Small business owners are an integral part of the American economy, generating millions of jobs and providing identity to the communities they serve. Small businesses have generated a net 12.9 million new jobs over the past 25 years, accounting for two-thirds of the jobs added to the economy, according to the U.S. Small Business Administration. By promoting entrepreneurship and innovation, small businesses keep local economies healthy and vibrant.
Despite these benefits, many small businesses often lack financing to maintain and expand their operations and rely on local investors to obtain the capital they need to grow. Investing in small businesses offers potential returns, diversification, and an opportunity to participate in the success of the U.S. economy.
This handy guide explores how retail investors can strengthen their portfolios by investing in local businesses.
Small businesses invest in numbers
- According to the U.S. Small Business Administration, small businesses have been responsible for 66 percent of employment growth over the past 25 years.
- A study by the 3/50 Project, an advocacy group, shows that for every $100 a customer spends at an independent store, $68 returns to the community through taxes, payroll and other expenses. By comparison, if you spend $100 at a national chain, only $43 stays in the community.
- According to the U.S. Chamber of Commerce, there are 32.5 million small businesses in the U.S., accounting for 99.9 percent of all businesses.
- According to Dataman Group, small businesses employ about half of the U.S. private sector workforce.
- A 2020 Union Bank survey found that 72 percent of Americans said supporting a small business was more important than getting the best deal elsewhere, with many respondents willing to spend $20 more for an article in a independent store.
- Nonprofit organization SCORE found that 91 percent of Americans shop at local stores at least once a week, while 47 percent visit a local store two to four times a week.
Ways to invest in a small business
Whether you are considering financing a new business or taking ownership of an existing business, there are generally two main options:
- Equity investments This involves offering money in exchange for a share of the company. This approach puts you in ownership of the business, sharing the profits or losses and possibly even participating in business decisions.
- Debt investments are loans made to small business owners in exchange for interest payments over a predetermined period of time. By agreeing to pay back the total balance plus interest, business owners retain full ownership of the business.
While each deal is unique and may include a combination of equity and debt, these two principles form the basis of most transactions. But like any other investment, each option has pros and cons.
Stock investments
| Positives | Disadvantages |
|---|---|
| Potential for high returns | May lose entire investment if business fails |
| May be involved in business strategy | Paid last in case of bankruptcy |
| Can receive dividend payments | High risk |
Debt investments
| Plus points | Disadvantages |
|---|---|
| Lower risk than shares | Limited benefit when business is going well |
| Predetermined interest rate | Limited ability to influence strategy |
| Can fully or partially recoup investments if the company fails | The return may not exceed inflation |
Aside from the motivation to make one’s dreams come true, many investors choose small business investments to generate passive income and diversify their assets beyond the stock market and real estate holdings. Owners can also allow investors to become involved in a company’s strategy while potentially adding value to the local community.
Who can invest in small businesses?
For a long time, investing in small businesses was reserved for accredited investors or individuals with a net worth of at least $1,000,000 (excluding their primary residence), an annual income of more than $200,000 for each of the past two years and the expectation that they will do so. continue, or those who have certain investment permits. Depending on the deal, federal regulations prohibited private investors from accessing what officials considered high-risk investments.
However, the Jumpstart Our Business Startups Act (or JOBS Act) of 2012 lifted some restrictions, allowing retail investors over the age of 18 to invest in crowdfunding platforms such as Mainvest or Honeycomb Credit. Both startups research small business owners and provide access to credit.
Nevertheless, due to regulations, most investors can only invest up to $2,500 or 5 percent of their annual income over a twelve-month period if their annual salary or net worth is less than $124,000. For people with a higher income, the limit rises to 10 percent of their annual salary or assets, whichever is higher. There are no investment restrictions for accredited investors.
The Securities and Exchange Commission periodically adjusts these limits based on inflation.
Financing options for small businesses
Small businesses have several options when it comes to financing their business. These include: crowdfunding, friends and family, small business loans, grants, bootstrapping, angel investors, and venture capital.
Questions to ask before investing in a small business
Because small businesses are more sensitive to economic shifts, overhead costs, changes in supply and demand, and other conditions, investors should exercise due care when selecting a potential investment. One benefit of investing through crowdfunding platforms is that these companies do much of the prep work upfront, such as reviewing tax returns, credit scores, and other essential documents.
Before making any investment decisions, here are some questions you may want to consider:
- What is the business plan and strategy?
- What is the current state and future potential for that sector?
- What does the competitive landscape look like and what are the main barriers to entry?
- How much money does the company need to raise?
- How much equity, debt and obligations does the company have?
- When can you expect a return on your investment?
Of course, there are plenty of other considerations, including non-tangible ones. For example, what is the story of a small business owner and what value does the business bring to the community? For many investors, small business investing transcends monetary factors, but be careful not to fall in love with the story and forget that you are making a financial investment. Emotional behavior is not a good idea when it comes to investing.
Risks of Investing in Small Businesses
All investments involve varying levels of risk, and small businesses are no different. Aside from the fact that you may lose your entire investment, these deals are inherently risky, especially since many entrepreneurs don’t qualify for financing from traditional banks. That’s why many financial professionals recommend only investing what you can afford to lose.
Target returns can range from 10 percent to 25 percent to compensate investors for that risk, according to crowdfunding platform Mainvest.
According to the Small Business Administration, about half of small businesses will fail within five years, making small businesses some of the riskiest investments you can make. Many small businesses start in industries with low barriers to entry, such as retail or restaurant industries. This creates a highly competitive environment where profit margins can be low and customer preferences change frequently.
Additional resources for small businesses
If you have more questions about small business investing or would like to develop an overall investment strategy, consider finding a financial advisor to discuss your personal financial situation with. Below are additional resources to help you invest in small businesses.
- 5 things you need to know before investing in start-up companies
- Best investments for beginners
- Crowdfunding for companies: the basics
- Putting personal money into a business
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
