How to invest in small businesses

The story of the “mom and pop” small business is really the story of America.

Hollywood has celebrated the small business theme in films, books, and television shows like Shark Tank, but what people don’t seem to talk about enough is the investment power fueled by small businesses. Overall, there were 33.2 million small businesses in the United States in 2023, according to the US Small Business Association (SBA), representing 99.9% of all American businesses.

While every small business has a story, the general consensus is that a robust small business, be it a local launderette or an up-and-coming artificial intelligence tools provider, can be a money maker. According to Bank of America’s 2023 Small Business Owner Report, 65% of small business owners surveyed said they expected revenue increases over the next 12 months, and about 50% said they were expanding their businesses in the year ahead.

With the ever-expanding amount of money on the table, it makes sense to consider investing in small businesses. Properly executed, small business investment can be a reliable source of income not just for banks, credit unions, and venture fund investors but for Main Street Americans as well.

Why invest in a small business

Investing in small local businesses has its advantages and its risks.

On the upside, aiming “small” can mean getting into the ground floor of a highly profitable business.

“Small business makes up the backbone and muscle of the US economy,” said Kelly Ann Winget, founder and CEO of the private equity firm Alternative Wealth Partners. “It’s the country’s largest, most robust, and resilient piece of money-making. They have the most opportunity for growth, generational wealth building, and creativity for investors to work with — whether passively or actively involved.”

There’s plenty of opportunity in the small business investment space, as the sector is often overlooked by investors more focused on stocks, funds and other investments.

“The key to successful investing is to build a diversified portfolio while attaining above-market returns,” said Jay Jung, president and founder of Embarc Advisors, a business consulting firm. “Small businesses are often an uncorrelated alternative asset class to typical investments such as public equity, fixed income, and commodities. This allows investors to further diversify risk with exposure to the potential high returns of a small business.”

On the downside, small businesses can fail, and investors (especially new ones) have to be diligent and decisive in choosing the small business investments that make sense for them.

Lack of liquidity is also a potentially risky issue. “You can’t just sell your investment and get out any time you want,” Jung added.

Pros and cons of investing in small businesses

How does investing in a small business work?

There is no best or worst way to invest in a small business.

It all depends on the small business owner’s needs and your requirements for your investment, said Jaime Raskulinecz, founder and CEO at Next Generation Trust Company, a financial services company serving self-directed retirement accounts.

“Basically, it’s about the needs of the small business and how they want to structure it,” Raskulinecz said. “It can be structured as an outright loan with an interest rate and set term, it can be a loan that can be converted into shares or a percentage of the company, or it can be an investment directly into the business for a share in the equity of the company.”

Most small businesses wade in where banks and credit unions either don’t or can’t go.

“Early-stage companies that want to raise money often seek non-banking sources, such as friends and family members,” said Chris Rawley, CEO of Harvest Returns, a platform for investing in small agricultural businesses. “More recently, equity crowdfunding platforms have allowed average individuals to invest in various small companies. Generally, individual investors take an equity stake in a small business, allowing them to share in the profits and growth of that company.”

Ways to invest in a small business

Two primary methods of investing in a small business are equity investments and debt investment (i.e., loans).

Equity investments

Venture funders and angel investors often make equity investments in small businesses by offering cash for business funding in exchange for equity in the company. This gives an equity investor an ownership stake in the company, and with that ownership comes a commitment to making the company successful, which helps the company’s founders and investors alike.

Debt investments

On the other hand, banks and credit unions often make debt investments when they lend money to emerging companies. Private investors can loan money, too, offering loans in exchange for a profitable interest rate over a fixed period of time.

The main difference is that debt investing doesn’t give the lender ownership in the small business (unless specific language is written into the loan contract if the company goes bankrupt or experiences another significant setback). Once the loan is fully repaid, the founders (or any successive owners) still own the company.

Other types of investments exist, but you must roll up your sleeves and go to work.

Having the financial means to invest is an excellent starting point, especially for anyone new to business ownership. “If you don’t have the capital, consider working within the business initially,” Winget said. “The value of sweat equity can become very valuable.”

