Did you know that 34.8 million small businesses drive the U.S. economy? According to the Small Business Administration (SBA), they account for 44% of GDP and create two-thirds of new jobs. For investors, these figures aren’t just data points; they represent a wealth of untapped potential.
Investing in small businesses can significantly increase your wealth, but it’s not without risk. The difference between success and failure often comes down to strategy, which requires an in-depth understanding of the business’s valuation, investment, liability, exit strategy, and timeline.
In this article, we’ll answer the question, “How does investing in a small business work?” We’ll also discuss the two core investment approaches and how each can help increase revenue and build lasting wealth.
What Exactly is Small Business Investing?
Many new investors ask, “How does investing in a company work?” Essentially, you can either buy ownership shares or provide the money it needs to grow.
Whether you want passive income or a shot at exponential growth, small business investing lets you choose your role: silent partner or structured lender. The key is picking the most appropriate strategy for your goals—and the right business to back.
Who Can Invest in Small Businesses?
Different groups of people can invest in small businesses, each with varying requirements and regulations. Here are some of them:
Accredited Investors
This is the traditional category for small business investors. The U.S. Securities and Exchange Commission (SEC) defined accredited investors as individuals or entities meeting certain income or net worth thresholds. These thresholds ensure investors have the financial resources to handle the higher risks associated with small businesses.
Angel Investors
Angel investors are wealthy individuals who invest their own money in startups and early-stage businesses. They often provide capital and mentorship to help the venture grow. While some angel investors may not be technically accredited, they usually invest alongside accredited investors in angel investor groups, which pool funds to meet investment minimums.
Friends and Family
Friends and family can be a common source of initial funding for small businesses. However, it’s important to have clear agreements in place regarding the investment terms to avoid future conflicts. Regulations may apply depending on the amount invested.
Crowdfunding Platforms
Online crowdfunding platforms allow businesses to raise capital from a large number of people. Investment amounts can be smaller, but regulations may limit who can participate and the types of businesses that can use these platforms.
Venture Capital Firms
These firms invest in small businesses that have the potential for rapid growth. In return for their investment, they usually receive a portion of ownership (equity) in the company. Generally, venture capitalists invest larger sums of money and look for companies with the potential for a significant return on investment. Due to the high-risk nature, they typically only invest in businesses with a strong track record of success or disruptive technology.
Institutional Investors
Institutional investors are big financial players like banks, insurance companies, and pension funds. They may invest in small businesses through various channels, such as venture capital funds or private debt placements. Like venture capital firms, they typically look for companies with strong growth potential and a clear path to profitability.
Pros and Cons of Investing in a Small Business
Like any investment, investing in small businesses comes with potential rewards and risks. Here’s a breakdown of the pros and cons to help you decide if investing in a small business is right for you.
Pros
High Potential Returns
Small businesses have the potential for significant growth, which can translate to high returns on your investment. If the small business succeeds, your investment could be worth much more than you initially invested.
Direct Impact
Investing in a small business allows you to directly support local businesses and contribute to their success. You might even have the opportunity to be involved in the decision-making process and see your ideas come to life.
Diversification
Adding small business investments to your portfolio can diversify your holdings and potentially reduce overall risk. Small businesses often operate in sectors different from established companies, offering a hedge against market downturns.
Control (Potential)
In some cases, you may have a say in the direction of the business, especially if your investment is significant. This can appeal to local investors who want to be involved in shaping a company’s future.
Cons
High Risk
Small businesses are inherently risky. Many fail within the first few years, which could mean losing your entire investment.
Limited Liquidity
Unlike the stock market, where shares are traded publicly, small business investments are often illiquid. It can be challenging to sell your shares quickly if you need the money.
Greater Time Commitment
Investing in a small business may require more time and effort than traditional investments. You might be expected to offer guidance or participate in decision-making processes.
Less Transparency
Small businesses might not have the same level of financial reporting as publicly traded companies. This can make it harder to assess their economic health and potential risks.
2 Types of Small Business Investments
To answer “how does investing in a business work?”, you must understand the difference between equity and debt financing.
