A Basic Guide to Investing in Small Businesses
There are over 30.7 million small businesses operating in the United States, making them the backbone of our economy. Small business investing could significantly increase your wealth, but it’s important to carefully think about your investment strategies before putting your money on the line.
Some factors you need to pay attention to include: liability, the business’ valuation, your exit strategy and your timeline. In this article, we’ll discuss the two types of small business investments and how each can help build your wealth and increase your revenue.
What Exactly is Small Business Investing?
There are two ways you can invest in a small business: buying company shares or loaning money. Investors can earn through appreciation, interest or dividends.
If you choose to finance a small business, you’ll earn money through interest payments. If you choose to buy shares in a small business, you’ll receive a portion of the company’s earnings over time. These shares will increase in value if the company grows and expands.
2 Types of Small Business Investments
Before investing in a small business, you must understand the difference between equity and debt financing.
Equity investments involve buying an ownership stake from a company. If you’ve purchased a company’s stock, you now own a portion of the business and you’re eligible to receive a share of the dividends and revenues the company earns.
When you make a debt investment, you loan money to the business in exchange for the promise of principal and interest repayments. Instead of taking out a traditional bank loan, the company you’re planning to invest in would rather secure funding from individual investors.
In an equity investment, you’re buying a “piece of the pie”. Equity investors provide capital to business owners, usually in the form of cash, at the expense of a percentage of the business’ profits and losses. The business can use the capital for almost any type of business expenses including reducing debt, hiring new employees and paying for daily expenses.
The profits or losses the investor receives is usually proportional to the capital he or she has invested. For instance, if you invest a $100,000 as capital and the other investors pitched in $900,000, you’re entitled to a 10% share of profits and losses. The percentage of ownership and dividends may vary depending on the terms of the investment.
If the expenses are greater than the sales, investors will assign the losses to the investors. But if the business is profitable, the returns can be great.
Instead of borrowing from banks, debt investments enable small businesses to receive a loan from investors. You can invest through direct loans or the purchase of bonds 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 you’ve been given a lien on real estate, you can repossess the property if the business goes south. You should be able to recover your investment by selling the confiscated property.
8 Steps to Small Business Investing
Performing proper due diligence is the key to a successful investment. Here are the steps you should take to choose and invest in a small business:
Do Your Research
The last thing you want to do is to invest in a business you don’t understand. Start by picking an industry that interests you and then assess that industry. Is it considered a high-risk sector? Could there be legislation coming that could affect the businesses within it? This could affect a company’s growth potential, and therefore your money’s growth potential.
Once you’ve settled on an industry, do your research on small businesses of interest within it. Hone your list to perhaps ten to 20 companies that you can really investigate thoroughly – both the companies themselves and the investment opportunities that may exist within them.
Review each company’s profit and loss statements, a list of their overhead, as well as their business and marketing plans. Check their recent balance sheets and bank statements to get a clear picture of each company’s cash . It also helps to run credit and background checks on the company’s leadership.
Find Investment Opportunities
When it comes to finding investment opportunities, look to see if the company is currently seeking financing. Not all companies in need of financing want an investor, but this is typically a good place to start. If you approach a company and they are interested in taking on an investor, ask them how they’d plan to use the money. The more detail they can provide, the better. You always want to know where your money is going.
Talk to the CEO(s)
Business owners are an important factor to consider when it comes to small business investing. Reading about the CEO is different from talking to him or her directly.
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 biggest risks associated with running this business? How do they mitigate those risks to deliver results?
Speaking with owners directly also helps you to assess passion. As an investor, you want to work with business 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? How much have they themselves invested in the business?
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 how effective it is in solving a problem.
When speaking to these customers, pay attention to which of the following three categories they belong to:
- Promoters – loyal customers who can help grow the business and who will recommend the products/services to other people.
- Passives – indifferent customers who’re easily swayed by competing brands.
- Detractors – customers who are unhappy with your products/services.
It’s important 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 potential new customers.
Understand the Deal
You’ve done your research and selected the company in which you want to invest. Now what?
It’s important you fully understand what the company’s value is and what your deal structure will look like. The deal structure refers to what the company is planning to offer you in exchange for your investment. How do both of these things compare to that 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’ value is too high.
Schedule an Appointment with Company Leaders
At this point you should have at least spoken to the company’s owner(s) as part of your own evaluation, but now it’s time to meet with them and discuss the investment opportunity specifically. This is where you should be learning about and assessing their intended uses for your funding. Transparency is key. Remember, if you move forward with the investment, these people will become your partners. It’s important you feel secure that they’re the types of people you want to work with.
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 document with company principals and after you agree on the broad points, you can work finalize the investment terms.
Seal the Deal
Once you’ve come to an agreement with the business’ leadership, the last step is to close the deal to finalize your small business 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 contract that outlines the terms of the loan, or you’ll get company shares.
Best Industries to Invest In
COVID-19 has undoubtedly changed the world of business. While some industries suffered immense losses, others are benefitting from the newly transformed economic climate.
Choosing the best industries to invest in isn’t rocket science, but it does require a bit of legwork on your part. To help you in your search on small business investing, we’ve rounded up three of the best industries to invest in right now:
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 it is projected to reach $3,294 billion by 2025.
As of July 2020, 59% of the world’s population are active internet users. This means that 4.57 billion people all over the globe are connected through the internet and technology. It’s safe to say that the IT sector will continue to grow for years to come.
Digital commerce encompasses online merchants, payment solutions, local and international delivery services and traders. According to another study published by Meticulous Research, the digital commerce sector currently has a CAGR of 11.7% and it is projected to increase to $24.3 trillion by 2025.
As more and more people use their mobile phones to facilitate cashless payments, the global payment industry has significantly contributed to the increase of the global eCommerce market. Statista says that the digital payment sector has a total transactional value of $4.4 billion in 2020 and this number is expected to increase to $8.2 billion by 2024.
Due to the global pandemic, more people are using touchless transactions through mobile payments. Therefore, the digital commerce sector is one of the few sectors that benefit the most during the coronavirus pandemic.
Throughout the years, the healthcare industry has survived several economic crises and they continue to make profits. Both the healthcare and biotechnology industries are seeing a rise in technological improvements, especially during the COVID-19 pandemic.
According to BlueWeave Consulting, the AI in the healthcare industry has a global CAGR of 52.3% and it’s expected to increase to $37.9 billion over the next five years. The healthcare 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, the healthcare industry is one of the few sectors that will most likely have a high growth rate despite the pandemic. The demand for healthcare services remains constant regardless of a country’s current economic standing.
The Bottom Line on Small Business Investing
By investing in a small business, you can share the rewards of 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 comes down to your risk appetite and your investing philosophies. Regardless of what you choose, make sure you know what to look for in a company, do your research, and ask questions before you invest your hard-earned money.