Each year entrepreneurs pitch Venture Capital firms in hopes that their startup company or business expansion will get funded by them. The vast majority do not get funded. Furthermore, “getting funding” almost always means the entrepreneur must sell a sizable piece of his company to the VC.

Getting funded by a VC is a dream, but it can easily turn into a nightmare for both the entrepreneur and the VC. Because the VC owns a piece of the company, if further rounds of funding are needed in the future it could mean diluting only the founder’s ownership, depending on how the contracts were setup. It’s not too uncommon for founders to eventually wind up with a minority stake in their own company and to lose control of it. For the VC, there’s a big chance of failure. They usually need an exit strategy, such as taking the company public to sell its shares to the marketplace or to sell the company to a private party. But before they sell it, they need to try to juice up the revenue of the company to max out the sales price. When maxing out revenue becomes the primary unconditional focus, it’s easy for the business to go in a very different direction than the founder had intended.

The above horrors can happen when an entrepreneur does get funding. Let’s not forget that most entrepreneurs seeking capital just don’t get funded.

These are problems. And yet the world has a way about finding solutions to problems and getting them to those who can benefit. Sometimes the solution can be so incredibly simple that it’s hard to believe. In the case of funding a small business, the solution I see is a matter of breaking the habit of selling equity.

Instead, sell revenue. A slice of your gross revenue, that is. Here are the benefits when raising capital:

• Keep all of your company. Don’t sell it to investors.
• A flexible payment. In a month with low sales, your payment to the investor is lower. In a month with higher sales, your payment to the investor is higher.
• More long term profit is kept. Once you’ve paid the investor fully as agreed, you still own and control all of your company.

Here are the benefits to the investor:

• A built in exit strategy. A revenue participation contract can have a fixed repayment period or a fixed repayment amount, similar to debt.
• Lower risk. It’s easier to project gross revenues than it is to project profit. An investor whose repayment is a percentage of gross revenue only needs to be confident the entrepreneur can and will make the payments.
• More winners. Because of the built in exit strategy, the investor doesn’t have to assume most of their investments will tank and thus doesn’t need to have an astronomical ROI for the slim few that succeed.

For example, an entrepreneur has a business with $100k in gross income and $48k in net income. He needs $50k to expand his business by hiring and training a sales force and getting a larger office. He projects that in 6 months the expansion will result in an increase to $400k in gross income and $250k in net income. So an investor pays $50k to buy the right to receive 20% of the business’s gross revenue each month until those payments total $100k.

The investor will make a 100% ROI once the repayment is completed. If all goes as planned, that 100% ROI will be paid in under 18 months. It could happen faster or slower, depending on how well the business performs as projected.

For the entrepreneur seeking capital, the chances of finding an investor (or investors) can significantly broaden when he can pitch a lower risk investment that has a built in exit strategy.

What’s more, this model is very compatible with smaller investment amounts. In today’s world, a startup with tons of potential might not be able to get VCs’ attention unless they need millions of dollars. With revenue participation contracts, an entrepreneur can seek out tens of thousands or a few hundred thousand dollars in capital from smaller local investors and businessmen. That also means the entrepreneur may be dealing with a kinder local businessman rather than heading out to Silicon Valley to deal with the sharks.

Prohibited transactions is a chief topic when exploring self-directed IRA & Solo 401(k) investing. When a person first discovers that his retirement accounts have been chained to Wall Street brokerages without necessity, his mind starts to imagine the possibilities.

Real Estate? Yes.
Private Businesses? Sure.
Precious Metals? Absolutely.
Getting my hands on my retirement money now? Slow down there.

There are two types of limitations on the average retirement account. One is an unnecessary restriction of investment options to securities products. That can be eliminated through restructuring your accounts and funds. The second limitation is legal and cannot be removed.

Setting up a self-directed IRA or 401(k) is about removing limitations. Once you have it setup outside the nearly monopolistic network of securities dealers, you can invest in almost anything… but you must fully understand the legal limitations.

The general premise behind prohibited transaction rules is that the government wants you to grow your retirement account as big as possible because they plan to tax it later on when you distribute the funds to yourself for spending. Without prohibited transactions rules, anyone in their right mind would grow their retirement account and then make “losing investments” that actually put their retirement funds into their own hands.

For example, imagine you grow your IRA to $1 million and now you’re ready to get that money into your own hands so you can spend it. You could distribute it to yourself and pay ordinary income taxes on the distributions. Or you could invest it into your business that you personally own and operate. The latter could be an “investment” from the IRA. Once the money is in your business you could do whatever you want with it. And maybe your business doesn’t pay anything back to your IRA. Maybe it was a “losing investment” for your IRA. Taxes avoided. Woo hoo!

