Before You Invest in a Small Business, See These Important Points
So you’re thinking of investing in a small business. That’s great news, and a lot of people are looking to improve their net worth.
Here’s a key point to remember. If you choose the right business and people to invest in, then you’ll be able to make a successful investment. If you make the wrong decision, you can lose your entire investment, making you start all over or keep you from ever investing in the future.
In this post, you’ll find tips and insights to help identify key issues when it comes to investing in a small company. You’ll also find a resource section containing tips and insights from various authors for a complete overview of what it takes to invest in a small business.
Is It Easy To Invest in a Small Business?
Donald Rumsfeld once said, “It is easier to get into something than to get out of it.” I have experienced this many times in my life. It’s a phrase you should keep in mind, especially when making any deal or getting into a partnership or working relationship.
It’s easy to invest in a small business. You look for a business that’s looking for investors, give them your money, and wait for the profits to come in, right?
Wrong!
Investing takes a lot of work to find the right business and set up a win-win for all parties.
For example, you don’t want to charge an outrageous interest rate so that you can make the most money. Suppose you charge 17% interest. The chance of success has diminished because all of their profits are going towards interest payments. The business may not survive. You want a deal where you make money, and the business thrives.
How Does Investing in a Business Work?
Small business investment isn’t a difficult concept to understand. For example, you have money sitting in the bank that isn’t giving you a good return, and you have no plans for it. You can invest the money in a business to gain a better return. The concept is simple. Finding a good small business investment opportunity and going through all the details takes time and attention.
As an investor, you are to make money through your investment without doing any work. If you were to participate in operating the business, you would become a partner rather than an investor.
Two Types of Investments You Can Make in a Small Business
You can invest your money in a business as an equity investment or as a debt investment.
An Equity Investment
In simple terms, an equity investment means you own a percentage of the company. An equity investor will receive profits, usually equal to the ownership percentage unless otherwise specified.
As part owner in the company, you don’t just get the profit the company makes. You are also responsible for the debt and losses the company may have and accumulate during operations.
Debt Investment
When you make a debt investment, you are investing money. You are usually getting back a return in the form of interest. Debt investments are usually at a higher ROI because the company could not get a loan at a regular financial institution and get a cheaper interest rate.
Suppose a corporation issues stocks and goes bankrupt. The debt must be paid before the shareholders. When assets are sold off, it goes towards the debt first, and if there is anything left over, it will go to the shareholders. Remember, not a lot of small businesses offer shares.
With a debt investment, you want to do everything possible to secure your investment. If the business owns the property, you’ll want to get a 1st mortgage. If not, see what other forms of collateral are available. Offering an investment with no security is possible, but the risk is high. With higher risk comes higher interest rates, and with high-interest rates, it’s harder for a business to succeed.
Is an Equity Investment Better Than a Debt Investment?
Which type of investment is better? It’s a good question, and I would say it depends on the intention of the investor.
If the business grows and becomes highly successful, an equity investment would be better for an investor. Imagine investing in Google or Amazon during the startup phase. What would your investment be worth today?
If an investor doesn’t want anything to do with a business and is just looking to make money off the interest, then a debt investment would be a better route to take.
What Is a Good Return on Investment for a Small Business
Here’s the way I look at getting a good return on my investment. It has to be something that works for me. Naturally, if I could triple my money in less than a year, I won’t say no to that, but that rarely happens.
You could be anywhere between 10 to 25%, but the question is, how safe is your investment? If you invest in a risky business. Naturally, your ROI is going to be a higher percentage due to the risk. With a safer investment, your ROI will be less because the odds are high you will get your money back with profit.
All that being said, you need to look at how comfortable you are investing in the business. You need to know when you’ll get your money back. If it takes ten years to get your money back with a low-profit rate, is it worth it?
Another way of looking at it is if it’s a safe investment backed by collateral. You can double or triple your earnings compared to keeping your money in the bank, which may be satisfying for some investors.
One more point to consider is the amount of money you invest. If you’re investing $1,000 at 10%, that’s $100 profit a year, which is not much of an investment. If you’re investing $1,000,000 at 10%, then that’s $100,000 a year, which is worth it with a safe investment. So when looking at ROI, keep the total profit into consideration.
For more on calculating ROI, I found How to Calculate ROI For a Small Business helpful.
How Much Should You Invest in a Small Business?
The number one answer would be to invest as much as you are willing to lose. Investing in a small business doesn’t guarantee you’ll get your money back. Just like the business owner is taking a risk so are those that are investing. That’s one thing you need to remember.
Now there are high-risk ventures and safe investments. The higher the risk, the higher the returns. Suppose you lendg a business owner $50,000 because they can’t get a loan from the bank.
The bank may charge 8%. But because the bank won’t approve the loan. You may charge 12% to get a good ROI. The business owner may be good with the terms because they don’t have another alternative.
Another point is looking at the total profit to be made. As discussed earlier, if you invest $1,000 with a 10% return, you make $100 a year. Invest 1 Million, and you get a hundred thousand a year at 10 percent. A lot more attractive.
You also have to look at how the investment will benefit the business.
For example, suppose the business owner is looking for $50,000, and you’re only going to invest 25,000. In that case, that might not be enough to keep the business running.
