With the growing ranks of unemployed, there is an increase in people looking to finance new businesses using 401-k retirement funds. 

Many of these accidental entrepreneurs have not built up much savings beyond their retirement accounts, or if they did, may have depleted them once any severance ran out.  And if they try to get bank financing they soon find out that without a job, they are not bankable.

There are two ways to tap into 401k’s for funding for a new business: a traditional 401k loan or a Rollover as Business Start-up loan.  Hardship 401k distributions should not be used to fund a new business.

The traditional loan is fairly simple, but not all 401k plans allow for loans.  If they do, IRS rules place restrictions on such loans: 

“Generally, if permitted by the plan, a participant may borrow up to
50% of his or her vested account balance up to a maximum of
$50,000. The loan must be repaid within 5 years, unless the
loan is used to buy the participant’s main home. The loan repayments must be
made in substantially level payments, at least quarterly, over
the life of the loan.”

Note that the dollar limit is a total cap on what can be borrowed, not a limit per loan.

Christine Dugas points out at an article at USAToday that there is another type of 401k loan for funding a business called a Rollover for Business Start-ups loan (also known as a “ROBS” loan by the IRS — is this an editorial comment from the IRS about using your own money for funding a venture?):

“Entrepreneurs using this option typically need help from a
firm specializing in such work.

“For a fee, these firms help the new business create its own
401(k) plan and transfer funds from the owner’s existing 401(k). The retirement
money is then used to purchase company stock that’s held in the new 401(k) plan.
This provides the entrepreneur’s corporation with start-up capital.

“Some experts believe that it is harder for a new small
business to meet IRS guidelines for ROBS loans.”

Given that IRS regulations on ROBS are rather vague, I would STRONGLY caution against using this approach.  Many of the 75,000+ pages of the IRS code come from court cases that were used to interpret other unclear tax legislation. 

I usually shy away from any new tax laws that require IRS interpretation — let others have their names placed on court cases that help sort out what was really meant by the new law.  I had a hard time finding much information on the IRS website on this alternative, which is not a good sign. 

I was able to track down a memo and a newsletter from the IRS that seems to indicate that ROBS loans are not looked on very favorably by the IRS:

“For these reasons, we intend to scrutinize ROBS arrangements. Our guidelines will serve as instructions to our technical specialists to resolve issues they encounter when evaluating these plans. We believe that ROBS arrangements may endanger the qualified status of otherwise tax-qualified employee plans and may be prohibited transactions, requiring complete undoing of the transaction, and imposition of excise taxes.

“In recent years, the IRS has taken steps to combat transactions that we believe are abusively tax avoidant. At the same time, we have noted an upswing in the number of these transactions that seek to exploit the generous tax benefits enjoyed by qualified retirement plans. While we are not ready to throw ROBS into this category, we are certainly mindful of the old adage that things that appear to be too good to be true usually are.”

So even the IRS cautions about the ROBS loan option — not a good sign! 

If an “expert” tries to convince you to use a ROBS loan from your 401k, find another expert.  This type of loan is at too much risk for IRS scrutiny — your start-up will have enough risk without adding IRS problems to the mix.

To career entrepreneurs, using retirement money may not sound that risky.  Most have always viewed their businesses as their retirement funding.  But, these are folks who have gotten comfortable with that level of risk-taking.  Make sure you think through what you will do next if the deal fails and your retirement is badly depleted.

Using a 401k to fund a business may be a reasonable risk.  Make sure you have done your homework on the business before you draw down retirement to fund it.  Develop a sound business model and develop a business plan.  Once you do that, find some experienced people who will poke holes in your plans before you finally pull the trigger.

(Thanks to Ben Cunningham for suggesting this topic).

Financial literacy is a real challenge for many entrepreneurs.

The folks working with Investopedia.com (part of Forbes) are asking for our opinions. They are developing videos to assist people with their understanding of basic financial terms.

They have asked us to take a look at a sample video they have produced and give our feedback.
Would videos like this be helpful? Is the material clear?

Any suggestions and opinions will be welcomed.
Please take a look at the video below and pass along your thoughts — positive or negative — through the comment feature of this blog post.

Thanks!

 

I continue to be in the camp that is worried about inflation — even possibly hyper-inflation — in the not too distant future.  Our ballooning debt along with the many latent inflationary pressures could soon create the spark that ignites a fire storm of runaway prices.  If we see a currency crash, or many are now saying when we see one, we could likely see double or even triple digit inflation.

The problem for small business during inflationary times is that they are less able to adjust prices as quickly to
adjust to inflationary pressures.  There is never a smooth and orderly increase in
prices for every business in the economy and small businesses often suffer the most.

If you have big suppliers and/or customers they can tie your hands. 
Your costs go up, but you are unable to pass along these costs with
higher prices.  One of the added costs we now have to worry about is increased taxes.  This is a real cost to entrepreneurs and cannot be ignored as a part of inflationary costs.

What
I worry about even more is that we may see inflation take hold long
before the recession is over.  This makes keeping prices up to stay
ahead of increasing costs even more difficult as demand will still be
fairly weak for some time.  Given the growing evidence that this may become a long, very long, recession this is a real threat. 

