Done right, a rollover of retirement funds can be smart option
More franchisees are using their 401(k) retirement funds to finance the purchase of a franchise. Who should consider the move? Experts explain the do’s and don’ts, including warnings about strict IRS rules.
Jeremy Turner’s decision to pretty much tap out his retirement funds to buy a Lawn Doctor franchise was very clear: He calls it the best option he had after banks would not lend him the money.
Turner withdrew $70,000 from his 401(k) plan and another $30,000 he and his wife had in savings to start the lawn care business in St. Louis in 2010. Turner says he discovered companies charge around $5,000 to help complete the financing process. “I would not suggest that someone try to do this on their own because of tax and other risks involved,” he says.
Some franchise systems, including Lawn Doctor and Anytime Fitness, have systems in place to refer potential franchisees to reputable outside firms to complete the process. That’s critical because 401(k) rollover transactions are regulated by the Internal Revenue Service and U.S. Department of Labor, resulting in potential tax consequences for franchisees if transactions are not done correctly. It generally takes about 15 days for franchisees to get their cash.
Taking a gamble on his retirement savings has been worth it so far. Turner now has three Lawn Doctor locations and plans to add two more by next year. Landing repeat business and adding new customers has helped keep business steady with revenue expected to hit $500,000 this year.
Turner, 41, says the rapid expansion and reinvestment into the business was geared to replenish what he took from his 401(k) faster. He expects to generate at least $1.4 million in savings over the next decade, aiming to build a comfortable nest egg for him and his family.
Relying on retirement money to finance a business can be risky, especially with about half of small businesses failing in their first five years, according to the U.S. Small Business Administration. Moreover, depleting retirement funds can be devastating financially if the cash is not recovered.
But the continuing credit crisis and sour economy is forcing many franchisees to seek non-traditional financing to buy and start up franchises. Firms such as Guidant Financial, Benetrends and FranFund that offer franchise financing are reporting double-digit transaction gains using 401(k) funds.
Franchise broker FranChoice of Eden Prairie, Minnesota, has seen 50 percent of its new franchisee placements funded with a 401(k) or IRA rollover during the last two years, says Andrew Horton, the firm’s former vice president of business development. He said the percentage grew when the financial crisis hit in 2008; such placements were largely unknown 10 years ago.
Guidant Financial’s CEO David Nilssen says he expects the demand for 401(k) rollovers to keep accelerating because the nation remains in a challenging credit environment and job growth is slow.
Nilssen says Guidant Financial of Bellevue, Washington, in 2012 did approximately $232 million in financing for 401(k) rollovers, up 37 percent from 2011. Since 2009, he says business has grown by an average 19 percent year over year, and the average rollover of $170,000 has not changed much over time.
Using money from retirement can be done with a loan from an existing 401(k), but there are limitations to the amount and terms. Nilssen says sometimes that financing option can be appropriate, especially when the total investment is less than $50,000.
Typically, though, creditable firms that provide 401(k) rollover financing suggest that franchisees use another option known as ROBS, which stands for Rollovers for Business Startups. It requires a potential franchisee to establish a C corporation and roll an existing 401(k) or IRA into a new retirement plan. The new retirement plan then purchases stock from the corporation.
Proceeds from that transaction are then used by a franchisee to buy a franchise. Because it is an investment and not a loan, a franchisee is not obligated to make interest payments and does not face early withdrawal penalties or taxes. “The ROBS arrangement is extremely intuitive to an entrepreneur because they have a high level of confidence in their ability to lead and grow an organization,” Nilssen says.
An investment, not a loan
Tara Bailey, 33, took about $100,000 from her 401(k) to do a ROBS transaction to help buy a Right at Home franchise in the Atlanta suburb of Marietta. She and her husband also invested $20,000 in cash savings to open the business in January 2013 that offers senior citizens home care services. “Using the 401(k) helped us to start the business and continue our current lifestyle without acquiring new debt like a bank loan,” she says.
Dallas Kerley, chief development officer at Benetrends in North Wales, Pennsylvania, says his firm is seeing more people using the rollover in conjunction with an SBA loan.
For instance, he says if someone is looking to invest $300,000 into a franchise, they generally can come up with the 30 percent or $90,000 needed for the down payment by taking money from their 401(k).
At Benetrends, financing for ROBS has risen more than 35 percent annually the past two years, with franchisees typically taking out about $200,000 from 401(k) plans, Kerley says.
Insufficient capital to cover a large small-business loan was a driving factor that led John Heifner to withdraw all $120,000 from his 401(k) to open a Workout Anytime franchise in Powell, Tennessee. He used $30,000 from a bank loan and other savings to open the 24-hour, seven-day fitness center in 2011.
Heifner, 42, says business has been strong and he’s hired five people to help continue that momentum. “Starting our third year, I can start thinking about funding a retirement again instead of keeping my money more fluid for cash flow,” he says.
A lack of financing by banks to service-based franchises like senior citizen home care, window cleaning and water restoration businesses has helped boost activity at FranFund of Fort Worth, Texas. COO Sherri Seiber says FranFund has had an average per year growth rate of 35 percent to 40 percent since 2009 from franchisees using 401(k) rollover plans to buy franchises. She says franchisees have taken an average of $100,000 to $150,000 from the savings plans the past two years.
Even with some of the intricacies and risks, Seiber is confident 401(k) rollovers are viable financing options for franchisees.
Do’s and don’ts for using 401(k) funds
If you are looking at using your retirement funds to buy a franchise, consider these factors:
• Don’t make the move if your retirement amount is not substantial enough to offset the cost of using the plan. Financial providers charge a fee for the service and they can help determine if the move makes sense for a franchisee’s personal situation.
• Do work with a reputable Employee Retirement Investment Securities Act (ERISA) firm on the transaction. The firm can help you follow applicable tax laws on properly investing retirement funds into a business and avoid potential problems with the Internal Revenue Service.
• Do be careful to hire a provider that can clearly explain the rollover program. Select a firm that has a proven track record and is capable of servicing your 401(k) plan during the life cycle of your business.
• Do use the same scrutiny and due diligence to evaluate the rollover option as you would to buy a franchise.
• Do your homework and ask about potential financial and investment risks before deciding to use the rollover option.
• Don’t invest your retirement funds into a business unless you think it’s a great investment and will benefit your retirement goals.