Even though the business owner may say yes, I’ll take the $25,000, it’s going to be a high risk because he needed $50,000. A 25k investment won’t get them through his project, jeopardizing the entire business.
Let’s look at another example. Let’s say A business owner is looking for $200,000. You look at the business. You find it a really good investment; instead, you offer to expand and offer one million.
The million dollars is tempting for the business owner to not try as hard because of the extra cash. The only situation where I would invest more is when I have a better plan, and the business owner agrees to that plan in writing.
The Right Way to Invest in a Small Business
Define Your Goals
One of the first points you should consider is your expectations. When you know what you want, it’s easier to determine if this is the right investment for you. You may come across a point that meets your needs, which allows you to complete your due diligence effectively.
Define Your Investment Amount
When you determine the amount of money you are willing to invest, you’ll be able to go through the due diligence process quicker.
Here’s my point suppose you have $50,000 to invest. During the first part of your due diligence, you find the company needs close to $ 175,000 to prosper. Now you know your investment won’t help and your better off looking for a different business to invest your money in.
Conduct Some Research
The research you do before you invest is priceless. The more you know about the business, the more you can make an informed decision about investing.
Take your time and look into each of the important issues. You’re not going to take the business owner’s word for it. You want to see proof. You don’t have to consider it as a trust issue but rather an accuracy issue.
Many business people will give you a rough idea. Still, it will be off by a bit when it comes to the actual number, and that difference may be the deciding factor of whether to invest or not.
For example, you may ask how much are monthly expenses. The owner replies around $24,000, forgetting to factor in the salaries, which is an additional $8,400.
Request a Business Plan
A business plan is an important document that every business should have, especially companies looking for investors.
A business plan reveals the company’s structure, ownership, target market, products, services, and more.
For more on what’s included in a business plan, have a look at, How To Write A Business Plan Using These Resources
Talk to the Owners
Companies are about people, not assets. You want to know who owns and operates the company. Pick the brains of the owner and the people in charge.
You want to be able to trust the people that are running the show. If you don’t feel you can trust them, walk away. You want to make money, and you want your investment to be safe.
A highly competent business owner who knows the business numbers and understands aspects of operations makes an investor more comfortable. Compare this to an owner with a “don’t worry about it, it will all work out in the end” attitude.
Do Not Invest Based on the Hype
Make your investment based on proof and numbers. You don’t want to get caught up in the hype. You may have heard it before, “this can be a billion-dollar idea.” Yeah, maybe, but show me how and when this will happen. Most of the time, you find it’s a billion-dollar dream, nothing more.
Calculate the Risks Involved
When it comes to investing, one of the most important points is the risk. Suppose there were zero risks for every investment. In that case, you can invest in thousands of companies without worrying about losing your money. Some investments would yield a high return and others a lower one while the combined profit of all of them would be well worth it.
Unfortunately doesn’t work that way. The biggest problem is the risk involved and losing all your money. One of the most important parts of deciding whether you’re going to invest in a company or not is to assess the risks involved.
Risk assessment for investing in a small business goes beyond the scope of this post. I have included below to help you assess the risk before you invest in a small business. For more on risk assessment see, Conducting a Small Business Risk Analysis: Steps to Get Started
Keep Records of Your Agreements
Naturally, when you have struck a deal, you want to have everything documented. Have your lawyer go through the agreement to make sure everything is legal, and there are no loopholes.
If you go to court due to a breach of contract, this is the document you will use, so you want to make sure it’s created by a professional to protect you.
Compare Related Businesses
Take time to research related businesses to compare the information. When you research similar businesses, you may find points you had not considered.
You may take one more step to look at other businesses similar for sale. Interview the owners to understand the industry. You never know you may find a better business to invest in than the one you’re considering. For more on this technique see, An Inside Look Into The Business You’re Considering
Get Certified Financial Statements
A strong balance sheet shows a solid track record and shows potential for lasting success. You want to get certified documentation to ensure you have the right information.
You can’t take someone’s word for it and mostly because of accuracy. Certified financial statements will show you the business’s true value and its performance from a financial point of you.
You may also want to show these financial statements to your accountant to make an informed decision.
Get To Know the Business
Understand what you’re investing in; even though you’re not going to run the business, you should have a thorough understanding of how it operates.
Without a thorough understanding of how the business operates, the business owner may come back to you with problems unless you understand its operation. You won’t be able to understand the problem.
If something doesn’t make sense about how the company operates, either get clarification or walk away.
Sleep on It
Take your time, and you don’t want to get excited and move forward based on emotion. After you have all the information, take a few days to think about it.
Often, when you sleep on it the next day, questions about the investment will come to you. Allowing you more time to find the answers. If you have already made the deal, it’s too late to ask questions the deal is done.
Have a Lawyer Look at the Business and Do a Background Check
You want to dig deep into the company’s background. You can have your lawyer do a background check to determine if there are any liens or lawsuits against a business that may harm you as an investor.
It’s better to invest in research and due diligence. Otherwise, you may wake up one day to find that you have lost your entire investment because of something you didn’t know.
Conclusion
When considering investing in a small business, take your time. Keep your emotions out of the decision-making process. Avoid hasty decisions. Use professionals to help with due diligence and research.