There are two initial options when deciding how to invest in a small business: by founding a business yourself, or buying into an existing one. We’re going to focus on buying into one, as founding your own is for a whole other blog post.
When it comes to deciding which business to invest in, there are a whole host of things to contemplate before you hand over the money. We’ve explored some key requirements to look into before you decide how to invest in a small business.
First of all, the shareholder agreement is crucial, as it’s the binding contract between you, the investor, and the business. It defines the rights of the shareholders, plus obligations and privileges, and how their money is protected.
Before you invest, you must believe in the CEO. The leadership of a small business is crucial for its success. The CEO will know the business inside out and back to front, and have the motivation and perseverance to drive it onwards. It’s worth doing reference and third-party background checks before you meet the CEO, and asking questions when you’re there.
Further, do you believe in the brand? Does the business offer a unique product, and how does it differentiate itself from other brands offering similar products? A strong brand builds engagement, brand awareness and trust, which ultimately lead to sales.
Sales from repeat customers allow the business to expand its customer base. Acquiring a new customer is expensive – think of the content, SEO, development, paid ads and social media that build a brand new sale. It pays to look after a loyal customer base, so you must ask how the business does this, and how much recurring revenue the business achieves.
The difference in percentage between revenue and production costs, gross margin allows the business to put money into marketing and distribution, which in turn will help make the business successful. A very small gross margin will leave little room for error, while higher margins are a safer and more logical investing option.
Once you’ve decided which small business you’d like to invest in, there are two types of investment to choose from:
An investor with an equity investment owns a stake in the business. You, the investor, will provide the business with capital, in exchange for a percentage of the profits and losses. These can be proportional to the amount you put in, i.e. if you fund one tenth of the business, expect 10% of the profits and losses, however, that’s not always the case. Equity investments generally provide the biggest gains, but they come with high risk – if expenses are higher than sales, or the company goes under, the losses come to the shareholders.
Essentially, a debt investment is a direct loan. The investor loans the business money, and in return receives interest income, and eventual repayment of the initial funds. Interest can be paid as cash, but usually it comes in the form of bonds. Returns are generally lower than equity investments, however, the risk is lower. When a company goes bust, debt investments have priority over stockholders.
Considering how to invest in a small business is complicated, but if you do your research right, it can lead to huge financial gains – just be prepared to take the risk!