By many economic indicators, it looks like a good time for small businesses to flourish: Gross domestic product is expected to grow 3.1 percent by the end of this quarter with business capital spending up about 5 percent, according to the Conference Board, an independent research organization.
It may be a good time to reap the benefits of small-business growth and opportunity as a private investor, too. But only if you know what you’re doing.
Investing directly in a small private business can deliver a much better return than a traditional mutual fund or index fund, but your potential for losses is greater, too. Unlike funds, which historically lose up to 60 percent during bad years, these smaller business can lose 100 percent, and they do regularly, says Matthew J. Ure, an investment advisor representative and president of Anthony Capital’s San Antonio, Texas, office.
About a third of businesses with employees don’t survive after two years while half don’t survive five years, according to the Bureau of Labor Statistics. And contrary to popular belief, economic conditions have little to do with a business’s chances of survival.
“Investors often see exciting local businesses as the key to wealth, or at least a shortcut. Too often, these investors learn hard lessons that take years to recover their losses,” says Matt Ahrens, a financial advisor with Integrity Advisory in Overland Park, Kansas.
If you want to invest in a small business, experts suggest doing the following first.
Only invest what you can afford to lose. Even if the business is successful, you probably won’t see a return on your money for at least three years.
Investors in local, small enterprises should be accredited by the Securities and Exchange Commission based on their net worth and income requirements, says Nicholas Stuller, author of “The Truth Shall Set Your Wallet Free: The Secrets to Finding Everyone’s Perfect Financial Advisor.” If you’re not accredited, limit your investment in the business to just 5 percent of your available capital so you won’t lose your entire savings if things go south, he says.
Negotiate a controllable interest if possible. “Small business investing is tricky and is something I only recommend for people that are or were business owners themselves since they understand the struggles of growing and maintaining a growing company,” says Taylor J. Kovar, CEO of Kovar Capital in Lufkin, Texas.
Investing in the kind of businesses you have experience with is an even better advantage because you can offer actionable guidance and advice to the owners.
“Don’t let the shiny promises lure you into investing in an industry that you know nothing about,” Ure says. “It will be very hard to know what metrics should be used and what they mean if you are totally an outsider. Experience in the industry could give you the potential to see diamonds in the rough.”
Plus, if you own a controllable interest in a business you know, you have the power to take over if it eventually needs a lifeline. Kovar requires a 51 percent ownership stake in most of his investment businesses until his funds have been returned along with a bonus.
Research, research, research. Only invest in businesses that you understand thoroughly. Ask to see profit and loss statements, an examination of the business’s overhead, and business and marketing plans, says Mark Nicholson, marketing director of Absolute Results in Surrey, British Columbia.
Request to see audited accounting books from previous years because balance sheets and bank statements will give you the most accurate picture of the company’s cash flow, Ahrens says. Review the sector or industry the business is in. Is it a volatile sector, and is there legislation coming that could affect the business? You’ll also want to see how easy it will be for the business to grow so that your money can grow too, Nicholson says.
If a business is requesting capital, make sure it has a well thought-out plan for the money, says Ahrens. Is it going to require more capital later on to sustain operations and growth, and would you be responsible for providing it?
“Find out how long they expect the capital to last and how many investors they’re looking for. A small company with many small investors can be inefficient and costly for the business due to reporting and a fiduciary requirement toward minority owners,” says Ahrens.
Interview the owners. The business operator is the most important factor for investors examining an opportunity, Stuller says. Kovar suggests asking business owners how much experience they have running a business, managing employees and interacting with customers.
Find out how much of the owner’s own money is invested in the business. “An investor should want to work with an entrepreneur who loses along with him, if the business goes south. If the owner is simply using other peoples’ money, he doesn’t have the same drive to succeed,” says Scott M. Freund, president of Family Office Research in Bethesda, Maryland.
Consider performing a background check on key personnel, and if they refuse, run from the deal, Freund says.
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