that specializes in self-directed I.R.A.’s and alternative small-business financing.

“We have seen significant growth in our business since the end of 2008 and early 2009 when the markets collapsed,” said David Nilssen, Guidant’s co-founder and chief executive. “What is interesting is that today’s small-business and franchise buyer is aware of the credit crisis, and they are investigating their funding options much earlier in the process.” Between 2009 and 2011, he said, the number of inquiries at Guidant increased by 196 percent.

Companies like Guidant and DRDA, a Houston-based accounting firm, facilitate the process of rolling over funds from a 401(k) to purchase stock in your own company. “Rollovers do not operate on a debt model,” Mr. Nilssen explained. “They allow a person to invest in a business without paying interest, making payments or having a payback window.”

The plans frequently go by acronyms like BORSA (Business Owners Retirement Savings Account) or ROBS (Rollovers as Business Start-ups), and they do not incur the taxes and penalties associated with early distributions from a 401(k). (If you consider using this type of financing to purchase a business, be sure to engage experienced professionals who are familiar with setting up and administering these types of plans, which are subject to compliance with both the Internal Revenue Code and ERISA law.)

There are upfront fees to begin the process, as well as annual fees to have the plan administered, so a bit of analysis is needed to determine whether it is a cost-effective option. According to Suzy Granger, business development officer at DRDA, clients are required to invest a minimum of $50,000 from a 401(k), with the typical rollover amount coming in around $150,000. The average rollover at Guidant is $174,000, according to Mr. Nilssen. In any transaction, the funds from a 401(k) rollover may be sufficient to complete the purchase, or they can be used in conjunction with other sources of financing like cash, Small Business Administration loans or other debt instruments.

When they closed their deal in 2010, Ms. Jamerson and Mr. McDonald were able to pay 100 percent cash for the Aluminum Case Company by using their 401(k) funds — with some cash left over for operating costs. “Since we were in such a great cash position, we had no problem securing an operating line of credit with banks backed by our inventory and accounts receivable,” Ms. Jamerson added.

Under new ownership, Aluminum Case reports sales have increased by 75 percent.

Of course, not all business transfers are successful. Ms. Granger at DRDA outlined what happens when a business with this type of financing is forced to close its doors. “Any assets of the corporation are liquidated to cash and used to buy back as many shares of stock owned by the 401(k) plan as possible,” she explained. “The dollars in the 401(k) plan are then rolled out into an I.R.A. for the benefit of the business owner, and both the plan and the corporation are dissolved.”

Obviously, there are risks involved with putting the bulk of your retirement nest egg in one basket. As with all things entrepreneurial, however, risk is in the eye of the beholder. “What I ask my clients to consider is this,” Ms. Granger said. “Currently their money is being invested in other people’s businesses. Do they feel that is more or less risky than investing in their own business, where they have control?”

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