So
what can a small business do in terms of pricing strategies to try and weather this
impending inflationary storm? 

The
recession has made entrepreneurs leery of doing anything but cut prices
to keep their businesses afloat during the recession.  While that may
still be the best course over the short-run, pay very close attention
to pricing from your suppliers, decreases in unemployment, increasing
interest rates, and pricing moves from the big boys in your industry. 
These are the elements of your inflationary dashboard.

When inflation heats up even a little, be aggressive with frequent
small price increases rather than waiting and trying to catch up at
some point with one big jump. Don’t let yourself get behind, as small businesses can almost never play catch-up with their prices.

This
can be tough to implement for some businesses, particularly if you publicly list your prices.  For example, it can get very costly to
print up new menus each month for a restaurant owner who wants to
follow this strategy.

But customers are less likely to pay
attention to price increases if they are small, so it is essential to
find creative ways to communicate your pricing to allow for you to
implement this strategy during inflationary times.  For a restaurant it
may require using menu inserts that can inexpensively be replaced. 
This was actually very commonly used in restaurants during the 1970s
and 1980s when we had high inflation.

I know the question of the
week is pricing, but I can’t let this discussion go without a brief
reminder that the income statement is also made up of costs.  Adjusting
to inflation also requires careful attention to expenses, as cutting
costs can at least somewhat help ease the pressure to increase prices. 

Continue the prudent management of expenses that helped you survive the recession:

– Keep overhead low.

– Build cash reserves to buffer short term price increases that precede your ability to get higher prices from your customers.  I know this sounds contrary to the investment advice we are now hearing about holding cash during inflation.  Don’t think of this cash as investment — it is your levy to hold back the rising tide of inflation. 

– Watch your margins carefully. Worry about growing profits, not sales.

– Don’t lock into long-term contracts that have narrow margins with large customers.

– Pay down variable interest loans ASAP, especially now that
interest rates are temporarily relatively low. As soon as inflation heats up, interest rates will continue to rise.  And given the stubbornness that the Fed is now showing with interest rates, we may soon see huge spikes in rates over just a few quarters as inflation takes hold.

I have received a few e-mails asking how in the world can you raise too much money, as I talked about in the interview in the American Express OPEN article.  This is a fair question, especially if you are a start up trying to pull together funding in today’s environment.

I actually do see some start-ups raise too much money, but not many.  They are almost always backed by venture capitalists.  VCs usually have a pretty high minimum investment, which can lead some entrepreneurs to “fit” their deals to fit this artificially high number.

But more often, I see successful companies raise too much money.  Success can make attracting money much easier.  Investors want to tag along on your success, and bankers love to lend to companies with rich cash flow.

Raising too much money can be much worse than not raising enough money.
I know those of you struggling to make payroll think I am nuts for
saying this, but it is true.

Too much money in a new venture leads to
poor decisions on unnecessary overhead, wasteful spending on
non-productive assets like opulent offices and furnishings, over
staffing, inflated salaries, and just plain mischief.  If sales don’t build quickly enough the entrepreneur has a business a high level of overhead that just cannot be sustained.

Too much money put into a growing venture can lead to unsustainable growth and chasing too many opportunities too quickly.  The influx of money is spent, but the now fast growing company has operating cash flow that just cannot keep pace with the expansion created by the infusion of money.  It is like a rocket that runs out of fuel before it ever gets into orbit — it just comes crashing down to Earth.

In a guest post at TechCrunch, Vivek Wadhwa adds his voice to those questioning the VC industry’s play for bailout money:

What we need to do is to apply the same rules to VC’s which they impose on
their companies – force them to make tough choices and get their business models
in order. And instead of giving the tax-breaks to the middlemen, let’s give
these directly to the entrepreneurs who take the risks and create the
innovation. It is the entrepreneurs who fuel the economy, not the venture
capitalists or investment bankers.

This post is cites reputable studies that show the real impact of VC money, including Paul Kedrosky’s discussed earlier at this blog. 

I have said this before, but it bears repeating — venture capital funds a very small part of the entrepreneurial sector.  One study suggests that 99.962% of all entrepreneurial ventures in the US had NO venture capital investment.

Venture capital does have some impact on our economy, but much less that the lobbyists for VCs would like us to believe.

(Thanks to Andy Tabar for passing the TechCrunch post along).

From Fast Company:

[N]ow there’s news Richard Branson is accepting “micropitches” via Twitter for new
startup ideas.

It’s all part of a new startup conference dubbed PerfectBusiness that the
billionaire entrepreneur is helping to get going, and it’s pretty simple. All
you have to do is Tweet your business idea to @PerfectBusiness and add the
hashtag #micropitch… which means your business idea has to be compressed down
to just 111 characters to fit into the available space of a Tweet. Winners will
get two tickets to the conference, airfare to L.A. included, and business
coaching to turn the Tweet into a meaningful, complete company plan. There’s
even the chance Branson and team will choose your idea and get some VC funding
on board.

(Thanks to Belmont alum Tyler Seymour, co-founder of Just Kidding Productions, for passing this along).

To all of you small business owners out there — be alert for yet another scam that is making the rounds.  This one involves fake checks.  Read about here in an article by Kathy Kristof at MoneyWatch.com. And please pass this along to other business owners.