Some may think of this as the proverbial chicken and the egg question.
The key is to plan ahead and consider both the business and the financial options at the same time. Just like a potential buyer and a realtor would look at houses, a realtor should not show a person a $400,000 house if the buyer only qualifies for a $200,000 mortgage.
In an effort to answer this question, let’s review two options:
- Debt – SBA type loans
- Equity – Accessing IRA/401(k) funds or using cash
Funding a Business with Debt Funding
Things to consider:
If it’s a franchise, is it on the SBA Registry?
If yes, then an SBA loan may be possible.
What is the total project cost of the business?
Don’t confuse total project cost with the franchise fee. A buyer needs to consider much more. Find out the approximate total costs for business, including the franchise fee, buildout/construction, advertising, licenses/permits, working capital and salary, for example. Further, include a buffer to all cost projections for an additional layer of funds should it be needed.
If the franchise is on the Franchise Registry and the individual is well qualified, SBA may be a fit. Here are some of the key things many lenders require for a new franchise owner:
Non-Borrowed Cash injection – 20-30 percent of the total project cost
Collateral – the most common is equity in a home or equity in rental properties. Note that the formula banks use is 80 percent of the home value minus the outstanding mortgage. This is the true collateral, per the lender.
Post Close Liquidity – borrowers need to show they have a buffer of cash on hand such as savings/checking/IRAs/stocks. Often banks will look for near 10 percent (or more) of the loan or three to six months of monthly living expenses.
A Job – the borrower, spouse or business partner need to show income coming into the household.
Credit Scores – scores of 685 or higher are generally required. One can check three scores at www.annualcreditreport.com.
Experience – what direct or relatable experience does the borrower or partner have? Who will be directly involved in the day-to-day activity? Will a General Manager be hired? Will the GM have a small stake in the business?
Resume – A management resume helps “sell” the borrower to the bank. Would the lender see the individual as a strong candidate for a loan?
Liens/Judgements/Bankruptcies/Inquiries – all are reviewed by the lender and may raise questions. Was the bankruptcy discharged far enough in the past? Are there just a few inquiries on the credit report?
Prepare by planning in advance. The SBA process takes time and must meet both the SBA criteria and the bank’s requirements.
Since the bank will require non-borrowed cash injection which cannot be from any type of loan or from a HELOC, the borrower will need to have personal cash for the injection. Without enough cash on hand, there are a couple of options:
- Do any partners have cash?
- Can the borrower be “given” the funds from someone who would have to sign a “Gift Letter?”
- Does the borrower/prospective owner have pre-tax IRA or 401(k) funds?
The last item listed may be the golden ticket for funding.
Any pre-tax retirement funds that are not from a current employer, such as an IRA, SEP IRA, old employer’s 401(k), 457, 403b, TSP, etc. can be the non-borrowed cash injection for a loan or can fund a new business without any debt.
This option is called a Rollover as a Business Startup (commonly called a ROBS) and is known to be a very common franchise funding option. Available since 1974 and approved by the IRS, a ROBS allows the use of pre-tax retirement funds for any business expenses and to pay salary without taking a taxable distribution and without an early withdrawal penalty.
How is that possible?
A C-Corporation needs to be set up as well as a new 401(k) Plan. Old pre-tax funds can be directly rolled over into the new qualified 401(k) Plan, then the 401(k) can purchase privately held shares of stock of the Corporation when the funds are moved into the Corporate bank account.
Many borrowers who are choosing this option after many years in the workforce have access to enough funds to use a ROBS as an exclusive non-debt option. However, for those who also plan to obtain an SBA Loan, the Rollover process can be in conjunction with an SBA loan. In that manner, the funds that are rolled over act as the non-borrowed cash injection which will satisfy the lender.
So, which comes first – the franchise or the funding?
It is wise to consider funding options in parallel to business exploration so that the prospective owner, franchisor, and funding consultant know that all the funding pieces can fit together.
Another key to being a successful new business owner is to ensure he/she has enough capital to begin the venture. No one has gone out of business because he/she was overcapitalized, but the opposite has been true for some. As we look into 2021, fully-capitalizing the business not only at startup, but for the life of the business, continues to be at the forefront of our business.
Diane Rosenkrantz has been a senior consultant with Tenet Financial Group for more than a decade, specializing in 401(k) Rollovers, SBA Loans, Unsecured Lines of Credit and more. Her career includes 30+ years in consulting, customer service and the pension insurance industries. Diane can be reached at firstname.lastname@example.org and (413) 754-3298.