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.
What Is Small Business Investing?
You can invest in a small business 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.
If you provide capital to a business in the form of a loan, it will be repaid over time, plus interest.
If you purchase shares, this ownership will entitle you to a portion of the business’s earnings over time. It also will allow you to benefit if the company expands, as your shares will gain worth over time.
How Does Investing in a Business Work?
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.
Debt vs. Equity Financing
Knowing how to invest in businesses begins with understanding the key differences between debt and equity financing.
In the case of debt investing, the business is borrowing for you, the investor. Rather than taking out a conventional bank loan, the company has opted to secure business funding from individual investors at a stated interest rate.
Alternatively, equity investments offer the investor an ownership stake in the company. 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.
Equity investments are a way of buying into a business through the acquisition of company stock. Purchasing an equity stake of a company entitles you to a portion of the revenue or assets that the business generates.
Major stock exchanges such as the Nasdaq and the New York Stock Exchange are marketplaces where common stock is bought and sold. This form of stock is the most popular equity instrument and usually is what people refer to when they say they are investing in stocks.
There are other ways to invest in stock other than through national exchanges, however. While exchanges can help you invest in large multinational companies, many investors find success investing in local businesses or new business ventures.
Equity investments often can make a lot of money for investors as stock prices rise over time. However, share prices can drop sharply, so these investments come with a degree of risk.
Unlike equity investments, investing in a business through debt financing doesn’t entitle you to a portion of the company’s profits over time. Instead, lending money to a business entitles you to regular payments with interest until the loan is paid back.
This is a lower-risk method of investing in a small business. Because debt instruments experience less volatility in the market, their value tends to be less erratic over time.
Bonds and mortgage investments are forms of debt instruments. These forms of investment are repaid at a predetermined interest rate. In the event of a company’s liquidation, bondholders are the first to receive a payout.
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 that 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 an opportunity, it’s important to meet with the leadership of the company. This is an excellent opportunity to see what they hope to accomplish and their intended uses for financing.
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. These people are your potential partners, and this is your chance to decide whether they’re the types of people you want to be in business with.
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 want to consider running background or credit checks on the company’s leadership or other owners.
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 financing to 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 financing 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.
The Best Businesses to Invest In
Here are some good businesses to invest in based on current forecasts.
With low overhead and relatively straightforward barriers to market entry, accounting firms present opportunities for growth for small business investors.
Whether you want to start your own accounting services company with licensed, qualified advisers and accountants or want to purchase stock of an established firm, this dynamic industry is poised for growth in the years ahead.
No matter where you live, everybody needs to consult an attorney from time to time. Legal services and small boutique law firms tend to carry a high, if not steady, demand. Law firms, with moderate overhead expenses, are solid opportunities for small business investments.
While the cost of human capital (i.e., paying lawyers, clerks, and paralegals) can be high, law firms generate high net profit margins on average. The most profitable law firms in major metropolitan areas can bring in margins as high as 50%.
The most profitable areas of legal services include:
- Intellectual property law (i.e., copyright, trademarks)
- Personal injury law
- Criminal law
- Employment law
- Trusts and estates
In today’s economy, skilled copywriters are earning more than ever. Thanks to their ability to work remotely, copywriters also have high-profit margins. From the convenience of their homes, coffee shops or libraries, copywriters produce eye-catching website copy, advertisements, newsletters, blog posts, and more.
With low barriers to entry and virtually no overhead costs, copywriting and web development present sound opportunities for keen small business investors. Keep in mind the success of an online copywriting agency depends on its ability to scale, which, in turn, requires a team of talented writers that can meet deadlines and keep up with demand.
With more dual-income households in the U.S., fewer homeowners are staying home to focus on domestic duties. Instead, these responsibilities are being placed on the shoulders of cleaning service workers who perform these routine tasks, often at a healthy markup.
Cleaning services are common, cheap franchise opportunities. Franchises represent particularly attractive opportunities for investors because franchisors already have put together a roadmap for success.
Doctor and Dental Offices
If you want to invest in companies that are all but guaranteed to generate reliably strong short- and long-term profits, consider investing in doctor or dental offices and clinics. As the population ages, demand for doctors and other health professionals will increase in the coming years.
While the labor expenses of the medical industry are high, they can be offset by the cost of medical services.
Mobile Catering and Party Services
The rise of the mobile economy has created new, in-demand jobs in recent years. With convenience being its main selling point, mobile beverage and catering companies can provide services at parties, weddings, and more at a high markup.
Although the startup costs associated with the drinks and food is high, the price tag more than compensates for the cost.
Small Businesses Investors Should Avoid
Knowing how to invest in business requires knowing where and when not to invest, too. As some industries are far less likely to generate a substantial profit, you must stay clear of investing in specific sectors.
Some of the worst industries to currently invest in include:
- Oil-and-gas extraction
- Beverage manufacturing
- Mining support services
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 constraints, 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 in 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.