Funding the Franchise through Debt or 401k
Joel Libava, blogger at FranchiseKing and owner of Franchise Selection Specialists Inc. in Cleveland (and invited blogger at this web site), was quoted in a Wall Street Journal article about franchisee funding sources:
• Think About Franchising. These days, franchisers are actively targeting boomers because of their deep pockets. Entrepreneurs are generally expected to put up some of their own money to start a franchise, and boomers have lots of it on hand.
But you don’t have to bet the farm. “We recommend that you use the smallest portion you can of your own money and leverage the rest,” says Joel Libava, president of Franchise Selection Specialists Inc., a franchise consulting and marketing business in Cleveland. Generally, entrepreneurs should expect to pay about 15% to 30% of the total cost of starting the franchise out of their own pocket, including the franchise fee and working capital, Mr. Libava says.
For instance, Louis H. “Gig” Runge of Houston has put up about $80,000 of his savings to open a Martinizing Dry Cleaning franchise. The money has gone toward franchise and legal fees and other necessities. He plans to fund the rest of the business with a $350,000 loan guaranteed by the Small Business Administration. The loan requires him to provide an equity injection of $82,000.
“It was a challenge for me to work through the tax benefits of borrowing versus just funding it myself,” says the 47-year-old Mr. Runge, a certified public accountant who has done a variety of financial jobs at JP Morgan Chase for the past 18 years. Mr. Runge decided that the SBA financing would help him protect his personal savings and use it as collateral to invest in other stores down the road.
Here are my initial thoughts….
Leveraging (borrowing money) is a good idea so long as the business ultimately works out, or you’ll end up losing the same as if you funded the whole enterprise with your cash savings. Leveraging does buy you some time if things don’t work out by leaving you some personal cash in the bank to invest in the business should it be necessary. But, all lenders to small startup businesses will require a personal guarantee, so if the business fails you will need to cough up the money to pay back the loan even if the loan is to a business.
Before getting a loan, you should set up your personal estate plan to protect/preserve the asset you already have from bankruptcy or lawsuits - which in small part entails moving assets out of your personal name to irrevocable trusts and business entities that have special control features and tax provisions so that you will still have these assets available for your use even if you get sued for a $10 million dollars or file bankruptcy.
Funding your franchise by transferring your 401(k) savings without penalty is possible, but it comes with debt restrictions. One route without tax or penalty (but will include fees imposed by the new custodian) is to convert your 401(k) to a traditional IRA held by a custodian that permits you to invest the money in “alternative investments” (some companies, like Charles Schwab, permit alternative investments but require pre-approval and offering documents from the business offering the investment). This is exactly how we accepted investments of retirement plan money where I used to work at the private equity and specialty finance company. Also, most 401k plans allow you to borrow up to $50,000, or 50 percent of the value of the account, whichever is less. This is penalty-free, unless of course you don’t pay the money back.
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Here are a few thoughts.
1) The SBA should not guarantee loans.
2) The SBA is bad public policy.
3) Any provision that allows you to borrow from your 401k to start a business is poor public policy.
In a nutshell, if a business is viable and has an appropriate risk-reward scenario “capital” will be attracted to it - period. All the SBA does is “steal” via the coercive power of Government and force business men to subsidize their own competition, artificially raises rents, drive sup the cost of unemployment insurance, drives up the cost of capital, and makes it more difficult for true entrepreneurs to find capital.
Stated differently, the SBA subsidizes a loan, which protects the lender against default. Now you are a bank, with money to lend, at a given interest rate, do you want to lend a dollar to someone with a guarantee or someone without a guarantee? Of course you are going to flock to the safer loan which means a credit worthy person ends up having to pay more for their loan then they would if the “risk” associated with a loan put the banks equity capital(the money that keeps them solvent) at risk as there is less demand for their loans at a given rate of interest. The way banks work is they can only lose the amount of equity they have, once that is exhausted their capital the assets are then sold to other banks and they are liquidated, usually the depositors don’t even notice. So banks normally have to be conservative with how much of their equity is actually at “risk”, however with loan guarantees they can essentially engage in risks they would not otherwise undertake. With the SBA this does not happen.
But there is more. With loan guarantees many marginally and out an out unviable concepts are launched, this allows many more entrants in a given vertical then the market can actually support (can you say sub shops), with so many ventures competing for available spaces rents rise, with so many folding left and right the unemployment insurance goes up for everyone in that vertical, and to make matters worse ultimately the very people who do things the right way, without sucking at the public teat, get stuck with the cost of the loan guarantees.
As for 401k and other plans, they are suppose to be for your retirement - period. You get a tax deferral as an incentive to “invest” in yoru future, not gamble on your future. In the end, the tax payer will get stuck with the tab for those who lose their savings to unviable concepts that would never exist if pure market forces were allowed to value them.
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To Fuwa:
I think you are overstating the economic and business environment impact on the economy of the SBA guarantees. As a matter of public policy, should the government be guaranteeing loans of any kind (business, student loans, etc.)? No, in my opinion. But the reasoning is more about the role of government than the disproportionate impact on rents, business failures, etc.
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