In this article we will cover some of the most advantageous reasons why a Roll Over as Business Startup (ROBS) works for some entrepreneurs, and discuss some insights as to why we want to leverage these concepts to the entrepreneurs’ advantage.
Sufficient Working Capital
All too often, small businesses fail because the entrepreneur didn’t do effective cashflow planning before getting into business. It’s very difficult to float the growth of a business based purely on new sales alone. Many would-be entrepreneurs instead dive right in — not realizing the real cost of doing business.
“I’d like to own my own hair salon!” exclaims Sally the Salon Stylist. She tosses her apron in the air, quits her job, and merrily goes off and signs a 3-year lease at the local mall. Little does she realize, after adding up the rent, utilities, insurance, wages, workers compensation, cost of goods sold, marketing, supplies, and inventory expenses, Sally will run out of money long before she can fill up all the salon chairs with new clients.
I’m confident that millions of coulda-been great ideas floundered just as soon as they began, simply because enthusiastic founders didn’t have sufficient funds to survive their first few years, despite their earnest fervor.
A ROBS arrangement overcomes this because on day one of business, the enterprise is well funded through the entrepreneur’s 401k plan. As a quick recap, a ROBS is created when the entrepreneur (1) Forms a C-Corporation, (2) Rolls their existing retirement account over into an ERISA-approved ROBS 401k plan, and then (3) Exchanges C-Corporation stock for ROBS 401k dollars. Now the corporation has a big pile of working capital, and the entrepreneur’s retirement account owns one investment in the form of the new privately held corporation.
With sufficient cash in hand, that salon operator now can come up with a strategy on how to grow the business within the limits of a realistic budget to turn a profit. At Baum CPA, we refer to this, as it is commonly known in the venture capital world, as the company’s burn rate.*
* Click here to read Investopedia’s excellent explanation of the term, “burn rate.”
Since a ROBS corporation has a big investor (i.e., the retirement plan), it is prudent to come up with a burn rate calculation for the business. This helps the entrepreneur get a more accurate picture of their required business performance in order to succeed. In the venture capital world, this calculation is something VCs demand to ensure their investment isn’t being irrationally consumed with no outlook of getting that money back.
Here is a simplified example of what Sally’s Salon could expect to see from their burn rate:
Armed with this burn rate information, Sally has realized that the soonest she could become profitable will be around month 14 in business! Yikes! Did she think about that when she quit her job? Does she have sufficient funds saved for daily living expenses during this time period? Maybe she would have saved up a little more or conducted more research before diving headfirst into the vast entrepreneurial ocean had she seen the company burn rate first.
At Baum CPA, we consult with ROBS entrepreneurs and those thinking about starting a business to see if their plans make sense, to ensure they have sufficient working capital to endure the costs of starting a company. We can provide several burn rate scenarios based on data provided. It makes sense to spend a few dollars for proper planning rather than roll the dice with your entire nest egg.
If you are a ROBS entrepreneur, and would like to talk about working capital planning and creation of a burn rate formula, schedule a free consultation with us by clicking here.
Debt free financing
Many businesses in America are started with an SBA loan. Most SBA loans require healthy credit, good income history, as well as a tangible asset which can be collateralized such as an entrepreneur’s home, investment property, or their stock portfolio. However, the SBA is highly unlikely to collateralize your retirement account. If you paid attention in school, maybe a few teachers told you to put money away in your IRA or 401(k) account. While this is great for retirement planning, it’s absolutely devastating when you’re rejected for a loan — even though you have $1 million sitting in the retirement account.
In a ROBS arrangement, most businesses are funded without any debt whatsoever — which means no interest expense, no loan repayment, and no cash flow concerns related to making bank payments on time. This allows entrepreneurs to hoard capital and apply their funds more directly towards their business instead of back into the bank. For certain businesses that have a low profit margin, such as coffee shops, hot dog stands, or laundromats — this absence of debt service makes a material difference in the company’s profit margin.
Here’s an example to illustrate the point:
Debby wants to start a diner — Debby’s Diner — and she’s going to use an SBA loan totaling $500,000 to finance her vision. The loan is for 10 years, at a 4% rate of interest (compounded monthly). Robby is going to start a diner too — Robby’s Restaurant — and will use $500,000 of his IRA in a ROBS arrangement to equity finance the business startup.
Based on the data provided, Debby is going to incur $107,470.83 in interest expense on her $500,000 loan over the next 10 years:
With a monthly mortgage payment of $5,062.26, Debby will also need to have $60,747.08 of cash available to cover her debt service each year. If Debby is short on cash in any given month, she’ll have to inject more cash into the business (which is probably now coming out of her personal savings, or sadly, a premature distribution from her IRA!).
Meanwhile, Robby has been flush with cash this whole time, and is drawing from his starting working capital of $500,000 to keep the growth of his businesses in-line with his burn rate projections. If Robby can reach profitability, he will be better positioned to ask a bank for a loan or line of credit to address those months his business may fall short on cash or profits.
Most businesses take 2 to 3 years before they can turn a profit. Many businesses will run out of startup capital funding well before they become profitable enough to sustain ongoing operations. And when you need money the most, banks are least likely to give it to you. With proper planning, a ROBS arrangement can forecast with reliable precision to meet cashflow expectations to get the new enterprise through its first years of business. If you’re considering using a ROBS arrangement, it would be prudent to give Baum CPA a call and discuss planning for your cashflow needs. You can schedule an initial consultation with us by clicking here.
Continue reading about this topic at The Advantages of ROBS [Part 2].
This blog and its authors provide this content strictly for informational purposes. No content herein should be misconstrued as financial advice. Everyone’s specific circumstances vary — Always consult with a qualified, licensed financial advisor, legal counsel, and tax professional before venturing into any investment or business activities.