Investing in business entities in the early stages of their development presents an excellent opportunity to increase your wealth, especially when compared with more conventional investment strategies.
Although less common, investing in a small business can net returns several times higher than investing in publicly traded companies.
If you want to build long-term strategic assets in your portfolio, growing and nurturing small businesses should be one of your key priorities. We’ll break down the various types of business investments and how you can get started building wealth and growing revenues.
How to Invest in a Business and Make Money: Debt vs. Equity
Regardless of whether a business is an early-stage startup or major multinational corporation, the same basic rules apply.
Investing in a business is done by taking a debt or equity position in a company. While it is true that both can deliver promising returns, there are crucial differences worth noting.
Knowing how to invest in businesses begins with understanding the key differences between debt and equity financing. Two ways you can invest in a small business are by lending capital to the business or buying company shares.
By lending to a business or buying part of the company, you can earn a return in the form of interest, dividends or appreciation.
Debt financing: If you provide capital to a business in the form of a loan, it will be repaid in installments over an agreed-upon term, plus interest. This is known as a debt investment or debt financing.
Equity financing: In contrast, if you purchase shares, this ownership will entitle you to a portion of the business’s earnings over time, known as equity financing. Technically speaking, owners of a company’s stock own a portion of the company (i.e., whatever the percentage of the share is) and, consequently, are entitled to an equivalent share of the revenues and dividends generated by the business. Additionally, if the company expands, your shares will gain worth over time.
5 Steps for How to Invest in a Small Business
If you want to invest in a business through either debt or equity, there are many steps that you should follow to lower your risk and improve your odds of generating positive returns.
1. Source Deals
If you want to invest in small businesses, the first thing to do is find business investment opportunities — namely companies that are looking for financing.
Keep in mind not all companies seek investors. They may not be ready to give up ownership, or they may be fully extended and unable to make additional loan payments.
2. Meet With Company Principals
Once you’ve found a small business investment opportunity, it’s important to meet with the company leadership team. This is an excellent opportunity to see what they hope to accomplish and their intended uses for the financing or capital investment.
Additionally, this is a chance for you to get a feel for the business you may invest in and the character of the company’s principals. After all, they are your potential partners, and this is your chance to decide whether they’re the types of people with whom you’d want to be in business.
3. Conduct Due Diligence
The next step when investing in a small business is to take a close look at the business as well as its financials and potential viability. This may mean reviewing the books, looking at outstanding loans or reviewing a market study for the product or service the company is selling.
You may also want to consider running background or credit checks on the company’s leadership or other owners.
Additionally, consider the following due diligence questions to ask when investing in a business:
- How long has the company been operating?
- What is the company’s revenue and cash flow?
- What are the company’s financial projections?
- How will the invested capital be used?
- How did the business come up with its valuation?
- How frequent are the returns or distributions?
- What type of return can you expect?
- Is the business scalable?
- What does the management team dynamic look like?
- What other capital requirements does the business have?
- What are the risks the business may face? (e.g., regulatory, legal, product liability, etc.)
4. Negotiate the Terms
Once you’ve done a comprehensive review of the business, you’ll need to come up with a term sheet or sample financing agreement if you want to offer a loan or invest in the business.
Once you put together a detailed outline of what you’re willing to offer, you should review it with company principals. Once you agree on the broad strokes, you can work out the fine points.
5. Close the Deal
After you’ve come to an agreement with the company’s principals, you’ll need to close on the pact to finalize your investment in their business.
This is when you’ll sign agreements and provide the capital you promised to offer. In turn, you’ll receive company shares or a signed contract that reflects the terms of your loan and outlines how and when it will be repaid.
Experienced entrepreneur seeking an investment loan?
How Much to Invest in a Business
You may decide to provide a business with $10,000 in capital, $100,000 or $1 million and up. At the end of the day, how much money to invest in a small business can vary depending on numerous factors, including the company’s needs, its potential for growth and your ability or willingness to part with capital. The type and size of the company may also be considerations.
Small Business Investment Companies (SBIC) licensed and regulated by the Small Business Administration, for example, typically offer debt loans ranging from $250,000-$10 million. In contrast, typical equity investments made by SBICs range from $100,000-$5 million. Additionally, SBIC investments are typically made over a 3-year period.
Risks to Consider When Looking to Invest in a Small Business
Investing in small businesses doesn’t always reap rewards. Here are a few reasons to be wary.
Internal Challenges
Reputation issues, fraud, business interruption and security concerns are just a few problems that can materialize for small businesses. These difficulties can impact the company’s revenue stream and, consequently, your investment and return.
Investment Illiquidity
Once you lend or invest funds in a business, that capital is tied up, typically for years. Make sure you have enough cash in reserves to keep your own operations going or pursue other potential investment opportunities that arise.
Business Closure
Nearly one-third of small businesses close up shop within 2 years of opening, according to the U.S. Bureau of Labor Statistics. That said, the potential to lose your capital investment is real. As a consideration, only invest money you can afford to never see again.
Related: Why Small Businesses Fail (and How You Can Succeed)
Positioning Your Small Business Investment Strategy for Growth
Sometimes it isn’t enough to start your own small business and build it from scratch. Between time constraints, capital limitations and opportunity costs, there’s a lot that can get in the way of successfully building a small business to generate high, long-term profits.
This is why it’s so important to channel your entrepreneurial vision into a sound investment strategy. When you buy into a small business, in the form of a debt or equity investment, you can share the rewards of a company’s success without having to invest the serious time and energy commitment of managing it.
Granted, small business investments can be risky, and no one business can guarantee consistently high revenue or capital gains. But the market does tend to reward those who invest in a diverse portfolio of small, growth-oriented companies.
If you think investing in a small business sounds enticing, the first thing to do is to assess the situation. You’ll need to consider how much you can afford to invest and how much risk you can tolerate so you can make the best choice for your own finances.
Now that you know how to invest money in a small business as well as the questions to ask before investing in a business, you can be on your way to backing a venture that’s aligned with your wealth-building goals.