March 15 2010|12.38 PM UTC


401k the New Angel Investor

Category: Personal Finance, SavingsTags: , , , ,

Using a 401k to start or fund a business has been a hotly debated topic among industry leaders. Some glorify their business success stories and the 401k plans that made it all possible. Others criticize the practice as an unstable and risky alternative to creating a business savings. To the opposition, why use an unreliable financial strategy when more conservative options can be just as appropriate?

Aaron Franklin, CEO and co-founder of Lazymeter, stands by using his own capital rather than tapping into a 401k or investors. This former Microsoft employee left the software giant to start his own company, but not before he had the funds saved up. According to Franklin, “Fortunately I paid attention to my bills, and was responsible, and put money away. I never knew why I was doing it at the time, but I was really happy when I had this big idea.”

That big idea was Lazymeter, a personal communication system that serves as a task management tool. Although Franklin himself has a bit of an aversion to the phrase “task management”, this is most likely because his product offers so much more. Franklin, just two months after launching Lazymeter, has received interest from an angel investor. However, Franklin is one of the lucky few who has access to the Silicon Valley network of investors. Since most people don’t, let’s first examine in real terms how starting a business with a 401k works.

The best case scenario

Suppose a corporate-hire holds a 401k with their employer, worth a total of $26,000. The retirement plan grows by ten percent each year. Unlike Franklin, this entrepreneur decides to keep their day job and borrow cash from their 401k to fund a business (In most company sponsored retirement plans, employees may borrow 50 percent or up to $50,000, whichever is greater, without paying a penalty or tax on the borrowed amount). Using the total 401k value of $26,000, a start-up is born. Five years later, the business becomes profitable and the owner recoups their initial investment. That money is then placed back into the 401k to resume interest growth.

The pay-off, or down side

In another ten years of growth at ten percent interest, the 401k should be worth $67,000. Now, this business owner has managed to hold onto an egg nest as well as create a profitable business. Pat on the back, right? Not quite. If this individual had not tapped into their retirement savings for business expenses, the account could have been worth $108,000. In essence, this entrepreneur lost $41,000 by taking money out of the interest bearing account to use as cash for their business.

If the business profits grossly outperform the 401k plan’s interest gains, then the $41,000 should not be counted as a shortfall? Sure. However, most businesses won’t be this profitable in their first years. In fact, only 50 percent of small businesses with employees (employer firms versus individual entrepreneurial ventures) remain open after five years, according to the Small Business Administration (SBA). The SBA estimates that of the 627,200 employer firms opened in 2008, 595,000 of them closed by year end. That is a turnover of approximately ten percent for exit and ten percent for entry. These numbers increase by three times as much for solo entrepreneurial companies. Meaning, for most small businesses, they do not survive long enough to become profitable. Thus, for entrepreneurs who tap into their nest egg, that money will never be regained.

There’s more…

Another catch to this finicky financing: if loans from employer sponsored 401k’s are not repaid, then the borrower will have to pay penalties. Asheesh Advani, Startup Financing columnist, wrote in his article, Tapping Your Personal Savings to Fund Your Startup, that “[Borrowing from your 401k] is penalty-free, unless of course you don’t pay the money back. Then the usual early withdrawal penalties apply.” Additionally, “Most plans also require you to repay the loan within five years, and definitely before you change employers.”

With the loss of a lifetime’s savings at stake, tapping into a 401k comes with much risk. Aaron Franklin suggests that a personal savings allows for more freedoms than would other means of financing. “You don’t get money for free,” says Franklin in explanation of raising funds from investors, “You’re getting someone who is going to be watching over you. You’re going to spend three to six months raising that money.” Also, Franklin says, it takes money to raise money. Putting all of these factors into perspective, investor funding obviously comes with strings attached. As a 401k limits an entrepreneur in terms of the risk he or she is willing to take, venture funding limits an entrepreneur’s creativity if the investor has a different vision for the end product. “For me,” says Franklin, “I found that working out of my own savings is motivational.”

401k v Investors v Personal Savings

Ultimately, the choice is up to the entrepreneur. Whichever factor that motivates someone to choose one source of funding, may be a major deterrent to another. For the “play-it-safe” crowd, however, draining a 401k is probably the last resort.

Thinking of saving-up to start your own business? See BillShrink for savings and CDs to compare savings tools with the highest yields of return.

Also, a low interest credit card is almost always a small business owner’s best friend. See BillShrink for business to compare credit cards that best suit your needs.

Are you a small business owner with financing advice to share? Maybe you are looking into a market, but have some financing questions first. Share your comments below…

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