Investors can diversify their portfolios and potentially achieve higher returns investing in small businesses. Purchasing equity stakes or lending money to the nation’s more than 30 million small enterprises provides an alternative to more conventional investments such as stocks, bonds and real estate. It can be hard to identify good opportunities. However, and federal regulations also limit the amount most investors can invest into small businesses. The practice involves significant risk of loss and lengthy commitments as well.
A financial advisor could help you create a financial plan to protect your investments and identify new opportunities to make money.
Small Business Investing Basics
There are more than 31.7 million U.S. businesses with fewer than 500 employees, according to the Small Business Administration. This group of enterprises, which represent more than 99.9% of all companies, has little or no ability to raise capital by selling equity on the stock market or issuing debt instruments for the bond market. Instead, they typically finance operations and growth with the help of bank loans and investments from the founders.
Just as small businesses are largely absent from the securities markets, investors are much less likely to put money into small firms than into large, publicly traded ones. However, small businesses can represent attractive opportunities to diversify out of conventional asset classes and sometimes gain outsized returns.
Small Business Investing Opportunities
To tap these opportunities, investors have to overcome sizable challenges. Those include:
- Identifying the relatively few small businesses that are suitable for investments,
- Accepting the likelihood of losing much or all their money due to the high inherent risks of the asset class,
- Waiting long periods up to several years to cash in without access to their invested funds and,
- Finally, working within federal regulations limiting the amounts they can invest.
Small business investments can take the form of equity or debt. Equity involves buying an ownership stake in the company in exchange for an infusion of capital, much like purchasing shares of a public company on the stock exchange. Debt investing is similar to giving the company a loan that will be paid back with interest. Variations include convertible debt securities that can be changed into shares of ownership, as well as equity investments that pay dividends.
Small businesses are not suitable investments for everyone, and this is not just an axiom but an official government rule. The Securities and Exchange Commission allows only accredited investors who meet certain wealth, income and knowledge guidelines unfettered use of Instead, crowdfunding portals, one of the most popular ways to invest in small business.
Non-accredited investors with annual income or network less than $107,000 can only invest up to $2,200 or 5% of their net worth in any 12-month period, according to the SEC rule. Those with over $107,000 in income and net worth can invest up to 10% of income or net worth, whichever is less.
How To Invest in Small Business
In contrast to the ease and simplicity of buying shares of mutual funds with holdings selected by financial analysts and fund managers, or even shares of individual public companies, small business investing is much more involved and unstructured. Information about small, private companies is harder to come by, and much of the job of evaluating opportunities has to be done by the individual investor.
Small business investors must first identify suitable opportunities among the millions of potential investments. Then they do their own due diligence, examining financial statements, interviewing company executives and evaluating market size and competitive challenges. Finally, they have to negotiate with the business about how to price equity shares, how much to charge for loans and other terms of the deal.
Small Business Crowdfunding
Over the last several years, in response to relaxed federal regulations, crowdfunding has become a popular way to invest in small businesses. Websites such as Mainvest and WEfunder accept applications from small businesses and vet them before offering them to investors.
Investors on crowdfunding sites can start with as little as $100. And they can receive regular financial updates much like quarterly and annual reports from public companies. The crowdfunding services also collect repayments from small businesses and distribute them to investors.
Pros and Cons of Small Business Investing
Risk is the major downside of small business investing. There is a high likelihood of losing the entire investment because most small businesses do not survive long-term.
On the upside, small businesses have much greater growth opportunities than those that are already relatively well established. Returns can reach 25% or more in some cases.
Another mark against small business investments is that they are highly illiquid. An investor who buys a stake in a small company may need to hold on to it for several years before getting an opportunity to cash out.
Investors in small businesses may find a special benefit that doesn’t come with investments in other asset classes. That is, the chance to make have an impact. Even a single investor’s backing can make the difference between a small company going out of business and surviving to become a major success.
Investors also may choose to back businesses that are owned by family and friends. Or choose products or services that they personally support.
Small business investing offers the chance to get higher returns and have a bigger impact than investments in other asset classes like stocks, bonds and real estate. However, the risks of losing the entire amount invested are high. With small firms, and it can take years for a small business investment to pay off. Crowdfunding sites can give an investor a chance to look at lots of small businesses that have already been vetted. But federal regulations limit how much most investors can commit to these opportunities.
- No matter how you want to invest your money, a financial advisor can help you make the right decisions. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Asset allocation is an important part of your investing plan. Figure out what your portfolio should look like based on your risk tolerance with our free asset allocation calculator.
Photo credit: ©iStock.com/pixdeluxe, ©iStock.com/svetikd, ©iStock.com/Davidovici