Financing Your Franchise

You want to open a franchise, but you need financing. You're not eager to take on a lot of extra debt, but you're not sure there are any other alternatives out there. However, you have a sizable retirement fund, but if you withdrew it now then you'd be facing a lot of penalties and taxes that would eat through most of the fund. What are you going to do?

A solution is available. That solution is known as ERSOP, and it can allow you to access those retirement funds in order to finance your business without causing you to accrue penalties.

ERSOP stands for Entrepreneur Rollover Stock Ownership Plan. With the plan, you can rollover your retirement funds as an investment into your new franchise. Because the money is being invested not simply withdrawn as cash, you won't be penalized for the transaction and you'll have the money you need to get started.

Basically, an ERSOP is an alteration of an ESOP (Employee Stock Ownership Plan). With ESOPs, the employees are able to buy stock in their employer's company in order to become partial owners. The difference between an ERSOP and an ESOP is that since you are going to be the sole employee at the time you're the only one eligible to purchase stock in your company.

Another good thing about ERSOP is that you can rollover the funds from almost any type of retirement account, including IRA, 401(k), 403(b), and 457 accounts.

First, you're not going to be able to do this on your own, so you'll need to work with an expert. Because the ERSOP concept is relatively new, not all attorneys and accountants will be familiar with it so your best bet is to find a firm that has done previous ERSOP plans for clients.

Next, you'll need to incorporate as a C-corporation. Once that is done, your experts will put together a 401(k) profit sharing plan that your new corporation will adopt. Now you have to rollover your existing retirement funds into that new 401(k) plan. Remember that if your retirement account is employer-sponsored, then you'll need to have left that employment in order to be able to rollover the funds. Generally, it takes about a month from the date of termination until you receive your retirement funds.

Basically, your retirement funds will be used to pay for the stock in your company through the 401(k) plan.

While ERSOP can be a good option to consider, you should always look at the pros and cons of any financing alternative before you choose one.

One consideration with an ERSOP is that you really must work with a professional to set all of this up. That generally costs between $700 to $1000, plus you'll have to pay an annual fee to that professional to manage your 401(k) account.

You also need to think about how much money you have in your retirement account. Because setting up an ERSOP is not the easiest method of financing a franchise, it may not be worth it if you don't have a sizable retirement fund. Plus, it might be a good idea to rollover some of your retirement funds into another type of investment since diversification is always a good idea and since you'll still have something to fall back on when you retire if things don't go well with your franchise.

Another issue is the IRS. ERSOP is not a type of plan they recognize yet. However, if you go through a professional who is experienced in dealing with setting up ERSOPs, then they will probably work to get you a determination letter from the IRS. The letter affirms that what you are doing is legal and provides you with some protection from the IRS. Without such a letter, you could end up in trouble because the tax code is not clear when it comes to these types of transactions.

One potential problem with having a C corporation are the potential taxes. For this reason, after the franchise is initially established and the 401(k) plan is put in place, most ERSOP experts recommend beginning the switch to an S corporation which is more tax-friendly.

To make this switch, you will need to hold onto a lot of the earnings of your business so that you can buy back the stock that was purchased with the 401(k) plan. This should usually occur within the first two to four years. Once you've bought back all of the stock, then you can change to an S corporation.

Because you bought back the stocks, your 401(k) plan now has money available again. If you desire, these funds can even be used to purchase additional franchise units.

There is, of course, risk involved in investing even a large portion of your retirement funds in your franchise. If things don't go well, then you could stand to lose everything you have managed to accumulate up to this time. That doesn't mean you shouldn't take advantage of ERSOP as a financing option, but it does mean you should weigh that decision carefully.

We've spent most of this time discussing ERSOP, but there is another possibility open to some individuals who are interested in franchises. As we all know, there has been a lot of job downsizing and outsourcing in corporate American in recent years. As a result, a lot of people have lost their jobs. Many of these people have considered opening franchises so they can be their own boss and have more control over their financial destiny.

If that describes your situation, then consider using your severance package as a way to finance your franchise. Most severance packages include a decent amount of cash which is intended to hold you over until you get a new job but which could easily help you finance your franchise dream.

Before you make that decision, you'll want to consider whether or not your family will be able to survive for that first year while your franchise is getting established since you won't necessarily be bringing in a steady income during that time.

Also, your severance package - all or part of it - could be used as part of your down payment on a loan, as working capital for your franchise, as a way to pay off existing debts so your credit will look better when you go to get a loan, as a way to purchase equipment, or as funds to cover your family's expenses while your franchise is getting off the ground.

In the end, ERSOP may not be your first choice for financing your franchise. It is more difficult to set up and can be complicated, especially for beginning entrepreneurs. However, if you really don't want to begin your franchise with a lot of debt and you have accumulated a good size retirement account over the years, then it might makes sense to take the risk. The payoffs can be significant, after all. Just remember that working with a professional is not a suggestion; it's a must. And don't forget that your severance package can be a valuable asset as you start looking for ways to fund your franchise.