Winget said she actively invests in small companies, often contributing to the operations in whatever capacity makes sense. “My capital investment is important to the business’s success, but so is my time and effort.”

Keep a sharp eye out for investment costs, too, and make sure those costs fit your budgets and expectations.

“Investment checks for early-stage investments for a small business can be as low as $5,000 (sometimes even lower), and small business investment, when successful, can deliver very high returns. But high returns come with high risk,” Jung said.

What to consider before investing in a small business

The good news is that anyone can invest in a small business, and there are various ways to do it.

“There are crowdfunding sites and local investor groups in your area that connect investors with small business owners,” Raskulinecz noted. “You can also invest with a retirement plan if you have the right custodian, and you can tap your financial advisor to see if they are aware of any opportunities.”

No matter which type of investment it is, small business investors should always do proper due diligence when making any investment.

“Some things to look at are the financials of an existing operating business or the projections if a startup, the business owners’ level of experience in the field, and doing some due diligence on the business owner if you’re unfamiliar with them,” Raskulinecz added.

Don’t stop there. Look for professional legal and accounting help, and keep on learning as you go.

“Make sure you hire a lawyer to draft/review the investment documents,” Jung advised. “You may be investing in someone you know, so it could be awkward to discuss the detailed terms, negotiate, and protect yourself. Someone may think you don’t trust them.”

That’s why letting a legal professional do the job for you is a good idea. “Once you get the hang of it you can leverage online platforms like Indiegogo and StartEngine to expand your reach and access a broader set of opportunities,” Jung added.

Questions to ask before investing in a small business

Like any investment that could cost money if not handled correctly, don’t steer any cash into a small business unless you get good answers to these three questions.

Is the business financially stable?

Profitability isn’t a requirement (in fact, a struggling business might offer a better deal), but it’s crucial to look for strong numbers.

“Assess whether there’s existing demand that is simply not succeeding due to a lack of efficiency,” Winget advised. “Consider if the business’s struggles are due to factors like location, management, or branding. You’ll also want to know how the company will sell its products and services.”

What’s the founder’s background and knowledge base?

You’ll also want to know about the people who founded the business and are leading it.

“The entrepreneur’s experience counts,” said Sundip Patel, co-founder and CEO at AVANA, a business investment services firm. “Investors will want the founder(s) to have led a successful business before or at least had a leading role at a successful small business.”

Often, grit and perseverance count more than having experience at a large company. “Reviewing a resume with big names does not necessarily translate to success for a small business,” Patel added.

What are your objectives in investing?

“You’ll need to know if the business contract terms match your goals,” Raskulinecz noted. Additionally, you’ll want to know if you’ll be OK financially if you lost your entire investment.”

Small business investors also expect significant returns on their investments, perhaps more than an entrepreneur may think.

One recent study noted the average return for angel investments (i.e., investors who often fund small business financing for a cut of the profit) is 2.6 times the initial investment. Those returns typically show up in about 3.5 years after the small business investment is made, which results in a 27% rate of return.

While some small business investors may be in for the long haul and others seek to cash out within a few years, small business funders should have specific investment return goals, a fixed investment timetable, and a buyout plan in place in the event the investors wishes to purchase the small business

Frequently Asked Questions (FAQs)

The primary benefit of investing in small businesses is getting in on the ground floor of a potentially lucrative investment opportunity. The biggest risk is losing money on your investment because either the business failed or didn’t meet financial expectations.

The fact is small companies may never grow to become big businesses due to myriad reasons, like lack of funds, poor management and/or an inability to keep abreast or ahead of the competition. It’s up to you to ask around and learn what those potential issues are before investing any money.

Start your small business investment journey by joining crowdfunding lists and investing small bits of money to gain some experience.

As Jung noted, there are a number of online platforms that specialize in small business investments, 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 businesses are banks and credit unions on the debt investment side and venture capital firms and angel investors on the private equity side.

Ask about the founder’s background and experience in the market where the business resides, which can be a major factor behind a small business’s success or failure. Also, don’t be afraid to ask about the business’s financials, including its current or projected revenue, debt and profit margins. Of course, you’ll also want to ask about costs, including the cost of rent, business equipment, marketing and payroll, and make sure to ask how your investment dollars will be spent..

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