What to Know About Investing in Small Businesses
Posted by: Joseph Kuo | September 3, 2021
National Small Business Week is coming up the week of September 13.
Small businesses are a key part of our economy. Did you know that nearly two-thirds of jobs in America are created by small businesses? You may even find your next investment opportunity in supporting a growing business in your area. If you’re considering investing in a small business, here’s what you should know when making your decision.
Do Due Diligence
Small businesses can take a bit of time to turn a profit. As an investor, be prepared to wait up to several years to see any returns on your investment. One way to help make sure you’re investing in a business that’s likely to succeed is to gather as much information about the business as possible before you make your investment decision.
Ask to review things like:
- Profit & loss statements
- Audited accounting books
- Marketing plans
- Overhead costs
- Other partnerships or investor agreements
Any business you are considering investing in should be able to provide this information upfront. If not, they may not be at a stage yet in which investing is a wise decision. Once you have obtained this information, take the time to review the facts and figures with your financial advisor or someone with experience in the particular type of small business. This way, you can make a smart, educated decision regarding your investment.
Be Clear On Owner Intentions
During the information gathering phase, find out what the owner has in mind for the future of their business. If you’re in talks with several potential businesses, ask them about their long-term goals. Things can always change later down the line, but it’s good to get an idea of their vision for their business before making an investment. Do they want to grow their business with the goal of selling to a larger corporation or investors, or do they want to maintain control over their company long-term? Is their plan to grow organically, or to seek additional capital so they can expand quickly?
When making your own investment decisions, this information may be helpful in deciding which small business aligns best with your own financial interests.
Types of Investments
While there are many different ways to arrange an investment deal with a small business, most offerings will fall under two categories: equity or debt.
Making an equity investment in a small business means you will own a share of the business. What you earn will directly correlate to how the business is performing. As an equity investor, you may receive dividends based on a percentage of profits.
In some instances, an equity investment is considered riskier than a debt investment. As an equity investor, you are looking to benefit from the continued success of the small business. After all, if you make an equity investment, you would be considered one of the owners. If the company has a rough stretch and needs an injection of capital, as a co-owner you would likely be one of the first be asked for more capital. Also, in the event the business fails, as an owner you would be last in line to recover any funds.
A mortgage is an example of a debt investment. A loan is made with the promise that the lender will receive a set amount of money (interest) at regular intervals until the principal amount has been paid back in full.
If you make a debt investment in a small business, this may work the same way. You’ve provided a loan to the business, and in return will receive regular payments containing both principal and interest. The risk is that if the business encounters cash flow issues, payments may be late or could cease altogether.
What to Do With Payouts
Either way, as the business grows and thrives you will receive payouts either as dividends or loan repayments. You’ll want to consider what to do with those payouts. You may not know the answer yet, but it’s important to keep this question in mind when investing with a small business.
If you’re looking to diversify your portfolio while supporting local entrepreneurs, investing in a small business could be an exciting opportunity. Your financial advisor may be able to provide you with more information regarding the impact this may have on your financial goals and next steps to take.