If implemented properly, investing in a small business can be very profitable. It is one of the most effective ways to unleash your entrepreneurial potential, enhance your cash flow, and embark on a journey to financial independence.
Unfortunately, few people are willing to put in the work of researching the best way to invest in a small business, and they decide to give up along the way.
In this article, we explore some of the important things you should know about small business investments.
Types of Small Business Investments
Whether you want to establish a new business or buy into an already existing business, there are several different types of small business investments you can make. Let’s look at the three major types:
Equity investments, sometimes called angel investing, are also known as ownership investments. When you invest in equity investment, you own a portion of the business. As an equity investor, you provide money in exchange for getting a percentage of the business’ profits.
Likewise, if the value of the business drops, you share the loss with other investors. Your portion of the company also gives you a say when it comes to making some critical business decisions about the future of the business.
One great advantage for angel investors and venture capitalists is that it can result in massive gains.
However, you should keep in mind that anything that is highly profitable is risky as well. There’s no assurance that the value of your investment will remain constant or grow in the future. It can even drop.
Moreover, there’s no assurance that you’ll make any profits. It’s hard to predict these aspects of a business as they’re normally controlled by external factors such as economic changes and political situations.
Lending to Small Businesses
When you make a lending investment, you’re acting like a bank. The investment involves buying a debt that should be repaid. Lending investments are less risky compared to equity investments, but they have considerably lower returns.
Debt investments are the most common type of lending investments. When a business needs money to grow, it will issue debt in the form of notes, bills, and bonds to investors.
When you buy the bond, you become a lender. In this, you are responsible for providing the business with additional funding.
The business has to commit that they’ll pay back your money in the future. The best thing about a debt investment is that they have priority over the equity investors.
If the business fails in the future, you’ll have a higher claim of its assets than the shareholders.
If you are looking for the safest type of small business investment, you might consider investing in Cash Equivalents. You should realize, however, that they deliver very low returns, ranging from 1% to 2%.
Cash equivalents also act as one of the primary indicators. They show the financial health of a business and help determine whether it is worth investing in or not. There are several types of cash equivalents, including:
- Commercial papers – These are unsecured debts issued by larger corporations to take care of short-term obligations
- Treasury Bills – These are short-term debt securities or bonds issued by the government
- Marketable securities – These include things like certificates of deposits (CDs) and government bonds. They should be redeemed within a year
- Money market funds – These are investments in bank loans whose goal is to generate interest for investors while upholding a net asset value (NAV) of $1 per share
These types of debt financing are as safe as a bank account fand great for those with a low risk tolerance but always do your due diligence on the opportunities you choose.
Considerations Before Investing
If you are looking to invest in a small business, there are several things you need to do before you take the plunge. They include the following:
You should have a clear understanding of what you are getting into, or you could lose money. Before you invest in a business, you should review the following:
- Business model
- Profit and loss accounts
- Financial Statements
- An assessment of the business’s overheads
- Business and marketing plans
Ask about the audited accounting books of the past years. Nothing can give you a clearer picture of the business’ cash flow than the bank statements and balance sheets. It’s also important to consider in which industry the business operates.
You want to know how volatile the industry is and if there is any upcoming legislation that could impact the business. Moreover, you’ll want to know how fast the business can grow, so that your investment can grow as well.
If the business needs working capital, you should first find out it has a proper plan in place for the money. You want to know long they think the capital will last and how many individual investors they wish to work with.
You should realize that a small business with many small investors can be inefficient and expensive to run. This is because of the complexities of reporting and fiduciary requirement toward minority investors.
Get To Know The Business Owners
When you invest in a business, the business operator becomes your key partner. Therefore, having some information about this person will help you decide whether to invest in the business or not.
You need to know how experienced the small business owners are at:
- Running a business
- Managing staff
- Handling customers
It’s also important to know how much money the owner has invested in the business. You would want to work with an entrepreneur who will share the loss with you if the business fails.
