11 Things to Consider Before Investing in a Small Business

In this text, you’ll study 11 issues to contemplate earlier than investing in a small enterprise.

The determination to make investments (or not make investments) in a small enterprise can have a huge affect in your funds – so it shouldn’t be made flippantly. Before you make this determination, it’s best to do a complete evaluation of the dangers and rewards, counting on quantitative and qualitative evaluation.

Here are 11 issues to contemplate earlier than investing in a small enterprise.

1. Business Plan

A marketing strategy tells you about a company’s services and products, advertising technique, monetary planning, and finances. If you’re contemplating investing in a new enterprise thought, the marketing strategy goes to be a large issue in your determination, as there isn’t any historical past of efficiency. But it’s additionally essential to fastidiously scrutinize the marketing strategy of a longtime enterprise – the doc provides you an thought of the founder’s long-term objectives.

A very good marketing strategy offers you with sufficient data to decide the long-term viability of the corporate. A poor marketing strategy, however, leaves you with extra questions than solutions.

2. Financial Statements

A marketing strategy has the potential to inaccurately painting a small enterprise. But monetary statements present a extra goal portrayal of a small enterprise. You ought to ask to see the final three years of monetary statements, together with tax returns, stability sheets, money move statements, and earnings statements.

By analyzing three years of information, you get a sense of the long-term tendencies. For instance, you have got two companies – Business A and Business B. Business A recorded $200,000 in income over the past yr, and has grown income at a CAGR of 20% over the past three years. Business B additionally had $200,000 in income in the final year… however noticed flat income over the identical time period. This means, different issues being equal, Business A ought to be assigned a larger valuation.

The money move statements, in explicit, deserve a lot of consideration. While enterprise capitalists may be extraordinarily affected person with their investments, you in all probability count on to be cash-flow optimistic in the early levels – if not from Day 1. So, it’s best to ensure that the money move is trending in the correct course.

And here’s one other means to derive worth from monetary statements: calculating ratios. There are a number of ratios – such because the price-earnings ratio, debt-equity ratio, and dealing capital ratio – that provide you with deeper perception into the monetary well being of a enterprise.

This monetary evaluation could seem overwhelming, however the excellent news is that you could get assist from a Certified Public Accountant (CPA) in case you don’t have the time or experience to do it your self – a CPA, opposite to widespread perception, will help you past tax season.

3. Financial Projections

A company’s e-book worth is its complete property minus complete liabilities. This quantity may be simply calculated by trying on the stability sheet. For instance, property complete $100,000 and liabilities complete $30,000. The e-book worth is $70,000. This quantity impacts the sum of money you’d pay to make investments in the enterprise. An organization with no marketing strategy and no earnings – and a e-book worth of $70,000 – continues to be value not less than $70,000.

So, e-book worth acts as a beginning quantity for a company’s valuation. The different factor that impacts a company’s valuation – and is tougher to decide – is monetary projections. The discounted cash flow (DCF) model is usually used to attain the current worth of a company’s future money flows. Here’s a fast overview of the way it works: you estimate the company’s money flows over the subsequent a number of years, and alter them to a current worth primarily based on the time value of money.

A DCF mannequin is nice in idea, however the issue is that it’s unattainable to estimate money flows for the subsequent quarter – not to mention 5 years into the longer term. So, the discounted money move ought to be used as one among a few instruments in reaching a valuation – price-to-earnings ratio, price-to-sales ratio, and trade comparisons are others.

When making projections, it’s essential to contemplate a company’s market share and the expansion fee of the trade.

As a potential purchaser, you may want the market share to be decrease, not larger, as the corporate goes to be valued primarily based on its money flows. Say you’re eager about investing in a firm with a 2% market share and a nice product – however the firm isn’t doing a lot advertising. There’s going to be a excessive upside in your funding in this case.

The development fee is extra easy. You need the pie to be rising, not shrinking.

4. Management Team

Depending on whether or not or not you have got a controlling stake, you’ll have the flexibility to make adjustments to the small business’s administration workforce – however in sure circumstances, no motion is one of the best motion.

Here are a few issues to contemplate:

• Is the corporate underperforming or outperforming expectations?
• Has the administration workforce made good or unhealthy selections in the previous? While hindsight is 20-20, you’ll be able to look again and objectively consider the decision-making of the administration workforce, primarily based on what they knew on the time.
• Are they being paid pretty? Say you have got a nice administration workforce in place… however you suppose they’re getting paid triple the market fee. In this state of affairs, you may want to re-negotiate salaries or deliver in new members.

What if you’re investing in a very small enterprise and the Founder/CEO – who’s exiting the enterprise – is the one C-level government? In this case, you have got to decide whether or not or not it’s best to tackle the position – this will depend on whether or not you have got the required time and experience. If you need the funding to be fully passive, you’d have to exit and discover a new CEO – which isn’t a simple activity.

5. Efficiency

“Fix it twice” is a frequent saying amongst profitable entrepreneurs. Here’s an instance that describes this idea: a number of folks name your customer support division every week with the identical query. The workers have to spend a complete of three hours answering the query. To repair it twice, you’d have to reply the purchasers who’re calling you and put the query and reply in the FAQ part in your web site.

