By Michael Kuntz.
I’m a sucker for ice cream. The more exotic, the better. Bourbon ginger snap. Salted caramel. Orange cardamom. You get the picture.
I’m also committed to the Slow Money movement. So, when my local creamery needs funds to expand their kitchen and pay for the sustainable ingredients of their sub-zero sublimities, I’m eager to invest. There’s the hitch.
“Hello, XYZ-Custodian. Yes, this is John Doe, account number ####, last four digits of social security ####. I would like you to move $10,000 from my IRA into a royalty note with ACME Ice-Creamery. What’s that? You don’t permit direct investments on your platform? How unfortunate!”
Large custodians like Fidelity, Schwab, TD Ameritrade and others are in the business of ensuring the security and safekeeping of your investments. They are also designed to handle large volumes of transactions, standardized for ease of electronic accounting. They are NOT designed to support diverse, small scale, physical investments that characterize local investing, be they royalty notes, promissory notes, convertible debt, equity, or some other structure. As a result, these types of investments are not approved for their platforms; they won’t let you direct your money there.
That’s where Self-Directed IRA custodians come in. These firms are set up to handle the more time-consuming administration of small, local investments. They support IRAs, rothIRAs, 401Ks, and other accounts, just like the larger custodians—but allow you, the account holder (or someone you nominate) to direct your funds.
There are a number of firms that have been providing this service for years: Pensco Trust Co, Equity Trust Co, and Self-Directed IRA Services, among others. A team of us at Slow Money Northern California recently went through the process of evaluating the custodians, pursuing our preferred vendor (each have slightly different emphases), and investing in a number of local businesses. Our experience has been instructive, and the following observations might help you get started with Slow Money investments of your own.
Observation #1 – Know How Much You Want to Invest
You may be familiar with asset allocation and appropriate diversification in your portfolio. Investing in Slow Money enterprises should fit into your overall investment plan as one slice of the portfolio pie, so your first step is to determine the appropriate share to allocate to local investing. Financial advisors can help you to consider a number of relevant factors, such as age, amount saved, income, goals and liquidity needs, and investment ability.
The share that you allocate is important for a number of reasons. For one, it may influence the custodian with whom you elect to work, as their pricing models vary in how they account for the total size of your account.
Observation #2 – Custodian Selection is Like Dating
You and your custodian will be working together, potentially for life (or until you stop investing in local businesses). It’s a big commitment, so do your homework. Our working group at Slow Money Northern California looked at five custodians. We rated them across a list of different characteristics and recorded our findings, which are available to all Slow Money members. The model we built can help you to make comparisons: see here.
First, investigate your custodian’s reliability and service. Relevant factors include size (assets under management), years in operation, insurance provided (FDIC), extent of out-sourcing, and customer reviews. Customer service varies among custodians, and levels of service have been different over time at each of them. The good news is that, as competition has increased, all the custodians that we reviewed are focusing on providing quality, timely service. That said, I recommend interviewing the firm you’re considering prior to tying the knot.
Cost is also an important consideration. Each custodian has a slightly different pricing structure. Most have tiered fees based on the total amount of assets you place with them in a given account. Some charge per transaction, others charge per asset. A few even charge on cash balances. All have a schedule of one-off charges that apply for things like wire transfers, paper statements, and other non-standard requests. In short: it’s complicated. Our calculator may save you time.
Observation #3 – Getting Down to Business requires paperwork
Once you’ve opened an account and funded your custodian, you can start investing. Let’s use ACME Ice-Creamery as an example. Having done my due diligence on the company and determined the amount I’d like to invest, I approach my Self-Directed IRA custodian and request they purchase the security. Not so fast.
Because these types of investments are not standardized or stored in some public database, the custodian requires evidence that they are a) legitimate; b) able to be supported by their systems; and c) do not conflict with IRS laws governing prohibited uses of tax-deferred funds. (For example, you cannot invest in your own business out of your IRA). To meet this requirement, you are generally required to provide certain documents, depending on the type of investment:
- 1 to 2 forms provided by the custodian that capture the relevant security and investee information for the entity or person in which you are investing;
- Documentation on the investee: Articles of Incorporation, Bylaws;
- Documentation on the security: Subscription Agreement, Note*, Term Sheet;
- *Other administrative documents, primarily for royalty or promissory notes: Payment Schedule, Loan Servicer Agreement.
The custodian forms are fairly clear about what you need to provide, but there is still a learning curve. You should budget a couple of hours to perform the administrative work for your first investment: completing forms, obtaining the required information and documents, signing, scanning, and faxing. Note that this process may also be new to the entity in which you are investing, but they should have the required information, such as EIN and business address, readily available.
You can expect it to take 2-4 days for the custodian to process and approve the transaction. You might receive requests for additional information the first time around, because it’s easy to miss a key document or overlook other details. Reviewed and approved, the custodian will then wire money or cut a check to your investee. Voilá!
The funds paid back by the investee will generally be directed to the custodian, athough you or your designee might serve as an intermediary by forwarding checks or payment coupons. Indeed, all the agreements above are a contract between the custodian and the trustee. The documents typically do not name you as the investor, but ABC Custodian FBO Your Name. (FBO means “For Benefit Of.”)
A number of resources are available to those considering this method of investing in local businesses. Custodian websites offer a wealth of information, webinars, and tools. Slow Money Northern California also has resources available to members. Google searches will also reveal articles on the subject. Finally, a number of online platforms allow peer-to-peer or crowd-sourced financing, such as Prosper (personal loans), Lending Club (personal loans), KivaZip (business loans), and Community Sourced Capital (royalty notes, not yet available in CA). Check with your custodian to find out whether they support these options.
It’s worth repeating that the reason for working with a Self-Directed IRA custodian is to enable you to invest your tax-deferred retirement funds into investments of your own choosing. For investments from your regular accounts, you can invest directly; a custodian is not required.
Please share your own experiences investing in local businesses below. I’ll enjoy reading them over a cup of Secret Breakfast.
 Note that “retirement” and “tax-deferred” are distinct items. Tax advantaged accounts include IRAs, 401Ks, and their roth counterparts. While these accounts are exclusively created for retirement (you can’t draw funds from them until you reach certain age thresholds), they are often insufficient to meet an individual’s retirement needs, meaning that regular (non-tax-advantaged) savings and investments are a material component of one’s retirement funds or portfolio.