A business owner who only uses other people’s money will normally not be as enthusiastic to succeed as you are.
Invest in a Familiar Business
Investing in a type of business you have experience with is advantageous. You have the opportunity to offer actionable guidance and advice to the business owners.
You should not invest in an industry that you don’t understand at all simply because it looks profitable. You will have a hard time knowing what metrics need to be used and what they mean if you’re a complete outsider.
When you have experience in an industry, it can be easy to spot investment opportunities that will succeed.
Furthermore, if you have a majority stake in a business you understand, you can easily take over the business if it needs to be resuscitated. It is advisable to do a background check on the key employees.
If they seem to be hesitant, you should think twice about investing in the business.
Places to Invest in Small Business Loans
If you want to invest in the small business lending market, there are two common types of loans that you can consider investing in:
- Working capital loans
- Equipment finance
Let’s take a detailed look at each:
Working Capital Loans
This form of a loan is designed for businesses that need capital but normally don’t have specific collateral against which to file a lien.
A good example is when small-business owners are looking for money to improve their current business location or finance marketing programs (market research, target market analysis, direct marketing, etc.).
The purpose is an integral element in the lending business. A healthy business is the one that looks for capital to grow. You should be wary of investing in businesses that are looking for funds to cover existing expenses, as they represent much higher risk.
Equipment Finance Loans
Equipment finance loans are mainly used to purchase business specific equipment. The best thing about equipment finance loans is that as a lender, you can attach a security interest in the equipment. The purpose is also essential in these types of loans.
It is imperative that you find out if the equipment being purchased plays an integral role in the business operations.
A simple way to determine the importance of the equipment to the business is by figuring out what would happen to the business if the equipment is pulled out.
A vehicle lift would be essential to an auto body shop, but a computer network would likely be a waste of funds. Another essential factor to keep in mind when evaluating an equipment finance loan is to understand that various types of equipment are hard to value.
So, you should realize that if a business considerably overpays for equipment, it can result in a much higher default rate. Take specialty medical equipment, which can be sold at varying prices depending on the purpose or who is purchasing them.
You can sell the same equipment to one institution for $25,000 and to another at $50,000. This will certainly result in major differences in the collateral value supporting the loan.
Alternative Investments to Small Business
Small business is a great way to invest. Some other investing options are:
Real estate has created tons of millionaires and is one of the most popular investing options. Whether you invest in real estate as a property owner or as an investor in an REIT, it can make you solid returns Mutual Funds.
Buying company shares is the bedrock of most investment portfolios. Stock market investing has a ton of different options and allow you to grow your investments over a lot of different industries.
Bonds are debt that governments and businesses take out so they leverage for specific purposes. Investing in bonds is considered one of the most stable ways to make a profit.
Exchange Traded Funds allow you to own a diversified portfolio of investments. Most ETF investing is in a variety of stocks, but there are tons of different options with ETFs in different industries.
Like ETFs mutual funds allow you to invest in a lot of equities all at once. Mutual fund investing can have goals of long term high yield growth, medium term safe investing, as well as creating annual income for your retirement.
Peer to Peer Lending
Relatively new as an investment strategy. P2P lending offers you the option to invest directly in the loans going out to other people. Returns are better than bonds, but not as much of a good investment, or risky, as stocks.
Commodities are physical products. This is normally gold, precious metals, or even produce. Commodities investing needs a lot of research, but it can be very profitable.
Bottom Line on Investing in Small Businesses
Every business can benefit from a helping hand, whether big, mid-sized, or small. However, a lot of people who are learning how to invest will be hesitant when it comes to small business investments due to the lack of security involved and the belief that they can find a better opportunity through other forms of financial planning and wealth management.
What they don’t know is that you can greatly increase your net worth with this kind of investments if you know what you are doing.
It is important to choose the right small business to invest in, as that will make all the difference in determining whether your money will turn to profit. Some profitable small business investments include Equity Ownership, Debt Investments, and Cash Equivalents.