So, you have an idea for a business venture. The next step is to secure some startup capital so you can begin forming your business. But, as any entrepreneur knows, cash can be hard to find. If you’re transitioning from employee to entrepreneur, you may be interested in your options for liquidating your 401k/IRA for use as startup capital. After all, you may have a lot of money in those plans. And it’s yours, right? So, you should just be able to take it out and start spending it? Unfortunately, this is not the case.

If you wish to liquidate funds from your retirement plan, you have three options. The first option is to take out a loan against those funds. This can be wise, since the interest you pay on the loan goes into your retirement funds, so you essentially pay interest to yourself. However, the ability to take out a loan against your retirement funds is dependent on the rules of your retirement fund plan. You can only do it if your employer/plan administrator lets you. Alternatively, you could just withdraw your funds early (assuming you are younger than 59.5). Unfortunately, this option is just plain bad, since you will pay a hefty 10% fee for early withdrawal. In addition, from the IRS’s perspective, you also receive all that money as taxable income in the year you withdraw early, meaning that you take on a LOT of tax liability.

So, what about that third option? Enter the Rollovers as Business Startups (ROBS) plan. A ROBS plan can allow you to utilize your retirement funds as startup capital. You can avoid a loan and any penalties for early withdrawal. Let’s first explore the process for creating a ROBS plan, then we can investigate the pros and cons of this option.

The Method:

A ROBS plan is conceptually uncomplicated. You first form your new business as a C-Corporation: the standard American corporate model. Next, you form a 401k plan for that corporation, name yourself as an employee of the company and beneficiary of the plan, and rollover your fund from previous retirement plans into this new plan, as you could anytime you started a new job. Then, that new 401k ROBS plan buys stock in your corporation. The proceeds from the stock sale can then be used by the new corporation as startup capital.

The Pros:

            The process of forming a ROBS plan, if done right, enables the liquidation of retirement assets without early withdrawal penalty, loan payments, or tax liability. Securing startup capital is a mountainous challenge for most entrepreneurs. Venture capitalists and other investors are unlikely to invest in your project if you can’t first demonstrate an investment of your own money – a vote of personal confidence in your idea. If you don’t have a nest egg laying around for this purpose, that startup capital mountain just became an impenetrable castle wall. You may need to liquidate your assets, and your retirement plan funds are a significant asset. This makes the  ROBS plan an extremely attractive option.

The Cons:

            Unfortunately, there are quite a few downsides to using a ROBS plan. The first one is obvious: you are risking your retirement on your business idea. If the company fails, you will probably lose significant portions of your retirement savings. On this basis alone, the utilization of retirement funds for startup capital should probably be a last resort.

            However, there are other problems with the ROBS plan. In order to institute a ROBS plan, you have to form your business as a C-Corporation. You can’t use an LLC or any other business entity form. C-Corporations require formal management systems: you will need company bylaws, a board of directors, to prepare annual filings, etcetera. These formalities make C-Corporations unattractive to entrepreneurs who want to manage their business on their own and in their own way. In addition, C-Corporations are subject to the corporate double tax. The new company will be expected to file its own tax returns and pay income taxes (as well as other corporate taxes). If the company issues dividends, the company pays taxes on the income from which those dividends are derived, AND the shareholders pay income taxes on the dividends they receive – double taxed.

Another downside of the plan is the annual filing requirements. ROBS plans are new 401k plans. The plan administrator will have to file the annually required forms on behalf of the plan, including the Form 5500, which summarizes the annual status of the 401k plan. These filing requirements can be a serious hassle, especially for small businesses which are trying to focus on daily operations.

            As a final note, ROBS plans face significant IRS scrutiny. The ROBS plan enables the taxpayer to dodge tax liability while liquidating retirement assets, and the IRS will ensure that the plan is formed and administered properly. If it appears that the ROBS plan is operating like a bank account instead of as a proper retirement plan, the IRS may become suspicious, and the resulting investigation will be a major disruption for your business. Be careful to follow the rules in forming and administering your ROBS plan.

The Takeaway:

            So, is a ROBS plan the way to go in securing some startup capital? The answer is going to depend on the situation of you, the entrepreneur. As discussed above, the plan is an option for liquidating retirement funds without incurring early withdrawal penalties, tax liability, or loan payments. However, there are tradeoffs to this plan. Prospective entrepreneurs should seriously consider whether the risk of forming a ROBS plan are worth it for the cashflow. Other options, such as bank loans or crowdfunding, may be more desirable.

 

Image Credits:

401k Graphic (Adobe Stock Photo) – https://www.theastuteadvisor.com/401k-plans/

ROBS Plan Graphic – https://psu.pb.unizin.org/expsk909/chapter/using-401k-retirement-money-for-seed-funding/

 

Sources:

https://psu.pb.unizin.org/expsk909/chapter/using-401k-retirement-money-for-seed-funding/

https://www.irs.gov/retirement-plans/rollovers-as-business-start-ups-compliance-project

https://www.irs.gov/pub/irs-tege/robs_guidelines.pdf

https://www.lendingtree.com/business/robs/

https://www.nerdwallet.com/article/small-business/rollovers-as-business-startups-robs

https://www.guidantfinancial.com/401k-business-financing-robs-guide/

 

 

 

Coke or Pepsi? D.C. or Marvel? It’s safe to say you probably prefer one of each category, or simply dislike both options. But why? After all, Coke and Pepsi are both Colas. D.C. and Marvel both make comic books. The answer is obvious. You prefer Coke or Pepsi because of the flavor, because of the recipe. You prefer D.C. or Marvel because of the characters and stories of one option.

