Small businesses are the backbone of the U.S. economy, creating millions of new jobs for the public. According to the U.S. Small Business Administration, small businesses have generated over 12.9 million new jobs over the past 25 years. This is more than two-thirds of the jobs added to the economy.
However, small businesses often face issues with funding as they only rely on local investors for capital. But what if we tell you, there is a way to invest in small businesses? Moreover, investing in small businesses offers potential high returns and diversification.
In this blog, we will discuss how to invest in a local business along with its pros and cons. Let’s get started.
What is Small Business Investing?
Investing in a local or small business involves contributing money to a small business with either debt or equity or a combination of both.
The objective of investing is to earn returns through profits from business or repayment of principal and interest on the loan.
What are the Ways to Invest in a Small Business?
Typically, there are two major ways to invest in a small business- equity investment and debt investment. There are also additional non-conventional ways to invest in the form of sweary equity investment and equity-debt hybrid investment.
Let’s break them down for better understanding.
Equity Investment
An equity investment involves buying the shares of a business in exchange for money. This means you effectively own a portion of the business, giving you the right to a percentage of profits and a say in business decisions.
It is one of the most popular ways to invest in a business and also the riskiest. This is because if the business plummets, the value of your shares will decrease too. However, if the business booms, the value of your share also grows over time, allowing you to enjoy higher returns.
Pros and Cons of Equity Investment
| Pros | Cons |
| Potential for high returns | Can incur heavy losses if business fails |
| A say in business decisions | Investors are the last to get paid if the business declares bankruptcy |
| Receive dividend payments | Very risky venture. |
Debt Investment
A debt investment is when you offer capital to a business in the form of a loan with the expectation of getting paid back in full with interest. By agreeing to pay back the principal amount along with the interest, business owners retain full ownership and control of their business.
And the best part is, if the business fails, debt has priority over equity investors. In other words, the company will clear its debt obligations before repaying its investors.
Pros and Cons of Debt Investment
| Pros | Cons |
| Relatively less riskier than equity investing | Limited earnings if the business grows |
| Predetermined Interest Rates | No say in business decisions or strategies |
| Debtors have priority over investors | The return may fail to outperform inflation |
Sweaty Equity Investment
Sweaty equity is a type of contribution that isn’t monetary but in the form of physical or mental labour. This is especially useful for individuals who don’t have a large amount of money but have the skillset required to grow a business.
Sweaty equity is the unpaid work and time that you invest in a small business in exchange for future profits.
Equity-Debt Hybrid Investment
If neither equity nor debt financing is worth your time, you can get the best of both worlds by an equity-debt hybrid investment. Small businesses sometimes combine elements of equity and debt financing and sell shares known as preferred stocks.
This solution offers nonvoting rights, higher dividend yields than bonds, and the ability to convert your shares to common stock. Moreover, if the business files for bankruptcy, the small business will pay its preferred stockholders before equity investors.
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Who Can Invest in a Small Business?
Investing in a small business can help a business owner grow their business. Meanwhile, you can benefit from potential profits and diversification of your portfolio. Here are some steps that will help you seek out the best small business investments for you.
Find the Best Deals
Before you can invest in a local business, you must seek out and find the best deals that have high potential. Not every small business is looking for an investor. Here is how you can find businesses looking for funding-
- Find business owners in your network
- Scout social media for potential business opportunities
- Go to your local Small Business Administration office
- Connect with your past colleagues or college alumni.
- Join your local Chamber of Commerce to connect with business owners
It is important to conduct your due diligence and put significant time and effort before going forward with a business investment opportunity.
Understand Business Funding
Before investing, it is important to understand the various ways a business is funded. The most common ways to fund a business are-
- Equity Investing
- Debt Investing
- Angel Investors
- Venture Capitalists
- Equity lines of credit
- Business Credit Card
- Second mortgages
- SBA Loans
Additionally, if a business is already running, you have to evaluate how the business is currently funded and the company’s status regarding
- Default Status
- Current Debt
- Assets & Liabilities
- Liquid & Illiquid Assets
Evaluate the Business Plan
Before investing in any local business, make sure to properly evaluate their business plan to determine their growth potential. It is important to be completely certain that a business has a clear goal and a proper roadmap to achieve those goals.
Investing in a business with no clear objectives and a subpar business plan will only result in losses.
Negotiate Terms
If you have found a business worth investing in, you may want to negotiate the terms of the agreement before signing the contract. If you are planning to fund business through equity, you should negotiate-
- How much you will contribute?
- Your ownership percentage
- Your percentage of profits
On the other hand, debt financing involves negotiating-
- The loan amount
- The tenure of the loan
- The interest rate of the loan
Consult a lawyer or financial advisor to draw up the documents for you.
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Identify Your Exit Strategy
Investing in a small business also involves having a clear idea about your exit strategy. When investing in a local business, make sure to ask these questions-
- Will I be an employee?
- How will I get my money out?
- Will I receive quarterly or annual dividends?
Make sure to have a thorough conversation about tax implications with your accountant before investing.
Invest in the Local Business
After you have sorted all the intricacies and have reached a mutual agreement with the business owner, it is time to close the deal. You will sign the paperwork and pay the capital or loan according to your type of financing.
Make sure to keep copies of all the documents that you have signed, including bylaws, minutes, shareholder agreements, and articles of incorporation.
Meanwhile, if you are investing in an LLC or partnership, the important documents include filings with the IRS, filings with the secretary of state, and agreements establishing the entity.
Drawbacks of Investing in a Local Business
All investments carry a certain amount of risk and small businesses are no exception. In fact, investing in a small business is more on the riskier side as you stand to lose your entire investment.
According to the Small Business Administration(SBA), about half of small businesses fail within five years. This is one of the riskiest investments that you can make as most small businesses start in retail or culinary industries which have very low barriers to entry.
This coupled with the competitive market where profit margins are low and customer preferences change every week makes running and growing a small business a herculean task.
Final Words
Investing in a local business comes with its fair share of pros and cons. It is a very lucrative investment opportunity with potentially high returns. On the other hand, about half of the small businesses shut down within five years of their inception.
However, investors can bypass these risks by researching the market and seeking out the best investment opportunities in high-growth potential industries that are bound to succeed. Overall, investing in a business is a high-risk, high-reward strategy.
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Frequently Asked Questions(FAQs)
Ans. You can start investing in small businesses by seeking out potential investment opportunities. This can be done by joining crowdfunding lists and investing small bits of money before you fund a large company.
Ans. The benefit of investing in local businesses is that it is a lucrative investment opportunity and can yield high returns if the business takes off. On the other hand, the biggest risk is losing your entire investment because the business failed.
