I think we can agree that every small business owner wants to increase his or her odds of success. According to a study by Guidant, 81% of small businesses funded with a Rollover for Business Startups (ROBS) were still operating after 4 years. Only 39% of businesses funded with a traditional business loan fared that well.
A ROBS provider such as Guidant helps you take money from an eligible retirement account, such as a 401(k) or traditional IRA, and invest it in your business without paying income taxes or early withdrawal penalties. A ROBS isn’t a loan, so instead of using business income to pay back debt and interest, you can use it to grow. As a result, business owners who use a ROBS often see higher success rates than those who rely on traditional business financing.
In this article, we’ll share with you everything you need to know to decide if a ROBS is right for you including:
- What is a Rollover for Business Startups (ROBS)?
- How a ROBS Works
- What You Need to Get Started With a ROBS
- How Much Does a ROBS Cost?
- Pros and Cons of ROBS – Is it Worth the Risk to Your Nest Egg?
- Frequently Asked Questions about ROBS
What is a Rollover for Business Startups?
Normally, if you take money out of a 401(k) or other tax advantaged retirement account before reaching age 59 ½, you have to pay income taxes on the money as well as a 10% early withdrawal penalty.
A Rollover for Business Startups (less commonly called a Business Owner’s Retirement Savings Account or BORSA) lets you invest your retirement funds in a business without paying income taxes or early withdrawal penalties. It can be used to fund a new business or franchise, buy an existing business or franchise, or recapitalize an existing business or franchise. A ROBS is not a loan, so there’s no debt or interest to pay back, allowing you to retain more of what your business earns. Just like any other type of business financing, a ROBS has pros and cons that should be carefully weighed before deciding if it’s right for you.
How a ROBS Works
Here are the main steps involved with a ROBS:
Since you are dealing with a sale of stock, a ROBS transaction is more complicated from a legal, tax, and compliance standpoint that getting a business loan. Because the stock in the company is privately owned, it’s also not quite the same as buying shares in a publicly traded company like Wells Fargo or Apple.
Fortunately, there are a number of companies, like Guidant and FranFund, that specialize in helping small business owners do a ROBS. We recommend Guidant. They’ve done over $3 Billion in ROBS transactions, and you can learn more in our ROBS buyer’s guide.
What You Need to Get Started With a ROBS
A ROBS is not a loan, so you don’t have to meet traditional underwriting criteria to qualify. For example, there’s no credit check and no down payment.
However, there are generally three requirements to be eligible for a ROBS:
- Hold a qualifying retirement account – Here are some popular types of retirement accounts that are eligible for ROBS:
- Traditional IRA (Roth IRAs are not eligible)
- Have at least $50K in retirement funds to use – Anything less and the fees won’t be worth it.
- Retirement account cannot be from a current employer. If you’re keeping your day job, most employers will prohibit you from rolling over a retirement account while you still work for them. You can, however, use a retirement account from a previous employer.
A ROBS can be used to fund a new business or franchise, buy an existing business or franchise, or recapitalize an existing business or franchise. Robert Newcomer-Dyer, Sales Manager at Guidant, says that if you’re planning to use a ROBS to recapitalize an existing business, the business should be generating some revenues already. While the business doesn’t have to be profitable, there needs to be a plan to profitability once you get access to the rolled over funds.
If you’re looking to fund your startup but don’t have any retirement savings, take a look other startup financing options in this article.
How Much Does a ROBS Cost?
A Rollover for Business Startup is a not a loan, so you don’t have debt or interest to pay back. However, Guidant and other ROBS firms will charge you two fees:
- Upfront Setup Fee = Approx. $5,000
- Ongoing Monitoring Fee = Approx. $120/month
The first fee pays for setting up the ROBS. This includes setting up the C Corporation, a financial valuation of the business, the creation of the company 401(k) plan, and filing paperwork with the IRS.
The second pays for monitoring the ROBS on an ongoing basis. This typically includes providing employees notifications when they become eligible for the plan, adding and subtracting employees from the plan, doing an annual valuation of the business, annually submitting required IRS filings, and keeping track of the owner-employer’s obligations for the plan.
