The story of the “mom and pop” small business is a very American story.
Hollywood has celebrated the theme of small business in movies, books, and TV shows like Shark Tank, but what people don't seem to talk about enough is the investment power small businesses bring. According to the Small Business Association (SBA), the number of small businesses in the United States in 2023 will be 33.2 million, accounting for 99.9% of all U.S. businesses.
Every small business has a story, but the general consensus is that solid small businesses have the potential to make money, whether it's your local laundromat or an up-and-coming artificial intelligence tools provider. According to Bank of America's 2023 Small Business Owners Report, 65% of small business owners surveyed expect to increase their revenue over the next 12 months, and about 50% expect to increase their revenue over the next 12 months. They answered that they would expand their business.
With more and more money on the table, it makes sense to consider investing in small businesses. When done right, investing in small businesses can be a reliable source of income not only for investors in banks, credit unions, and venture funds, but also for Americans on Main Street.
Why invest in small businesses?
Investing in local small businesses has both benefits and risks.
On the plus side, going “small” can mean getting into the ground floor of a profitable business.
“Small businesses make up the backbone and muscle of the American economy,” said Kelly Ann Winget, founder and CEO of private equity firm Alternative Wealth Partners. “This is the largest, most robust and resilient means of making money in this country. We have the greatest opportunity for creativity to collaborate.”
There are many opportunities in the area of small business investing, as this sector is often overlooked by investors who focus on stocks, funds, and other investments.
“The key to successful investing is building a diversified portfolio while achieving above-market returns,” said Jay Jeong, president and founder of business consulting firm Embark Advisors. “Small and medium-sized businesses are often an uncorrelated asset class that replaces typical investments such as public stocks, bonds, and commodities. You can spread it out even more.”
On the downside, small businesses can fail, and investors (especially new investors) need to be diligent and decisive in choosing investments in small businesses that make sense for them.
Lack of liquidity is also a potentially risky issue. “You can't sell your investment and exit at any time,” Jung added.
Advantages and disadvantages of investing in small and medium-sized enterprises
How does investing in small businesses work?
There is no best or worst way to invest in small businesses.
It all depends on the small business owner's needs and investment requirements, said Jaime Lasculinez, founder and CEO of Next Generation Trust Company, a financial services company that offers voluntary retirement accounts.
“Fundamentally, it's about the needs of small businesses and how they want to build it,” Raskulinec said. “It can be structured as an outright loan with a set interest rate and term, or it can be a loan that can be converted into stock or part of a company, or it can be a direct investment in the business to get equity in the company.'' capital. ”
Most small businesses operate in areas where banks and credit unions cannot or cannot enter.
“Early stage businesses looking to raise capital often look to sources other than banks, such as friends and family,” said Chris Rowley, CEO of Harvest Returns, a small farm business investment platform. says Mr. “Recently, equity crowdfunding platforms have made it possible for the average individual to invest in a variety of small and medium-sized businesses.Individual investors typically acquire shares in small and medium-sized businesses and invest in the profits and growth of that company. You can share it.”
How to invest in small businesses
The two main ways to invest in small businesses are equity investments and debt investments (i.e., loans).
stock investment
Venture funders and angel investors often make equity investments in small businesses by providing cash to fund the business in exchange for equity in the company. This gives equity investors ownership of the company, and that ownership creates a commitment to making the company successful, helping both the company founders and the investors.
debt investment
On the other hand, banks and credit unions often make debt investments when lending money to start-up companies. Private investors can also lend money, offering loans in exchange for favorable interest rates over a period of time.
The main difference is that a bond investment does not give ownership to the small business lender (unless there is specific language written into the loan agreement in the event the company goes bankrupt or experiences another significant setback). . The founders (or subsequent owners) continue to own the company even after the loan is repaid in full.
Other types of investments exist, but you have to roll up your sleeves and get to work.
Having the financial means to invest is a great starting point, especially for those new to owning a business. “If you don't have the capital, consider working within the business first,” Winget said. “The value of sweat equity can be very valuable.”
Winget said he is an active investor in small and medium-sized businesses and often contributes to their operations in a way that makes sense. “Capital investment is important for business success, but so is time and effort.”
Always keep an eye on your investment costs and make sure they fit your budget and expectations.
