Using Retirement Funds to Fund Startups

When considering funding a startup business with your retirement savings, the first question that comes to mind may be "Why?" The answer lies more in the people themselves, than the funds. These investors range from retired entrepreneurs who have "played it safe" throughout their careers and want their shot at their own venture, to retirees who need cash to sustain their lifestyles. Some want to "own something," while others like the excitement and the risk involved in being their own boss.

In this article, we'll address one of the first and most important steps for any small business: financing. We'll also take a look at what you can do to drum up this "retired" money. (For background reading, see Start Your Own Small Business.)

Getting It Started: Funding

Once you know what kind of business you would like to start and have made some plans, the first obstacle you are bound to run up against is funding. It will take a while (possibly a long while) before your business starts turning a profit, so you'll need some money to get things running and keep them running until you can secure a consistent base of customers. There are many ways to fund a small business, but some may be more appropriate for retirees. Let's take a look at some of the options available.

Retirement Seed Money

Taking cash directly from your retirement savings provides easy and instant access, carries no interest burden and keeps total control in your hands. However, if stealing from your main source of money is distasteful to you, then you might want to consider tapping your investments, severance-package monies, cash from refinancing your mortgage equity, and even your extra IRA and 401(k) plans. (For more on borrowing 401(k) funds, see Borrowing From Your Plan.)

This latter category of IRAs and 401(k)s can be accessed tax-free, penalty-free and with no required repayment. This is because this money is considered an investment in your own business. If the loan is properly set up, it will be just like any other investment made with IRA and 401(k) monies.

The process involves setting up the startup as a C corporation. This corporate structure has a slate of officers and a board of directors, which meet at least once per year and create recorded meeting minutes and issue shares of stock in the corporation. With a C corporation in place, funds from an existing 401(k) or IRA can be can be rolled over into the retirement plan of the startup C corporation. The retirement plan then invests the funds in the startup C corporation in exchange for shares of stock in the corporation. Although this method is not foolproof, plans of this type have received positive letters of determination from the Internal Revenue Service (IRS). (To learn more, read Common IRA Rollover Mistakes.)

This arrangement allows the tax-free dollars in the 401(k) and IRA accounts to be used without tax liability or penalty and delivers significant additional benefits to the business startup. These include:

  • Quick access to startup cash (two to three weeks)
  • Cash with no interest burden
  • Optimized business equity and value
  • The ability to receive a salary during startup
  • The ability to set aside tax-deductible retirement savings of up to $200,000 per year (To learn more about small-business retirement plans, see Plans the Small Business Owner Can Establish.)

If you elect to use your IRA and/or 401(k) funds, there can be important tax advantages depending on your income level, as mentioned above. In addition, your write-offs for startup costs and your early losses used to build the company can materially reduce your short-term tax burden.

In addition, as companies continue to reduce healthcare and dental insurance coverage, as well as disability and life insurance coverage for their retirees, your own startup business can be an important provider of these benefits for you and your family.

Betting Your Safety Net

It is important to consult experts, such as accountants and attorneys, to ensure that this process will suit your individual circumstances. This type of strategy must be set up properly, as the risks of using these self-funding cash sources can be significant. According to the Small Business Administration, four out of five small businesses fail in the first five years.

As such, the high rate of startup failures is something to be carefully considered. Once you're retired, you'll have very little time to recoup any losses you incur as a result of your failed business. Also, if you are using your retirement funds to start a business, you are essentially betting your "safety net" on the success of the startup. Therefore, be sure that any retirement funds you risk on such a venture is not your sole financing for retirement. Be sure you have substantial additional savings to back up this gamble.

Other Financing Options

If your analysis of funding sources indicates that 100% self-funding carries more risk than you wish to take alone, the retirement savings you wish to commit to the startup may be supplemented by debt financing, grants and equity financing.

Debt Funding
Debt funding can take the form of loans of various types, including lines of credit and credit cards. Debt funding usually requires a successful credit track record, a business plan, demonstrable cash flow, some collateral, an established banking relationship and some liquidity of the business assets. (For more insight, see The Best Way to Borrow and 7 Unconventional Ways Businesses Can Borrow Money.)

Advantages of debt funding include retention of ownership and its availability to companies that are unable to attract equity financing. The disadvantages include the burden of interest, the probability that personal assets (your home) will be required as collateral, and that a bank loan doesn't come with much networking or business savvy value for your business startup. (For more insight, see What do people mean when they say that debt is a relatively cheaper form of financing than equity?)

Depending on the type of business you are entering, grants may be a source of partial funding, even in startup mode. Companies with technology of interest to the federal government or those with research or social value can be eligible for Small Business Innovation Research grants or Cooperative Research and Development Agreements to facilitate technology transfers from government agencies to private industry. Other regional government and foundation grants are also available. The advantage of a grant is realized on two levels: the grant is "free" money and businesses that receive grants often attract investors who like the leverage the grant provides. The disadvantages of a grant are that grant awards are highly competitive (difficult to acquire) and the use of grant funds is highly restrictive.

Equity Financing
Equity financing involves relinquishing a portion of ownership in your company in exchange for cash. Going public and issuing widely held exchange or over-the-counter traded shares is not considered here, as startups rarely have the means or the market recognition to do an initial public offering (IPO).

The three major types of equity funding available to startups are "angel" investors, venture capitalists and strategic investors. Each category has advantages and disadvantages.

  1. "Angel" investors are individuals or small groups of individuals who invest money in businesses they see as having a high growth potential and an above-average rate of return on the monies invested. (They are different from investors who focus more on the success of the business than the return.) Angels usually have a higher risk threshold than a bank and may be more flexible in their terms. They may or may not invest in the business long term. They can also bring business networking contacts and business savvy to the startup.

    The downside to this option is that angels usually require a higher rate of return for their investment, may want a larger stake in the business if it does well, and may want to influence the direction of the business and its future. (To learn more, read When Your Business Needs Money: Angel Investors.)

  2. Venture capital companies are firms formed to provide equity financing in riskier situations than a bank would entertain. Their usual expectation is for a relatively short-term investment with a high rate of return and either their exit from the company or the sale of the business at a great profit.

    The advantage for a startup is the quick and flexible availability of moderate to large amounts of cash, in addition to the networking and business savvy of the venture capital company. Disadvantages include the difficulty in obtaining venture capital, the loss of total control of the direction of the startup and its future status.

  3. Strategic investors are those who may be willing to provide financing to a startup in exchange for equity and additional conditions for the benefit of the investor's company. This could take the form of a supplier company helping to finance a distributor in a market are that it doesn't currently serve. It could also be a way for a company to gain a competitive advantage by preventing you from dealing with its competitors. It may also be that a close working relationship with a strategic investor would benefit both companies. The strategic investor may also bring industry knowledge and contacts beneficial to the startup.

The Bottom Line

There are a multitude of personal and practical reasons why entrepreneurs start a business in retirement. Depending on the unique conditions of each situation, it can be the successful adventure of a lifetime, or an economic disaster with little time left to recoup losses. 

Enter such investments with both eyes wide open, with all the potential benefits and risks understood, and with all financing options explored, analyzed and chosen based on what best fits your situation. If you succeed in running a business that you love successfully, retirement could be the best years of your life – both personally and financially.