Raise Money with Your 401k

This primer on raising capital through your 401k was written as a chapter in the book called, Where's the Money. I wrote the book under agreement with its' authors Dwayne Moyers and Art Beroff and with Entrepreneur Media, Inc.

David R. Evanson

Entrepreneur Magazine, Fall, 1998

Definition or Explanation: A 401(k) is a tax deferred savings account which an employer establishes for its employees. This savings vehicle can invest in almost any kind of investment. The 401(k) stays intact even if the employee leaves the firm. If the employee leaves to start a new business, the 401(k) can be used to finance the new business by investing in it.

Appropriate For: Any company at any stage of development. Since an entrepreneur is funding the company with his or her own retirement savings, they need only convince themselves that the deal is worth the risk.

Supply: This option is for entrepreneurs who have been cut loose from corporate America with a 401(k) plan. Beyond simply having a 401(k), the supply is further influenced by how much of their tax deferred retirement savings entrepreneurs are willing to put at risk.

Best Use: Financing start-ups. When start-up companies are financed with equity from outside sources, itzzs the most expensive financing there is, because the company is worth so little. A round of seed financing can cost 30% of the equity. Although 401 (k) financing forces a company to surrender equity, this equity is surrendered to the firmzzs founders, and as such, is not really lost at all.

Cost: The fees can run high because several professionals are required to engineer the transaction. However, 401 (k) financing does not cost the founders any equity in their business.

Ease of Acquisition: Moderately challenging. There are several legal and accounting issues that must be resolved for this technique to work properly.

Range of Funds Typically Available: $100,000 and up.

After nearly 20 years in sales and sales management for a large manufacturer of printed forms, labels, and electronic printing systems, Jim Brien, was getting antsy. The business plan which he was writing in his head was getting more and more detailed. And when the future of the company he was working for seemed less certain, Brien, along with five fellow salespeople made the jump to form Print Integration Partners, which not surprisingly, brokers printing and also offers forms management services.

Brienzzs business plan showed the company needed about $500,000 during the first two years of operation for office equipment, inventory (of forms) and to fund receivables. Though Print Integration Partners was up and running, Brien wasnzzt ready to have the grand opening until he knew that the business could be funded. “I thought it would be a big mistake for us to launch headlong into the business without any funding”

“At the time,” he says, “the biggest asset I had was the 401(k) plan from my previous employer, so naturally, my first reaction was to see what could be done with that.” In fact, all the newly minted Print Integration Partners had 401(k) plans, and in the aggregate, there were more than enough assets to fund the business. The trick was unlocking these funds.

Brien and his partners could have liquidated their 401 (k) plans. But he says, therezzs a 20% penalty right off the top, and the distribution from the liquidation must be taken as income in the year in which it is received. So, if itzzs a good sized distribution, it will push the recipient into the higher end of the thirty something tax bracket. No thank you!

A simple and straightforward approach would be to simply have the 401 (k) plans purchase shares directly in Print Integration Partners. This could be easily accomplished despite the widely held, though mistaken belief that 401 (k) plans can only make investments in publicly held companies.


Shop Talk: An Employee Stock Ownership Plan is a legal and separate entity through which employees collectively can purchase equity in a business.


However Greg Brown, an attorney specializing in Employee Stock Ownership Plans (ESOPs), with law firm Seyfarth, Shaw, Fairweather & Geraldson counseled Brien that there might be better approach. Specifically Brown proposed Brien establish a Print Integration ESOP from which the 401 (k)s would purchase their shares in the company. Brown said that such a transaction would require a highly specialized team of financial professionals, but that the structure would deliver several tax and estate planning benefits that most small businesses donzzt ever think about, until itzzs too late to do anything about them. This team that Brien would need included an attorney, an accountant, a valuation specialist, and a securities firm.

401 (k) Financing With An
Employee Stock Ownership Plan

It took Brien about five months to assemble the team and put the transaction together. By April 1996, about five months after Print Integration Partners was incorporated, all the pieces were in place, and the transaction could be executed. Brien and his partners then instructed Smith Barney, the custodian of their 401 (k) plans to purchase shares in the Print Integration Partners Employee Stock Option Plan, for which it was also custodian. As a result, cash ($427,000 in total) went from the 401 (k)s to the ESOP, and from the ESOP into Print Management Partners bank account. Then stock certificates in Print Management Partners were issued to the ESOP in the names of each of the employees making the investment.