Because of these fees, it generally doesn’t make financial sense to do a ROBS for amounts below $50,000.
It’s possible to avoid some of these fees if do a ROBS on your own without the aid of a firm. We don’t recommend this because it’s easy to run afoul of legal and tax requirements. That being said, even if you did setup the ROBS yourself, it would still carry some costs. You would have to pay to create the company 401(k) plan and administer the plan.
Pros & Cons of a ROBS: Is It Worth the Risk to Your Nest Egg?
Many people are scared to do a ROBS because of the risk that the business could fail and they could lose their investment. What many people don’t realize is that business risk and the possibility of business failure aren’t unique to ROBS.
No matter how you fund a small business, there’s something on the line, says Dyer. If you do a ROBS, there certainly is a chance that the business could fail, and you could lose your nest egg. But if you got a business loan instead, you’d have to sign a personal guarantee and put up collateral. If the business fails, you could lose your home and other personal assets.
The risk of entrepreneurship exists no matter how you finance your business, so as with other types of business financing, we recommend balancing the pros and cons of ROBS before deciding whether it’s the right choice for you.
- No debt or interest payments. It can be difficult and expensive to acquire capital for a new business or to buy an existing business. Many loan providers to small businesses, particularly for startups, charge interest rates that are over 55% per year! A ROBS is not a loan, so you do not incur debt and do not have to pay interest. That means the business is more cash rich, and more of the business income can be reinvested back into the business.
- Better business success rates – Guidant commissioned a study showing that companies funded by ROBS have a much better survival rate than other startups, in part because they are not starving the business for funds in order to make debt payments. About 67% of Guidant clients are still operating after 5 years or have successfully sold their business, whereas the standard is around 30%.
- No income taxes or early withdrawal penalties. If you were to simply take money out of your retirement account and use it for your business, you would have to pay income taxes and, if you’re under age 59 ½, early withdrawal penalties. The penalty is typically 10% of the account balance. By structuring the transaction as a ROBS, you avoid these costs.
- No impact to personal credit – When you do a ROBS, there’s no credit check, and you do not have to sign a personal guarantee. Most loans require a personal guarantee, which means the personal credit of the business owner can be damaged, and personal assets taken, if the business can’t afford to pay back the loan. In contrast, with a ROBS, the failure of the business means only that the funds you invested are lost. It won’t impact your personal credit or other personal assets.
- Retirement funds can grow in a tax-advantaged account – A loan is one-sided with money flowing from your account to the lender to pay back the loan. When doing a ROBS, a 401(k) plan is created for the company. You can contribute to that account as your business produces revenue and use the funds for retirement.
- Possibility of business failure. Most new businesses fail, and if your’s does, then you could lose all the money you invested. Also, consider the opportunity costs: If the money was not invested in your company, it could be invested in stocks, bonds, ETFs or mutual funds. Assuming a reasonable rate of return, the money invested in the business could have earned much more had it been placed in more traditional investments.
- Possibility of an audit. Doing a ROBS increases the likelihood that the IRS or Department of Labor will audit your business. If they find that you violated certain rules, you may have to pay penalties and taxes. Fortunately, the increase in risk is small. With Guidant, only about a 0.25% of plans face an audit. Also, Guidant and other ROBS providers will help you if you’re audited, and most will pay for your audit costs.
- Must administer a retirement plan. When you do a ROBS, you become the administrator of a company-provided retirement plan. Although ROBS firms will provide guidance with this, you will need to market the plan to employees and tell them how to enroll. This can take time away from your business.
- Must operate as a C Corporation. It’s only possible to do a ROBS if you’re structured as a C Corporation. Many small businesses prefer the simplicity and tax advantages of an LLC or partnership instead of a Corporation. You’re giving that up if you decide to do a ROBS.
Given the risks associated with a ROBS, we think it’s important to use the guidance of a professional ROBS firms. One reason we recommend Guidant as the best ROBS provider for small business owners is because they give access to independent counsel before, during, and after the ROBS setup process. This gives you the opportunity to ask as many questions as you like so you can decide for yourself if the risks are worth it.
