Small businesses have been called the backbone of the American economy. As such, they need all the help they can get. Investing in a small business is a way investors can not only grow their portfolio but help local business owners on their journey to financial independence. It's a way to create, nurture, and grow an asset that can generate more than capital for an investor.
Instead of looking for financing methods that include investors, many owners choose to invest everything into their own restaurant or dry cleaning business. Investors offer small business owners different methods of financing that can reduce the stress on their personal assets. At the same time, investing in small businesses gives them a chance for growth, which can create local goodwill, jobs, and hopefully longevity.
Investing in Small Businesses
In years past, sole proprietorships or general partnerships were more popular, even though they provide no protection for the owners' personal assets because owners are all in. Many do not even know of different methods of financing available, besides business loans.
Today, small business investments are often structured as either a limited liability company or a limited partnership, with the former being the most popular structure because it combines many of the best attributes of corporations and partnerships. These structures also protect personal assets.
Whether you are considering investing in a small business by founding one from scratch or buying into an existing small company, there are typically only two types of positions you can take—equity (exchanging money for ownership and profits) or debt (lending money). Though there may be countless variations, all investment types lead back to these two foundations.
Equity Investments in Small Businesses
When you make an equity investment in a small business, you are buying an ownership stake, or a "piece of the pie." Equity investors provide capital, almost always in the form of cash, in exchange for a percentage of the profits (or losses).
The business can use this invested cash for a variety of actions—capital expenditures needed for expansion, cash for running daily operations, reducing debt, or hiring new employees.
In some cases, the percentage of the business the investor receives is proportional to the total capital he or she provides. For example, if you invest $100,000 in cash and other investors put in $900,000, you might expect 10% of any profits or losses because you provided 1/10th of the equity.
In other cases, the percentage of ownership and dividends can differ. Consider the investment partnerships Warren Buffett ran in his 20s and 30s.
He had limited partners contribute nearly all of the capital for his partnerships, but profits were split 75/25 to limited partners, (he received 25%) in proportion to their overall share of the capital, despite having put up very little of his own money. The limited partners were fine with this arrangement because Buffett was providing the expertise.
An equity investment in a small business can result in the biggest gains, but it comes hand-in-hand with the most risk.
If expenses run higher than sales, part of the losses get assigned to investors. If it turned into a bad quarter or year, the company might fail or go bankrupt. However, if things go well, returns can be generous.
Debt Investments in Small Businesses
When you make a debt investment in a small business, you loan it money in exchange for the promise of interest income and eventual repayment of the principal.
Debt capital is most often provided either in the form of direct loans with regular amortization (reduction of interest first, then principal) or the purchase of bonds issued by the business, which provide semi-annual interest payments mailed to the bondholder.
The biggest advantage of debt is that it has a privileged place in the capitalization structure. That means if the company goes bust, the debt has priority over the stockholders (the equity investors). Generally speaking, the highest level of debt is a first mortgage secured bond that has a lien on a specific piece of valuable property or an asset, such as a plant or factory.
A first mortgage secured bond requires property, such as real estate, as collateral.
For example, if you loan money to an ice cream shop and are given a lien on the real estate and building, you can foreclose upon it in the event the company implodes. It may take time, effort, and money, but you should be able to recover whatever net proceeds you can get from the sale of the underlying property that you confiscate.
The lowest level of debt is known as a debenture, which is a debt not secured by any specific asset but, rather, by the company's good name and credit. This is generally a bond, issued as a loan without collateral with fixed payments and interest.
Which Is Better: Equity Investment or Debt Investment?
As with many things in life and business, there is no simple answer to this question. If you had been an early investor in McDonald's and purchased equity, you'd be rich. If you had bought bonds (a debt investment), you would have earned a decent return on your money. On the other hand, if you buy into a business that fails, your best chance to escape unscathed is to own the debt, not the equity.
All of this is further complicated by an observation that famed value investor Benjamin Graham made in his seminal work, "Security Analysis." Namely, that equity in a business that is debt-free cannot pose any greater risk than a debt investment in the same firm because the person would be first in line in the capitalization structure in both cases.
The Preferred Equity Debt Hybrid
Sometimes, small business investments straddle the ground between equity investments and debt investments, modeling preferred stock. Far from offering the best of both worlds, preferred stocks (priority stocks, first in line for fixed dividends over common stock) seem to combine the worst features of both equity and debt—namely, the limited upside potential of debt, with the lower capitalization rank of equity.
In the end, the investment type you should choose comes down to your level of comfort with the risks of debt or equity, and your investing philosophies.