What to Know Before Investing in a Small Business
With the country emerging from pandemic lockdowns and economic activity beginning to expand, small business owners are optimistic about the future. Supporting local businesses can help them grow and thrive in a post-pandemic economy. But what if you could help a business while also helping yourself?
Investing in a small business can be a great way to diversify your assets and keep your money in your local community. This potential win-win investment can position the business for success and position you for a nice payoff. Before you invest in any business, though, you should first learn as much as possible about it by engaging in a rigorous due diligence process.
Do not conduct due diligence alone. Instead, collaborate with an accountant and an attorney to cast a wide due diligence net and keep important details from slipping past your attention.
The Time Is Right: Small Businesses Look to Rebound
Last year was one of the worst in many decades for the US economy. Many small businesses designated “nonessential” were particularly hard-hit as they were forced to temporarily close their doors due to COVID-19 health orders. However, those that weathered the storm have a sunnier outlook for 2021 and beyond.
According to the Bank of America 2021 Small Business Owner Report, economic confidence and business revenue expectations have bounced back significantly since the fall of 2020.[1] More than half of business owners surveyed said they expect the local economy to improve and their revenue to increase over the next twelve months.
Not surprisingly, 68 percent of business owners said they tapped into a variety of funding sources during the pandemic to stay afloat, including federal assistance, loans, friends and family, and community investments. Looking ahead, about 20 percent say they will seek financing in 2021.
Ways to Invest in a Small Business
If a small business in your community is looking for investors, there are two main ways you can provide funding: debt financing and equity financing.
Debt financing, or lending money, is the simpler and generally less risky of the two options. The business borrows money from you (the investor) and repays you the loan principal, plus an agreed-upon interest rate. There is a risk that the company will become insolvent and leave you holding the bag, but in the event of a liquidation, you could still get your money back.
The other way to invest in a small business is to purchase a percentage of the company’s stock. Known as equity investing, this can be done by purchasing stock directly from the company or through crowdfunding. Your ownership stake in the company entitles you to a percentage of its generated revenues and dividends. While this benefits you if the business grows, its losses will also be your losses.
Performing Due Diligence
Due diligence means performing a thorough investigation of the small business you are interested in financing. It involves looking at key categories such as profits, losses, debts, legal liabilities, past performance, and future projections. When conducting due diligence, it is important to review the following items:
● Business and marketing plans
● Outstanding loans
● Market studies
● Balance sheets
● Bank statements
● Income statements
● Profit and loss statements
● Business expenses
● Ongoing and potential lawsuits
● Future financial projections
These are just a few of the items that should be on your due diligence checklist. You should hire legal and accounting professionals to assist with the process and create separate checklists for financial, legal, operational, human capital, and product and service matters. The entire due diligence process usually takes thirty to sixty days.
Meeting with the Principals
In addition to formal due diligence, it is advisable to meet with the business owner and company principals. These individuals, who could end up being your partners, are vital to the business’s success or failure—and by extension, the success or failure of your investment. Find out how much experience they have operating a business, managing personnel, interfacing with customers, etc. Beyond their business credentials, meeting with the principals face-to-face is a good way to determine whether you could work well together.
Know Yourself
It goes without saying that you should learn as much as possible about a business prior to becoming an investor. But a self-assessment is also important. You do not want to invest in an industry you know nothing about.
If you are a total outsider, you will lack the proper context for assessing critical business metrics. On the other hand, if you have previously worked in an industry—or better yet, are or were a business owner—your experience could allow you to spot strong opportunities. And if you do ultimately decide to invest, your experience will enable you to play a more active role in guiding the business—or even take it over entirely if you have a controlling interest.
Next Steps
If you are exploring local investment opportunities in your community, our team is here to assist you. Our experienced attorneys can help you perform due diligence and stay abreast of any other important legal aspects of your investment. Schedule a consultation today.
[1] Bank of America, 2021 Small Business Owner Report, https://newsroom.bankofamerica.com/content/dam/newsroom/docs/2021/2021%20SBOR%20FINAL%20ADA.pdf.