Equity investments involve buying an ownership stake in a company. If you purchase a company’s stock, you now own a portion of the business and are eligible to receive a share of the dividends and revenues the company earns.
When you make a debt investment, you lend money to a business with the agreement that they will repay the principal amount plus interest. Instead of getting a loan from a bank, the company you’re investing in seeks funds directly from individual investors.
Equity Investments
When you invest in a company through equity, you’re essentially buying a “piece of the pie.” Equity investors provide money to small businesses in exchange for a portion of the company’s future profits and losses. The business can use this money for various purposes, such as paying off debt, hiring new staff, and covering everyday operating costs.
As an investor, the profits or losses you receive are usually based on the amount of money you’ve invested. For example, if you invest $100,000 and other investors contribute a total of $900,000, you would generally be entitled to 10% of the profits and would also bear 10% of any losses. The specific percentage of ownership and how dividends are paid out can vary depending on the agreed-upon terms of the investment.
If the business’s expenses are greater than its income, investors will share in those losses. However, if the business is profitable, its returns can be substantial.
Debt Investments
Debt investments enable small businesses to receive investors’ loans instead of borrowing from banks. You can invest through direct loans or the purchase of bonds that the company issues.
One of the primary benefits of debt investments is that debt investors are prioritized over the stockholders (equity investors). For instance, if you invest in a law firm and have been given a lien on real estate, you can repossess the property if the business goes south. Selling the property should allow you to get your investment back.
8 Steps to Investing in Small Businesses
Performing due diligence is the key to a successful investment in a small business. Here are the steps you should take:
Do Your Research
The last thing you want to do is invest in a business you don’t understand. Start by picking an industry that interests you and then take the time to assess it. Is it considered a high-risk sector? Could legislation be coming that could affect the businesses within it? This could affect a company’s growth potential and, consequently, your money’s growth potential.
After selecting an industry, thoroughly research 10 to 20 small businesses within it, examining both the companies and their investment potential. Review their financial projections and statements (profit and loss, overhead, balance sheets, bank statements), as well as their business and marketing plans. Running credit and background checks on the company’s leaders is also beneficial in understanding their financial standing.
Find Investment Opportunities
When finding investment opportunities, check if the company is currently seeking financing. Not all companies that need funding want an investor, but this is typically a good place to start. If you approach a company that’s interested in taking on an investor, ask them how they plan to use the money. The more detail they can provide, the better it is for your potential investment. You always want to know where your money is going.
Talk to the Small Business Owners
Before investing in a small business, thoroughly evaluating the owner is a must. While research is helpful, direct interaction provides critical and unique insights for making informed investment decisions.
Whichever business(es) you want to pursue, you’ll need to assess whether the owner(s) and leadership team can effectively execute their ideas. Ask questions! Do they have previous experience in running other businesses, and if so, what was the outcome of that experience? Do they seem adept at forging business relationships and managing staff members? What do they consider to be the most significant risks involved with running this business? How do they mitigate those risks to deliver results?
Speaking with owners directly also helps you assess passion. As an investor, you want to work with owners who are fully committed to the business. When they talk about their company, are they oozing with enthusiasm? Are they filled with ideas for the future? Consider their personal investment in the business as an indicator of their dedication.
Talk to the Customers
The more you know about the customers a business serves, the better you’ll understand the business itself. Talk to the customers who use the company’s products/services. Understand what they like about the product/service and their effectiveness in solving a problem.
When speaking to these customers, pay attention to which of the following three categories they belong to:
- Promoters are loyal customers who can help grow the business and who will recommend the products/services to others.
- Passives – indifferent customers who are easily swayed by competing brands.
- Detractors – customers who are unhappy with your products/services.
You need to identify the company’s promoters, passives, and detractors because they directly influence the growth of the business you’re considering investing in. Think of the promoters as a sales channel — studies show that referrals from loyal customers have a 37% higher customer retention rate. These brand loyalists also spend 200% more than the average consumer.
