Q: Should I Tap My 401K To Bootstrap?

Written by Sean Murphy. Posted in 1 Idea Stage, 2 Open for Business Stage, skmurphy

Q: Should I tap my 401K to bootstrap my startup? I had a conversation with the CEO of another firm and he and his partners did this to bootstrap. They started a C corporation and set up a corporate retirement account, the partners then rolled existing retirement accounts into the corporate plan and invested the money in the company’s stock. I did a little research and found these articles:

A: My concern would be that retirement money is designed to protect not only you in your old age but also your “widows and orphans.”  At best a startup is a coin flip, a 50-50 chance of success, and you have increased the negative impact of the downside considerably if you shut down without any life savings. It’s an interesting question: what constitutes a poor choice for funding your startup. My list would be:

  • credit cards – very high interest
  • 401K – loss of tax deferred compounding compared to other investments to tap
  • second mortgage – risk of losing your house if you fail

All of these are possible but I think you have to consider very carefully before choosing any of them. I cannot construct a scenario where you would not use other funds available to you and if you were down to your 401K it seems like that should be your stopping ruletime to look for a job.

Beware the “Gambling Story with a Happy Ending”

Reading those stories in Money and Newsweek of people who bet their life savings on a new business reminds me of a line from Mordecai Richter’s novel “Joshua Then and Now”

“But the Book of Job is more than just a gambling story with a happy ending.”
Mordecai Richler in “Joshua Then and Now” (novel)

I think if you reach them carefully they point out the complexities and risks. In the Newsweek article it points out the need to pay a third party on an ongoing basis.

“Avoiding violations typically necessitates paying regular fees to CPAs like Bode or to the several companies that have sprung up especially for this purpose. Guidant Financial, one such company, has been in the business of helping individuals roll over their 401(k)s for over 10 years. The Washington state-based company charges $5,000 for the initial setup fee and $119 monthly to fulfill ongoing reporting requirements.

[…]

David Nilssen, a co-founder of Guidant, says 80 percent of ROBS businesses his company has worked with survive after four years, roughly double the rate for small businesses overall. (That means 1 in 5 has gone under, presumably wiping out the proprietor’s retirement fund.) Since 2003, the company has worked with over 9,000 clients who have collectively invested $3 billion from their 401(k)s.”
Using ROBS to Cash in Your 401k Is Risky Business (NewsWeek: August 3, 2014) 

Clearly it’s a source of ongoing fees for Guidant, and Guidant admits that the 20% that have failed–so far–end up in a very bad place. It’s not clear the the actual failure rate won’t approach 50% or higher as many of those who have not failed in four years may still be burning through their savings. If your stopping rule is to “shutdown before you tap retirement savings”  vs. “after you have exhausted even your retirement savings” then you are more likely to succeed but also to fail much much more painfully.

Beware Investors Who Ask You to “Go All In”

Q: What if an investor asks you to “go all in” on your startup by investing your 401K?

I would run not walk from an investor that asked me to commit all of my savings–including my retirement savings–to a venture before they put the first dollar in. It seems to me to be the thin edge of the wedge of indentured servitude. What exactly constitutes all in? Do they also require that you take out six new credit cards and max the cash advance so that your credit is destroyed if you fail?

Also entrepreneurs are specifically NOT asking investors to go “all in” if they are qualified investors. You never ask a VC to invest their entire fund in your startup (and they would not even if you did). Professional investors have a plan to survive a complete wipeout of their investment in your startup. And you should not ask relatives or friends for money they cannot afford to lose because the chances are at least 50-50 that you will if it’s the early going (before break-even operation).

For an early stage venture where there is less proof of traction an entrepreneur needs to offer convincing evidence that they are committed to making it successful. But even in the best case the odds are probably 50-50 you can succeed: if your stopping rule is essentially complete bankruptcy it’s likely to cause you problems for the rest of your life (business failure is common and survivable if you don’t exhaust all of your financial and social capital). I would set the tripwire for giving up so that you have enough resources for an orderly shutdown and time to find a job.

Q: I am looking at all of my options–Angel, Friends & Family, Private Equity, Venture Capital–and wanted to explore the ramifications of any potential source of funding.

Most technology firms have a high failure rate: unless you take money from accredited investors who understand the risks of total failure you may be luring folks onto the rocks.  In “You Have to Be a Little Crazy” (a great book on the emotional roller ride of entrepreneurship by the way) Barry Moltz talks about the risks of taking seed money from friends and family who are not prepared for the possibility of a total loss. A more subtle but all too real problem is that these are the same folks you will go to for emotional support in difficult times in your startup, if they are invested in your startup this may trigger fears of loss that makes for a difficult and unsupportive conversation.

Q: Thanks for the pointers to “You Need To Be a Little Crazy” I will have to check it out.

We did a panel discussion of it for our “Book Club for Business Impact.” You can listen to “Webinar Replay: You Need to Be a Little Crazy” if you want to hear several experienced entrepreneurs discuss it.

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