In the Cola example, each company’s recipe is not public information. In the D.C. vs. Marvel example, each company holds intellectual property rights over its characters and settings. These companies’ business models necessitate protection of their intellectual property from use by other companies. This business model is the norm in most industries: if you create/invent something, copyright, patent, or trademark it so you can control the sales. But what if your company totally ignored this standard? What if your company deliberately eschewed intellectual property rights and put the recipe about its products out on the internet, for everyone to see?

       

In the 2010s, a technology manufacturer headquartered in Loveland, Colorado tested this idea. Aleph Objects produced a 3D printer line called the “Lulzbot.” What made this product interesting was the “open ethos” behind its production. Not only was the product developed using open-source technology – technology produced and published without securing intellectual property rights – but the device itself was “open.” The recipe of hardware components used to build the physical printer was available online through Aleph’s website. The software used by the printer was fully open-source as well. Nothing in the device’s makeup was proprietary. Individuals were free to build their own Lulzbot with Aleph’s help and without paying the company anything.

So, can this model be effective? If the company doesn’t protect its product from being replicated by other manufacturers, can it still make a profit? Let’s explore the pros and cons of this model.

Pros:

Cheaper startup expenses on the legal side: If you’re starting a company to sell a product you designed/invented, any decent lawyer will encourage you to get a patent on your design. You produced something unique, which is why it can be competitive in the marketplace. However, the expenses necessary to secure a patent can be intimidating when starting a company. Costs vary depending on the industry but securing a patent will likely cost a business thousands of dollars. This price tag includes fees assessed by the USPTO and expenses on attorneys who will help secure the patent. You may spend even more money if your first application is rejected and you need to try again. If you choose not to patent your product, you obviously save this money, allowing it to be allocated elsewhere.

Harness your customers to improve your product: Employing an open model can reduce R&D expenses. If you produce open-source software and hardware, your customer base can contribute to the development of your company. As customers tweak the product with minor improvements and revisions, you can implement these changes in your production model. Under this scheme, you aren’t dependent on your R&D engineers (which, as a startup, may just be yourself) to come up with all the good ideas. A limitless team of people can make suggestions, all for free.

No need to defend your IP: Even if you secure intellectual property rights to your product, you still need to defend these rights from would-be duplicators. Failing to do so will hurt your business as your market share is eaten up and also may result in the loss of your patent altogether. If you never secured the patent in the first place, this problem doesn’t exist. You don’t need to spend money on lawyers protecting your IP.

Cons:

Idea Theft: Obviously, if you aren’t securing Intellectual Property rights over your product, your competitors are free to replicate it. If you place your cards on the table, your opponents will know exactly what they’re up against. Any good ideas you have will be implemented in their product, and their improvements won’t be so visible to you. It’s easy to see how your business can fall behind the competition in this situation.

Industry Dependent: Let’s face it, in most industries, this model just can’t work. You won’t beat Coke by simply making your own Cola and publishing the recipe online. If you’re trying to beat D.C. and Marvel, letting them use your characters in their stories isn’t going to help. This business model may be effective in the technology industry, but perhaps nowhere else. Open-source software is already an industry standard, and open hardware has been done before, as seen with the Aleph Objects example.

How do you make money? If you publish the schematics for your product online, allowing anyone to build their own, how can you expect to sell any units? Why buy from your company when they can make their own? In order for this business model to work, you need to take advantage of economies of scale. Your production costs need to be low so you can still price compete with individuals who would buy the parts and build your product themselves. But these margins are going to be tight. You can’t markup your product’s price when building one is easy and cheap. This model may require higher startup costs in order to make production efficient enough for prices to stay low.

The Takeaway

It’s impossible to recommend an “open ethos” model to all business owners. The model is too industry and circumstance specific. Lawyers usually recommend that business owners secure IP for a reason. However, for some entrepreneurs (particularly those with very progressive views regarding the philosophy of ownership) the model may just work. Playing while showing your hand is a bold strategy in any card game, but you can still win if those cards are good enough.

 

 

Image Credits:

Coke vs. Pepsi – CNN Money https://www.cnn.com/videos/cnnmoney/2018/04/26/coke-vs-pepsi-cola-war-back-orig.cnnmoney

DC vs. Marvel – Games Radar (DC / Marvel Comics) https://www.gamesradar.com/whats-the-difference-between-marvel-and-dc/

Aleph Objects Logo – Wikipedia (Aleph Objects) https://en.wikipedia.org/wiki/Aleph_Objects

Lulzbot Printer – Lulzbot https://lulzbot.com/store/taz-6

Cards – Wellness Training Institute http://www.wellnesstraininginstitute.com/blog/2018/03/08/cards-on-the-table-heres-what-were-all-about-at-the-wellness-training-institute

 

Sources:

https://www.elsevier.com/connect/6-things-you-should-know-about-open-source-hardware#:~:text=Using%20open%2Dsource%20hardware%20can,researcher%20for%20the%20same%20scope

https://opensource.com/business/15/11/open-ethos-powers-lulzbots-success

https://www.schroederpatlaw.com/intellectual-property-faq-archives/can-i-lose-the-right-to-patent-my-invention/

https://www.uspto.gov/trademarks/basics/trademark-patent-copyright

https://uslawpros.com/how-much-does-a-patent-cost/

https://www.ycombinator.com/library/56-why-the-best-companies-and-developers-give-away-almost-everything-they-do