The more promoters the business has, the higher its potential value. Detractors, on the other hand, can impede potential sales. Consumers are more likely to share negative experiences and feedback than positive ones, and this could influence the buying decisions of new customers.
Understand the Deal
You’ve researched and selected the company you want to invest money in. Now what?
It’s important to fully understand the company’s value and your deal structure. The deal structure refers to what the company plans to offer you in exchange for your investment. How do these things compare to those of the company’s competitors?
Assess the business’s value by comparing it to similar or competing companies and consider the following factors: revenue, growth rate, capital structure, risk profile, and net income. It’s also important to remember that good companies don’t necessarily make good investments, especially if the business’s value is too high.
Schedule an Appointment with Company Leaders
Schedule a meeting with the business owners to discuss the exciting possibilities of your investment and meticulously evaluate how your capital will fuel their vision. Remember that if you move forward with the investment, you’re not just providing funds, you’re forging a powerful partnership built on transparency and mutual success.
Negotiate Investment Terms
You’ll need to show a sample financing agreement or a term sheet where you outline the details of your investment and how much you’re willing to offer. Review these documents with company principals, and after you agree on the broad points, you can work to finalize the investment terms.
Seal the Deal
Once you’ve reached an agreement with the business’s leadership, the last step is to close the deal to finalize your investment. This is the part where you sign contracts and give them the capital you agreed to offer. In return, you’ll receive a signed agreement outlining the loan terms or company shares.
What are the Best Industries to Invest In?
Choosing the best industries to invest money in a small business isn’t rocket science, but it does require a bit of legwork on your part. To help with your search, we’ve rounded up three of the best industries to invest in right now:
Information Technology
The information technology sector has been one of the leading industries with great potential for growth and innovation. This industry offers various investment opportunities from different IT categories, including computer software or electronics, business data processing providers, technological service companies, computer hardware manufacturers, and more. Some examples of these companies include Google (GOOG), Facebook (FB), Apple (AAPL), and Microsoft (MSFT).
Countless innovations are created in the digital field; according to a report by Meticulous Research published in February 2020, the digital transformation market has a 22.7% compound annual growth rate (CAGR) as of 2019 and is projected to reach $3.294 billion this year.
As of July 2020, 59% of the world’s population are active internet users. This means that at least 4.57 billion people worldwide are connected through technology and the internet. It’s safe to say that the IT sector will continue to grow in the coming years.
Digital Commerce
Digital commerce connects businesses with customers online. It involves online stores, secure payment options, reliable delivery services, and a growing community of sellers. This system is constantly evolving as technology advances and consumer preferences change.
Mobile phone use is a major factor in this growth. Secure mobile wallets and contactless payments make online shopping easier and faster. Today’s customers expect a smooth experience, from browsing products online to secure payments and quick deliveries.
The global pandemic accelerated the shift to digital commerce. With a focus on health and safety, contactless modes of payment became the norm, making e-commerce a leading retail channel. This trend is expected to continue as businesses find other ways to meet customer expectations in the digital world.
Healthcare Industry
The healthcare industry has survived several economic crises and continues to make profits. Both the healthcare and biotechnology sectors are seeing a rise in technological improvements, especially during the COVID-19 pandemic.
According to BlueWeave Consulting, AI in the healthcare industry has a global CAGR of 52.3% and is expected to increase to $45 billion over the next five years. The industry comprises several sectors, including drug manufacturers, hospital conglomerates, biomedical companies, insurance companies, institutional services, and drug instrument manufacturers.
Along with IT and digital commerce, healthcare is one of the few sectors that will likely have a high growth rate despite the pandemic. The demand for healthcare services remains constant regardless of a country’s economic standing.
The Bottom Line on Small Business Investing
Now that you understand “how do investors make money in a small business?”, you’re equipped to share in a company’s success without the stress of managing it. But remember that investments can be risky, and high returns aren’t guaranteed.
The type of investment you pursue depends on your risk appetite and investing philosophies. Regardless of your choice, make sure you understand the business, do your homework, and ask questions before investing your hard-earned money.
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