This is the fourth in a series of posts about buying a small business and how we purchased our first one. If you are catching this series mid-stream, I recommend you start at the beginning of the series with Buying a Small Business: Overview.
In the first post in this series, I covered the benefits and downsides of buying an existing small business. I also mentioned the fishing lure business that my wife was unenthusiastic about purchasing and that one week later, she found the perfect business to buy.
In the second post in this series, I talked about how you might go about finding a business for sale and establishing selection criteria. I also shared where we found our business and the selection criteria that we used.
In the third post in this series, I talked about debt financing and how you might go about borrowing money to purchase a small business.
In this post, I’m going to talk about equity financing to purchase a small business.
Small Business Equity Financing Overview
As I discussed in the prior post, there are two types of money to use in financing the purchase of a small business. You can use debt, which is a loan that needs to be repaid. Or, you can use equity, which conveys ownership and a right to profits, and does not need to be repaid until the business is sold. Often, purchases will be financed with a combination of both debt and equity.
The problem with equity, is that buyers often struggle with how to come up with enough equity to purchase a business. Just like buying a house, coming up with 20% for a down payment can be a struggle. The same goes for buying a business. Even if you can get an SBA guaranteed loan, the bank will likely want to see you putting in 20% of the value of the business yourself. Why?
Banks always want the owner to have some money in the deal so they will be motivated to make the business work and make their payments on time. It also gives them a cushion in case you disappear one day and they have to sell the business to get their money back. If they only lent you 80% of the value of the business, then they have the other 20% of the value to play with to cover the costs of selling, etc…
Three Places to Get Equity Financing
There are basically three places that you can go to in order to find equity financing. First, you can fund the equity yourself. This is pretty straightforward as you just look at your non-retirement accounts and decide how much cash you want to tie-up in a business. Don’t forget to leave your emergency fund intact.
Second, you can get money from investors. This is also straightforward, but more difficult to do. You’ll have to reach out to high net worth individuals that you may know or be acquainted with to see if they would be interested in investing in your business. You’ll have to market yourself, market the business you are buying and of course, hold yourself accountable to your new shareholders and give them a share of any profits.
I would put friends and family in the “investor” bucket too. While they may not be as tough on you as a disinterested third party, you’ll still have to give them a share of the profits unless they just make you a loan. If you’re business doesn’t turn out so well though, it could make for an awkward Thanksgiving get together, something to consider. Personally, I’d recommend staying away from friends and family funding if you can.
Finally, and much less commonly known, you can get the money from your retirement accounts. Wait, what? From retirement accounts? What about the early withdrawal penalty?
Yup, this is one of the interesting things that I learned when I was looking for a larger business to buy, back in 2014 when I was laid off. You can actually do this without any penalty. One caveat before we even discuss funding the purchase of a small a business with your retirement funds. You need to think very long and hard about how much of your hard earned retirement money you want to put at risk. That being said, let’s see how it’s done.
How to Access Your Retirement Funds to Buy a Small Business
In speaking with a business broker in my area, he told me that the vast majority of businesses he sells are to mid-career executives who get laid off from big corporations and then cash out their 401ks and IRAs to buy and run small businesses. They do this without paying an early withdrawal fee.
Before I walk you through the process though, here’s another caveat. This type of financing requires very specific accounts to be setup in very specific ways in order to comply with tax laws and to provide you with the maximum benefits and flexibility. So, before following any of these steps, you should contact a lender that specializes in this type of financing and have them walk you through the process step-by-step. Here goes…
First, you setup a c-corporation that is the legal entity that will ultimately buy the business. Work with your lender to setup the c-corporation and retirement plan properly, it will need to be setup as a self-directed retirement plan. Then, you rollover your old 401k into the new self-directed retirement plan. A properly executed rollover is always a non-taxable event. So far, so good.
Now comes the cool part. Since your retirement plan is self-directed, you have more discretion in where to invest the money. In this case, your new retirement plan will use some or all of your old 401k money to purchase stock in your new c-corporation. What does that mean for you?
Your retirement account now has less cash, but owns stock in your new company and your new company now has the cash from the transaction. You just sold yourself an ownership stake in your own company – congratulations!
You can use that cash to not only buy the small business that you were looking at, but to cover normal operating costs once you’ve acquired it. You can use the cash to pay yourself a salary, cover marketing expenses, payroll, etc…
Here’s a video from one of the leading providers of this service, Benetrends Financial:
I was amazed when I heard about this financing option, and this is just another reason why I think everyone should max-out their tax-deferred savings accounts. There are lots of way to access your retirement money without paying an early withdrawal penalty if you need it.
There are several lenders that specialize in this type of financing and if you are going to move forward with this type of financing, I would recommend going with an expert. Here are two that are popular:
So, those are three different ways to get equity to fund the purchase of your business. Pretty cool, right?
What We Did
One of the main reasons we wanted to purchase a small business in the first place was to generate some cash for our household. So, if you recall from the last installment, we had NO equity to make the purchase. We financed the deal with 100% debt from our HELOC. Nice and clean.
We worked it out so we broke even on the purchase after one year. Every year since then, the business has been generating cash for us, year in and year out – wahoo! It turned out to be a really nice deal.
In the next installment, I’ll talk about some other aspects of buying a small business, like how to handle the due diligence and making the seller an offer.
Did you know it was so easy to access your retirement funds to purchase a business? How much of your retirement money would you tie-up in a business? What if it was a “sure thing”?