The first investment option we will look at is investing in small businesses. The drive for entrepreneurship is leading to the creation of many new companies every now and then. It is on record that about 12,000 new companies are registered in China every day. The global interest in entrepreneurship provides opportunities for investors to invest in startups and earn considerable returns. As said before, investing in small businesses comes with massive potential for returns, though the risks are also significant. It is, therefore, essential to understand the different ways you can invest in small businesses and how to do it right.investing in small businesses comes with massive potential for returns, though the risks are also significant. It is, therefore, essential to understand the different ways you can invest in small businesses and how to do it right. Click To Tweet
How to Invest in Small Businesses
Defining a small business is not very simple. Nevertheless, in this article, we take a small business as a startup that does not have access (at least at the beginning) to large investment sources like FDI (foreign direct investment) or venture capital. These businesses start by pooling capital from some individual investors rather than institutional investors.
A small business can start as a limited partnership, a limited liability company, or some variations in between.
You can invest in small businesses in three ways:
- Start a small business: If you have a sound business idea and a good business plan, you may decide to use some of your savings to start a small business. Starting a small business does not necessarily mean managing its daily operations. You can choose to do so or see the business through its early stages and appoint a manager.
- Buy a small business: Alternatively, you can decide to purchase a small business that is up for sale or table an offer to buy a company you might be interested in purchasing.
- Invest in another person’s small business: This is the easiest route (in terms of your involvement) to take. You can choose to invest your money in a viable small business and earn returns on your investment.
If you take the third route, you will need to subscribe to either of two investment structures:
- Equity: With equity, in exchange for your investment in the business, you will get a portion of the ownership of the company. You will get returns according to the share of profit or the rate of return whenever the company makes a profit. For example, if five investors paid $100,000 each, the share of profit (ceteris paribus) will be 1/5 or 20%.
- Consequently, for every profit declared, you can expect 20% of the returns. With equity investment, you keep partaking of the returns of the company. However, should in case the company folds up, you also bear the loss.
- Debt: The alternative route is to lend money to the founders of the small business and get your money back with interest over a stated period. With debt, you are sure of getting back your money even if the company fails.
Equity provides you with better prospects for returns in the long term but with significant risk. In contrast, debt provides you with only a return on your initial investment with no risk (as long as it is secured on the company’s assets). Making a choice is never easy. Imagine how frustrated you will be if you borrowed Amazon money (for example) at the start rather than purchasing equity. On the flip side, imagine the frustration if you invested in the equity of a business that failed three years from inception.Equity provides you with better prospects for returns in the long term but with significant risk. In contrast, debt provides you with only a return on your initial investment with no risk (as long as it is secured on the company’s… Click To Tweet
Pros of Investing in Small Businesses
There are some good reasons why you should invest in small businesses. Some of them include:
- Potential for huge returns: A small business can turn into a large corporate organization in the future with enormous potentials for returns. Whether you start it, buy it or invest in it, the earning opportunities are massive if things go right.
- Opportunity to be part of something big: By investing in a small business, you may just be investing in the next P&G, Facebook, Amazon, PwC, among others. It is undoubtedly a delightful prospect.
- Tax Benefits: When you start a business, you can take more deductions and write off expenses in the ordinary course of business. Such deductions and write-offs reduce your tax bill.
- Retirement benefits: When you start a business, you can enroll for retirement contributions with higher limits compared to when you are an employee (a SEP-IRA allows up to 20%)
- Investing in your passion: Apart from the financial advantages, starting a small business or even investing in one can be an opportunity to be part of something you are passionate about.
Cons of Investing in Small Businesses
Despite the opportunities, investing in small businesses also come with some disadvantages:
- A greater level of risk: While many new companies spring up now and then, about half of them fail in the first five years. As a result, there is a higher level of risk when you invest in small businesses (especially if it is an equity investment). The company can fail, and you can lose your money.
- Lack of control (when you invest in another person’s business}
- Lack of steady income at the beginning (when you start the small business)
Recommendation for Investing in Small Businesses
What are some steps you can take to maximize the pros and minimize the cons for each of the investment options?
Starting the business
- Study and understand the market you are exploring
- Start a business in a niche you are passionate and knowledgeable about
- Create a viable business plan
- Be realistic about your expectations
- Have a plan B to deal with the uncertainties of a new business
- It’s best to start the business while you are still employed
- Get a strong team that shares your passion
- Seek professional help when necessary. Don’t be a lone ranger
- Get all the essential legal and tax-related paperwork in place
- Always do excellent business
Buying the business
- Be specific about what you are looking for. Don’t make fundamental compromises
- Understand all the liabilities of the existing company, especially taxes
- Better to start a new business and acquire the assets of the existing business than buying the stock of the business
- Get a lawyer and understand all the legal situations
- Find a way to walk through differences in culture
- Be firm in your negotiations
- Ensure the seller is willing to stick around for a while
- Ensure the key employees are willing to stick around for a while
- Get an indemnity from the seller in case of future lawsuits based on things the seller did before selling to you
Investing in the business
- Be specific about the type of business you want to invest in. Do not make fundamental compromises.
- Request a business plan
- Evaluate the risk factors and the different circumstances that can induce success or failure
- Understand the market and viability of the business
- Do due diligence on the business and the niche
- Be firm in the negotiations.
- Based on your risk management evaluation, choose between equity investment and debt investment.
- Ensure the founder(s) have something to lose. Don’t be the only person taking up the risk
- Ensure every agreement is in writing and well documented
Investing in a small business comes with potentials for high returns accompanied by great risks. Understanding the types of investments available and the pros and cons will help you navigate through the waters. When you decide to invest in small businesses, ensure you follow tested and trusted tips and recommendations to maximize returns, and minimize risk.