Before investing in a small enterprise, you need to ensure that it has wonderful processes and programs in place. Here are a few questions to ask:

• Are there customary working procedures (SOPs) to practice new workers?
• Does the enterprise use a buyer relationship administration (CRM) system, accounting software program, and different kinds of software program vital for clean operations? Is the software program built-in?
• Does the enterprise use KPIs to consider its efficiency?

You ought to ask extra questions primarily based on the specifics of the enterprise, however these are a few to get you began.

6. Margin of Safety

So, you’ve evaluated a small enterprise, its marketing strategy, monetary statements, monetary projections, administration workforce, and efficiencies. You got here up with a valuation for the small enterprise – let’s say it’s $500,000. Does this imply it’s best to make a proposal that values the enterprise at $500,000? Not essentially. By providing what you suppose the enterprise is value, you don’t give your self a margin of safety, in case issues don’t go as anticipated.

Warren Buffett popularized the concept of a margin of security, and it has allowed him to grow to be one of the vital profitable traders in historical past. He often applies a margin of security to his investments in publicly traded firms, however you are able to do the identical for a small enterprise.

Let’s return to that small enterprise you suppose is value $500,000. If your provide values the corporate at $400,000, you’ll have a built-in cushion for some surprising losses.

7. Opportunity Cost

It may appear to be a tremendous deal to get a $500,000 firm at a $400,000 valuation, however it’s potential that you just shouldn’t make investments in the enterprise. Before you cease studying, contemplate this: what if there may be one other $500,000 firm that could possibly be had for $300,000… and also you solely have sufficient money and time to make investments in one among them. In that case, it’s best to go along with the latter enterprise.

The alternatives which might be foregone to make investments in a firm are the chance value. With that in thoughts, it’s best to consider a number of companies in the marketplace earlier than investing in a small enterprise.

8. Downside Risk

When you’re eager about investing in a enterprise, it’s simpler to solely contemplate the upside, however you shouldn’t overlook the draw back danger. Here’s an essential query: how would your private funds be affected if the funding doesn’t work out? It’s cliché, however solely make investments what you’ll be able to afford to lose. This implies that if an funding represents a excessive proportion of your web value, you may want to give it a second thought.

In addition, it’s best to have a plan for the worst. If the enterprise goes south, would you search extra funding from potential traders? Or presumably make investments extra of your individual cash? By eager about these prospects forward of time, you set your self up to make the correct selections in strain conditions.

9. Long-Term Outcome

Are you sure that you really want to keep invested in the small enterprise without end? The reply might be no. This implies that it’s best to give you an exit technique.

Let’s say you need to promote your stake in the enterprise in 3-5 years. In this case, it’s best to mission how a lot the enterprise goes to be value in that time period and establish potential traders.

What in case you aren’t certain about your long-term plans? There’s nothing flawed with a little uncertainty, however which means that it’s best to take the time to give you a few exit methods. If you’re comfy with every risk, there’s a higher probability that you’ll finally be completely happy along with your small enterprise funding.

10. Investment Portfolio

Before investing in a small enterprise, contemplate how it will match in your funding portfolio. In actual property, it’s “location, location, location.” With investing, it’s “diversification, diversification, diversification.”

Ideally, you’d personal firms in a number of industries, in order that a downturn in one trade isn’t catastrophic in your private funds. A great way to get diversification at a low worth is thru mutual funds.

11. Financing Options

There are a number of methods to finance the acquisition of a small enterprise, with angel traders, enterprise capitalists, crowdfunding, small enterprise lenders, and your individual cash all being choices. But it boils down to two classes: fairness and debt financing.

The benefit of fairness financing is that you just don’t have to make month-to-month funds out of your money move. But in return, you don’t get the entire upside if the funding is profitable.

With debt financing, you have got to make curiosity funds each month, but when the worth of the corporate skyrockets in the longer term, you don’t have to share the upside.

There’s no proper or flawed financing possibility – it will depend on your circumstances.

The Bottom Line

A small enterprise funding ought to be primarily based on a number of components, as there’s no single means to precisely assess funding alternatives. While it’s going to take a very long time to attain an funding determination, that point goes to be effectively value it over the long term. Say you spend 50 further hours evaluating funding alternatives and you discover $50,000 in extra long-term worth – you’ll basically get $1,000 an hour in your time. You won’t give you the chance to assign precise numbers, however the level is that your due diligence is probably going to be rewarded for the reason that stakes are so excessive.

Want to use debt financing to finance your funding? Consider utilizing Biz2Credit.

We’ve helped a number of small enterprise house owners make enterprise acquisitions, together with Dharmendra Patel. Patel saved cash in a 401K for his first enterprise acquisition, finally funding the funding by means of a mixture of his financial savings and a vendor observe. But he turned to Biz2Credit for subsequent acquisitions, and we have been in a position to shortly facilitate an SBA mortgage for the rest of the funds required.