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What are the Benefits of Using Retirement Funds to Buy a Business?
Why would a buyer consider using retirement funds to buy a business? And why would a seller prefer a buyer to use retirement funds to buy a business as opposed to other forms of financing?
Retirement funds are easy to access – For the buyer, retirement funds can be accessed quickly and with a high success rate, whereas bank financing is often difficult to access. It is considerably easier for a seller to accept an offer that is contingent on a buyer accessing retirement funds to buy a business. Many offers are contingent on the buyer receiving bank financing to purchase a business. Most sellers are reluctant to accept these offers because of the traditionally high failure rate of obtaining a bank loan to purchase a business.
The seller cashes out at closing – Using retirement funds creates a win-win situation for the buyer and the seller. The buyer can easily access funds to purchase the business and the seller receives all cash at closing.
Streamlined process – The process of accessing your 401 (k), IRA or other retirement funds to purchase a business is quick and easy. Contrast this to the process of obtaining a bank loan, such as an SBA 7(a) loan, which is time consuming for buyer and seller. When obtaining bank financing, a buyer is often required to prepare a complete business plan along with projections, in addition to dozens of other document requests. These strict requirements are present when one accesses funds from their retirement to purchase a business. As you can see, it is comforting for a seller to accept an offer in which the source of funds is the buyer’s retirement account.
High success rate – Once an initial screening takes place, the likelihood of accessing your retirement funds to purchase a business is high, well above 90%. Contrast that to the process of obtaining a bank loan to purchase a business, which can take many weeks just to obtain a preliminary approval.
Cost of Funds – Using retirement funds to buy a business can be less expensive than using bank money to purchase a business. Simply stated, banks charge interest. A buyer can easily pay more than $100,000 in interest on a $500,000 loan over the life of that loan. Contrast this to the use of retirement funds as your source of financing – your retirement funds are your own money and there is no interest to pay. While there are fees associated with administering a retirement fund, they are likely to be significantly less than the cost of interest charged on a bank loan.
Creative deal structures – The use of retirement funds allows for creative deal structuring. This structure can be combined with other sources of financing, such as traditional or SBA bank loans, without causing complications. Because the retirement funds are treated as your own money, there is no issue with subordination.
Can be used as a down payment – Your retirement funds can be used as a down payment on a business. This can be combined with other forms of financing, such as seller or bank financing. For example, we recently sold a business where the buyer used $100,000 in his retirement funds as a down payment, the bank financed $700,000, and the seller carried a note for $100,000. The deal would have been impossible without access to the buyer’s retirement funds.
No credit score required – Your credit score does not matter when accessing your retirement funds. It is your money. You are not borrowing money from a bank and therefore no minimum credit score is required.
Multiple purposes – The funds, once accessed, can be used for a multitude of purposes, including working capital and purchasing new equipment or other corporate assets.
No debt – Some people seek to avoid debt at all costs. Using your own money, such as your retirement funds, is not creating debt.
Maximizes cash flow – Less interest to pay equates to higher cash flow for the buyer. This can help justify a higher purchase price if cash flow is strained when preparing financial models that incorporate some form of bank financing.
Tax benefits – The use of retirement funds presents many tax benefits for the buyer of a business, including the ability to set aside additional tax-deductible funds post-acquisition.
Only applies to individuals – Note that this source of financing is only available to individuals. Companies use alternative sources of financing.
Bank Financing should not be discounted – Bank financing is a valuable form of financing. In the absence of other forms of financing, bank financing is critical. Retirement funds, however, are one of the many sources of financing to consider when buying a business.
Costs – If you have less than $50,000 in your retirement funds, it is often cheaper to simply take the distribution and pay the associated taxes and penalties.
How does the process work? The buyer creates a new entity, typically a C Corporation. The C Corporation creates stock (not issues). The corporation then forms a profit sharing plan. The buyer then rolls over the retirement funds into the new retirement account. The funds are then exchanged for the newly issued shares in the new entity. The cash in the corporation can then be used to purchase a business or other corporate assets. One warning – do not do this alone. Always use the advice of a professional when setting up this type of account. ERISA and IRS penalties apply if you do not comply with all of the rules.
Why do we love this strategy? Frankly, it is a win-win situation for everyone involved. There are many benefits for the buyer, including ease of access and low fees. For the seller – it creates a simplified and streamlined process with a high success rate. This means a seller can accept an offer without worrying if the buyer will be able to obtain financing.
Have questions? If you are considering purchase a business and have questions about using your retirement funds to a buy a business, please leave your question below. If you are selling a business, and would like to know how you can offer this form of financing to buyers, please contact us.