“Investment checks for early-stage investments in small businesses can be as low as $5,000 (and sometimes less), and investing in small businesses can have very high returns if successful. But high returns come with high risks,” Jung said.
What to consider before investing in a small business
The good news is that anyone can invest in small businesses, and there are many ways to do so.
“There are crowdfunding sites and local investor groups in your area that connect investors with small business owners,” Raskulines pointed out. “If you have the right custodian, you can also use your retirement plan to invest. You can also contact your financial advisor to see if they are aware of any opportunities.”
Regardless of the type of investment, small business investors should always conduct proper due diligence when making an investment.
“Things to look at include the financial health of existing operating businesses and forecasts for start-ups, the level of experience in the field of business owners, and conducting due diligence on business owners if you are not familiar with them. and so on,” Raskulines added.
Don't stop there. Continue to educate yourself by seeking help from legal and accounting professionals.
“Always hire a lawyer to draft and review your investment documents,” Jung advised. “You may be investing with someone you know, so it can be uncomfortable to discuss detailed terms, negotiate, and protect yourself. Someone may think you don't trust them.” .”
That's why it's a good idea to leave the job to a legal professional. “Once you get the hang of it, you can leverage online platforms like Indiegogo and his StartEngine to expand your reach and access a wider range of opportunities,” Jung added.
Questions to ask before investing in a small business
As with any investment that can cost you a lot of money if not handled correctly, don't pour cash into your small business unless you have the right answers to these three questions.
Is the business financially stable?
Profitability isn't required (in fact, companies in a downturn may offer better deals), but it's important to look for strong numbers.
“Assess whether there is existing demand that is simply not successful due to a lack of efficiency,” Winget advised. “Think about whether the business's struggles are due to factors such as location, management, or brand. You'll also want to know how the company sells its products and services.”
What is the background and knowledge base of the founders?
You'll also want to know about the people who founded the business and are leading it.
“Entrepreneurial experience matters,” says Sundip Patel, co-founder and CEO of AVANA, a business investment services firm. “Investors will want the founder to have previously led a successful business or at least played a leading role in a successful small business.”
Grit and perseverance are often more important than experience in a large company. “Reviewing celebrity resumes doesn't necessarily lead to small business success,” Patel added.
What is your objective in investing?
“You need to know whether the business terms align with your goals,” Raskulinecz said. Additionally, you'll want to know if you'll be financially okay if you lose your entire investment. ”
Investors in small and medium-sized businesses also expect greater returns from their investments, perhaps more than entrepreneurs realize.
One recent study points out that the average return for angel investors (investors who often fund small business loans as part of their profits) is 2.6 times the initial investment. Typically, these returns appear approximately 3.5 years after investing in a small business and represent a 27% rate of return.
While some small business investors may be making long-term investments, and others may want to turn their money into cash within a few years, small business funders need specific You should have investment return goals, a fixed investment schedule, and an acquisition plan in case investors want it.acquire small businesses
Frequently asked questions (FAQ)
The main advantage of investing in small and medium-sized businesses is that you get access to the ground floor of potentially lucrative investment opportunities. The biggest risk is losing money on your investment because the business fails or doesn't meet your financial expectations.
As a matter of fact, small businesses may never grow into large businesses due to various reasons such as lack of funds, poor management, inability to keep up with competitors or stay ahead of competitors. . It's up to you to ask around and find out what the potential problems are before investing your money.
Start your small business investing journey by joining our crowdfunding list, investing a small amount of money, and gaining experience.
As Jung pointed out, there are a number of online platforms that specialize in investing in small and medium-sized businesses, such as Indiegogo and StartEngine. Other small business crowdfunding platforms include Mainvest, Honeycomb Credit, and Fundable.
Outside of the crowdfunding space, the most common companies that invest in small and medium-sized businesses are banks and credit unions on the fixed income investment side, and venture capitalists and angel investors on the investment side. private equity side.
Ask about the founder's background and experience in the market where the business is located. These can be a huge factor in the success or failure of a small business. Also, don't be afraid to ask about the financial health of the business, such as current or projected revenue, debt, and profit margins. Of course, ask about costs such as rent, business equipment, marketing, payroll, etc., and be sure to ask how your investment funds will be used.