When startups are seeking to obtain seed capital through a friends and family financing, most of the time, those friends and family members make a direct cash investment either in their individual capacity or through a business entity that acts as an investment vehicle. Another option that is not widely known is for the investor to use tax-deferred retirement funds for the investment, via what’s known as a self-directed IRA. Essentially, IRA funds can be used for many investments other than the familiar publicly-traded stocks, bonds, mutual funds, ETFs, etc., and among the other permitted investments are private company securities. However, the investment must be made through a custodian who administers the process, executing transaction documents on behalf of the investor, etc. The custodians are not the familiar brokerages like Fidelity and Schwab, but others you probably haven’t heard of that specialize in this area.
Self-directed IRAs are used in many cases because the investor simply has more available cash in retirement accounts than in taxable accounts, even if the investor is accredited. One can transfer existing traditional IRA funds to a self-directed IRA, or the funds can be rolled over from a company 401(k), where the investor no longer works at that company. So, in a lot of cases where a contact says that he or she would like to invest but currently doesn’t have the available cash, a self-directed IRA is an often-overlooked option.
Another primary benefit of using the IRA vehicle is the tax deferral aspect. If the investment pays off with a company sale, or with routine company distributions, the proceeds remain in the IRA, untaxed, and can be used for other investments, with the tax deferred until withdrawal at retirement age.
There are a number of restrictions on the use of self-directed IRAs, probably the most important of which is that the investor can’t control the company being invested in, i.e., it needs to be a passive investment. Otherwise, the custodian will be familiar with the process and will walk the investor (and the company being invested in) through the necessary steps.