Frequently Asked Questions about ROBS
What can a ROBS be used for?
A Rollover for Business Startups can be used to start a new business/franchise, buy an existing business/franchise, or recapitalize an existing business/franchise. According to Guidant, here’s the approximate breakdown of how ROBS is used:
Start a new business/franchise – 60%
Buy an existing business/franchise – 20%
Recapitalize an existing business/franchise – 20%
Does the company have to be a C corporation, or can it be an LLC, partnership, or S corporation?
The company must be a C Corporation to do a Rollover for Business Startups. Learn more about business structures here.
As the business owner, do I have to offer the company retirement plan to all employees?
Without getting into the nitty gritty of the law, the government does set minimum requirements on who’s entitled to a company retirement plan. Generally speaking, an employee must be at least 21 years old, have worked for one year, and have worked at least 1,000 hours during that time. Learn more here.
Do employees have to be provided the opportunity to purchase stock in the company?
Yes. The legal requirement is that company stock has to be made “effectively available” to employees in the same way it is available to the owners. However, company stock can only be purchased with retirement funds, such as retirement monies rolled over from another retirement plan. Since stock in new companies is usually illiquid (cannot be easily sold), most employees tend to avoid investing.
What happens if the business fails?
If the business fails, you could lose the money you rolled over from your personal retirement account. When a business that is financed with ROBS is forced to shut down, the assets of the corporation are liquidated and used to buy back as many shares of stock owned by the 401(k) plan as possible. Any funds remaining in the 401(k) plan are placed into an IRA for the business owner’s benefit, and both the plan and the corporation are dissolved.
Can the the amount invested in the business be paid back into the the retirement plan?
A ROBS is not a loan from the business owner’s retirement account to their business. Instead, it is the purchase of stock by the retirement account. There is no loan to be paid back. Distribution of money can go the stockholders of the business, including the retirement account, in proportion to their ownership. However, this option tends not to be popular because of the potential for double taxation. The C Corporation pay taxes, however, those receiving the dividend may also eventually be required to pay taxes.
Frequently, the business owner will tend to raise their salary when the company starts doing well. The owner’s salary is an expense to the business reducing the company’s profits and potentially lowering its tax burden.
Who is actually holding the retirement accounts?
The actual cash accounts are held by a brokerage firm such as Fidelity or TD Ameritrade. In general, the cost of having a firm like Fidelity or TD Ameritrade hold the retirement accounts is negligible or free. The brokerage firms make their money through their normal charges for buying or selling stocks, mutual funds, and ETFs.
Can a ROBS be used to purchase real estate?
While a ROBS cannot be directly used to purchase real estate, it can be used to invest in a C corporation which does buy real estate. However, there are a few potential problems with using a ROBS to fund a real estate investing business: 1) The business owners may have trouble asserting that they are bona-fide employees of the business, because of the number of hours they work; or 2) The investment structure might be inefficient from a tax perspective.
How many people can invest in a business using a ROBS?
There is no maximum provided that the investors are both employees of the business. It is fairly common for multiple business partners to invest in using a ROBS.
Does the business owner’s retirement account sell shares or get paid dividends?
Although it is not commonly done, should the corporation issue a dividend to shareholders, the 401(k) plan gets its proportionate share of the dividend since it is a shareholder of company stock. The more common practice is for the business owners to pay themselves bonuses and higher salaries as the company starts generating excess cash flow.
As for selling shares, if the company is sold, the retirement account(s) holding shares will get payment in exchange for the shares it held. Also, the corporation can offer to buy back (“redeem”) shares from the plan which provides another way to increase the cash in a retirement account.
A Rollover for Business Startups (ROBS) can be a great option for funding a small business, whether you’re just starting out, want to buy a business, or recapitalize your current business. Of course, there’s always the risk that the business could fail, wiping out your retirement nest egg. However, there are equally big risks when you take a business loan. Ultimately, you should weigh all the pros and cons of a ROBS and get all your questions answered by a professional before deciding if it’s right for you.