A Good Deal: If you finance your company with your own retirement savings, you do not surrender any authority to outside parties. This is important for early stage companies, because outside investors often believe a company is in trouble before it really is, and tend to cause difficulty with their knee-jerk reaction to the problems the company is facing.


Tricky yes, but when it was all done, Brien and his partners had successfully tapped their 401 (k) plans without any tax consequences, funded their new company without giving up equity or bringing in outsiders, and kept the balance of their savings in tact.

When reviewing the transaction Brien is quick to point out that the structure which Print Integration Partners and its team engineered had merit well beyond the initial financing.

First, Brien points out that the ESOP delivers built in liquidity for founderzzs shares. “The reason most private businesses rarely last more than one generation,” he says “is because there is nobody to buy out the founders or other stockholders when they are ready to retire or move on. But the ESOP means the exit strategy is already in place, because when shareholders leave they have the option of selling their holdings to the ESOP at a fair price.”

In addition to liquidity for founderzzs shares, Brown adds there is a compelling tax advantage too. “Business owners can sell their shares to the ESOP and defer the capital gains tax on these shares by purchasing stock or bonds issued by U.S. corporations.” Since, at retirement, most entrepreneurs must invest the money they take out of the business for income, this tax deferral meshes nicely with the business ownerzzs lifecycle.

Second, with an Employee Stock Ownership Plan in place, Print Integration Partners now has an effective tool to attract, retain, incentives and reward employees, with several options on how it can accomplish any of these objectives. For instance, Brien said, “commencing our second year in business, we issued ESOP stock to everyone in the company, so that everybody has a stake in what the company is doing.” Thatzzs the incentive. But as for the reward, says Brien, “We have the option of passing profits to stockholders via 401 (k) matching, without it being taxed. Really, there are now several options we have to manage profits, and pay a fair tax.”

Third, and most importantly, Brien says that Print Integration Partners was able to fund its start-up operations without searching high and low for outside investors who would extract a high price in terms of the ownership of the company they would demand. In the end, Print Integration Partners didnzzt give up a basis point of equity — no small feat for a start-up company.

The success of a 401 (k) transaction will depend largely on the team which is assembled to help get the transaction done. Here are the principal players:

– Counsel. You will need an attorney to draft the documentation for the ESOP, as well as to define and engineer the relationship of the ESOP to the 401 (k) plans. Although such a transaction is not beyond the ken of a general practitioner, its cutting edge nature probably demands an ESOP specialist.

– Valuation Consultant. Since, at the end of the day, the ESOP is purchasing stock from a corporation, there needs to be a qualified opinion about the value of the stock which is being purchased. There are lots of valuation specialists, and many of them specialize in certain kinds of industries. Rather than a specialist who understands a particular industry, itzzs also important to find a valuation specialist who can work with emerging or start-up companies. After all, traditional measures of value, such as assets, or book value, are often not available with start-up businesses.


Donzzt Forget: The valuation specialist will need a well developed set of financial projections to do his or her job. Donzzt wait until the last minute to get this done because it will add weeks to the process while the other moving parts in the deal cool their heels.


– Stock Brokerage. A brokerage firm is needed to act as the custodian for the ESOP stock. Care must be taken to choose a firm with the right size and capabilities. After all, current or future employees who participate in the plan will need to establish or rollover their plan with the broker. As a result, you want a brokers who can provide not just service, but investment options or access to investment options above and beyond the ESOP stock.

– Accounting Expertise. Everybody needs good tax advice, but with an ESOP in the picture the tax issues are even more complex. After all, as mentioned earlier, the companyzzs net income can be managed, in part or whole through the ESOP. In addition, the 401 (k)s will need an administrator to keep track of stock purchases by employees. Some accountants as well as a brokerage firm can fill this role.


Taking Action: Look at your 401 (k) plan and evaluate whether or not it contains sufficient assets to fund your business. If the 401 (k) contains less capital than you project needing, but makes a sizeable dent, contemplate the answer to the following question: Am I willing to put all of this money at risk?


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