The only problem with the above scenario is that the real loser isn’t your IRA–it’s the government who didn’t collect distribution taxes because your IRA “lost” all its money. For this reason, the prohibited transaction rules make the above scenario illegal. The government made the PT rules to ensure that you don’t end up “losing” your retirement money. There are six PT rules. Four of the rules are commonly quoted, written about, and understood easily. The remaining two rules seem to elude or mystify most people, so let me bring clarity to the matter.

In order to be legally compliant, every retirement plan transaction must involve a genuine effort to benefit the retirement plan itself without benefiting the plan owner or his relatives. Let’s go ahead and knock out the most common strategies that are wrongly believed to successfully “get around” the rules:

Benefit Swapping

Joe & Frank are friends and each of them setup a self-directed IRA. Joe’s IRA loans $50,000 to Frank and Frank’s IRA loans $50,000 to Joe. This doesn’t break the 4 rules that are most focused on, but it does break the usually-ignored rules. For each loan transaction the borrower is not a “disqualified person” for the IRA to transact with, but the loan is a conflict of interest for the IRA owner because he expects to receive a loan back from the other person’s IRA. Because his decision to extend the loan from his IRA involves the expectation of a chain of events that is designed to benefit him personally, this is a prohibited transaction.

Another example would be if Joe’s IRA and Frank’s IRA each bought a vacation condo, and each IRA let the other person stay in the condo. Real estate is a popular investment for self-directed IRAs, but if an IRA owns real estate its owner (and his relatives) are not allowed to make personal use of the property, regardless of whether fair market rent is paid. If Joe vacationed in property owned by Frank’s IRA and Frank vacationed in property owned by Joe’s IRA, it would be a prohibited transaction. Just like the loan swapping, what makes it prohibited is the fact that when the IRA owner made the decision to enter into the transaction, he expected to receive a personal benefit as a result of the transaction. This applies to direct benefis and indirect benefits that come about as an expected chain of events.

Strawperson

Joe wants to sell his house, but he can’t find a buyer. His IRA has enough money in it to buy the house from Joe, but that would be a prohibited transaction because Joe is a disqualified person. So Joe arranges for his friend Frank to buy the house from him who will later sell the house to Joe’s IRA. Joe thinks he didn’t break any rules because Frank is not related to Joe and thus is not a disqualified person. In this scenario, in the eyes of the law Frank is a “strawperson”… a person who is not involved in the transaction for genuine reasons. Frank doesn’t really want to buy and then own Joe’s house. He is just entering into the transaction to add separation to the real transaction. The law removes the strawperson to examine the real transacting parties. In this case the real parties are Joe and his IRA. Effectively, Joe sold his house to his IRA. That is a prohibited transaction and it remains a prohibited transaction even with Frank the strawperson inserted into the chain of transactions.

The same strawperson strategy fails the test no matter how it is constructed. If Joe’s IRA loaned money to Frank and Frank subsequently loaned money to Joe, it would violate the PT rules.

The lesson

Setting up a self-directed IRA or Solo 401(k) brings your retirement funds to an unlimited investment platform in the sense that you can invest in virtually any type of asset. You will save yourself a lot of time and headache (and possibly tons of money) if you clearly understand the remaining limitation: you must invest solely to grow your retirement account without engaging in conflicts of interest.

Now that’s not so bad is it? The merits of whether the income tax is good for our country in the first place is a topic for another discussion. But within our current system, it’s not so much to ask that you avoid all conflicts of interest. Use your retirement account for its intended purpose–to grow massive wealth. There is a whole world of opportunities out there that don’t involve a potential conflict of interest!

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For entrepreneurs, getting through these financially turbulent times may require some imaginative [read whole article on Forbes.com]

• If your IRA owns mortgage-leveraged real estate, you owe UBIT.
• If your IRA or 401(k) owns an active business structured as a pass through entity (such as an LLC or partnership), you owe UBIT.
• If your 401(k) owns mortgage-leveraged real estate AND the mortgage is a “seller carry”, you owe UBIT.

UBIT, or Unrelated Business Income Tax, applies to tax exempt organizations including retirement plans. To pay UBIT, Form 990-T must be filed with the IRS. If this is all news to you, once you are done scolding yourself, you may want to file for an extension using Form 8868.