Fund your company by tapping IRAs.
It's risky to invest in a biotechnology company. After spending millions of dollars and several years doing research, a company can still fail to bring a product to market--leaving its investors with little to show for their money except disappointment and a tax write-off. John Strisower, however, is hoping investors will see his biotech start-up as a retirement investment. He's pitched UVaCide, based in Chico, California, to investors more than 100 times, and he always ends his presentation the same way. After describing his product ideas and the scientific team he's assembled to develop them, he suggests that people invest in UVaCide through their individual retirement accounts, or IRAs.
It's a surprise to most of his would-be investors, Strisower says, but retirement funds don't have to remain safely snuggled in mutual fund and bond investments. A growing number of people are turning their IRAs--regular or Roth--into "self-directed" IRAs, using the funds to invest in anything they want, including start-ups. For entrepreneurs, self-directed IRAs can open up a whole new world of capital. "A $200,000 IRA isn't uncommon for someone who's worked in corporate America for 10 or 15 years," says Jeff Desich, president of Equity Administrative Services, which holds about $3 billion in self-directed IRAs. "So entrepreneurs aren't just stuck talking to the attorneys and doctors at the country club."
Self-directed IRAs have been around since 1974, when Congress passed the Employee Retirement Income Security Act, the law that created individual retirement accounts. But few people paid much attention to them until the mid-1990s, when the technology boom led to an explosion in angel investing. Data on self-directed IRAs is hard to find, because the Internal Revenue Service doesn't track them separately. But the companies that administer these accounts have seen considerable growth in recent years. Trust Administration Services, for example, managed $250 million in self-directed IRAs in 2001; that grew to more than $1.3 billion in 2006. Pensco Trust manages more than $2 billion today, up from $600 million five years ago.
Strisower discovered self-directed IRAs in 2006, when he was invited by acquaintances to invest in Golden Valley Bank in Chico, his hometown. He converted his IRA into a self-directed account and bought 13,333 shares for about $100,000. When the company went public a few months later, he sold a few shares for $10 each--a 33 percent profit. Strisower found the process easy enough to consider it as a fundraising tool for UVaCide. He had already started three companies, including Travidia, an Internet marketing firm in which he still owns a minority stake, and PRC Gaming, which he founded in 1993 and sold to Harrah's Entertainment (NYSE:HET) in 1997 for an undisclosed amount.
UVaCide was different. Four years ago, Strisower's daughter Jessica almost died of a bacterial lung infection that was resistant to antibiotics. While his daughter was hospitalized, he spent hours talking to doctors and was surprised to learn how difficult it was to treat bacterial infections when antibiotics failed. That inspired him to start UVaCide, which is researching ways to kill bacteria with light rays. He hopes to commercialize UVaCide's products for ordinary conditions like foot fungus while his team is researching treatments for serious bacterial infections.
Strisower says his investors are "pleasantly surprised" when he tells them about the option of investing with their IRAs. "Once people decide they want to take a chance on the company, the vehicle is a secondary question," he says. The tactic offers a number of attractions for investors. Any investments made through an IRA grow tax-deferred in the case of a regular IRA or tax-free for a Roth. Start-ups offer potential for growth far beyond what an investor would find with most mutual funds. (Of course, they also offer the potential for going bust.) And it's relatively easy to set up a self-directed IRA. Investors simply set up an account with a trust company. The process can take only a couple of days and usually costs less than $100 to set up, and about $100 to $1,000 in annual fees.
For an entrepreneur seeking investments, however, there are many restrictions to keep in mind. Self-directed IRAs are tricky to manage, so it's crucial to get help from specialized lawyers and accountants. "The law is not static and interpretations change," says Hubert Bromma, CEO of the trust company Entrust Group. Among the rules: IRA funds can be invested in LLCs, C corporations, and limited partnerships, but S corps and general partnerships are off-limits.
The regulations get much stricter for entrepreneurs seeking to invest their own retirement funds in their ventures. The IRS decides whether these arrangements are legal on a case-by-case basis, so the rules aren't set in stone. Generally, an entrepreneur cannot own 50 percent or more of the business that his or her IRA is invested in, unless the company has a minority shareholder with complete veto power over all transactions--but in some cases, even that won't be allowed. (For more information, see "Tapping Your Own IRA? Tread Carefully.") Because of those strict regulations, few business owners use their own retirement funds as a source of capital. At three of the major trust companies--Entrust Group, Equity Administrative Services, and Trust Administration Services--entrepreneurs who put their own retirement money into their own start-ups make up fewer than 1 percent of all the self-directed IRA holders who invest in private companies.
Most entrepreneurs avoid those complications by leaving their IRAs alone. Strisower, for example, hasn't touched his own retirement savings. Instead, he has raised $300,000 through the retirement accounts of six friends, family members, and acquaintances, and another $500,000 from 10 angel investors who put up cash. Eventually, he expects to raise one-third of the required funds from investors who invest with the money in their IRAs.
For one of his investors, Gary Randle, it was an easy decision. Randle, who runs a mortgage brokerage in Chico, had helped Strisower finance several real estate purchases. He knew about Strisower's previous success as an entrepreneur and wanted to invest in UVaCide. He wasn't worried about risking his retirement savings by investing through his IRA, but he was excited about the potential return. "It's a large sum of money that's available, and I'm not going to need it back for a while," Randle says. "There's a risk with any investment. For me, the question was, do I want to own Hewlett-Packard (NYSE:HPQ) or do I want to own UVaCide?"
Correction: This story incorrectly identified BDO Seidman as a law firm. It is a consulting and accounting firm.