A Basic Guide to Investing in Small Businesses

The last thing you want to do is invest in a business you don't understand. Start by picking an industry that interests you and then assess that industry. Is it considered a high-risk sector? Could legislation be coming that could affect the businesses within it? This could affect a company's growth potential and, therefore, your money's growth potential.

Once you've settled on an industry, research small businesses of interest within it. Hone your list to perhaps ten to 20 companies that you can really investigate thoroughly – Both the equity investment in small business companies themselves and the investment opportunities within them. Review each company's profit and loss statements, a list of their overhead, as well as their business and marketing plans. Check their recent balance sheets and bank statements to get a clear picture of each company's cash. It also helps to run credit and background checks on the company's leadership.

When finding investment opportunities, look to see if the company is currently seeking financing. Not all companies in need of financing want an investor, but this is typically a good place to start. If you approach a company that's interested in taking on an investor, ask them how they plan to use the money. The more detail they can provide, the better equity investment in small businesses. You always want to know where your money is going.

Business owners are an essential factor to consider in small business investing. Reading about the business owner is different from talking to them directly.

Whichever business(es) you want to pursue, you'll need to assess whether the owner(s) and leadership team can effectively execute their ideas. Ask questions! Do they have previous experience in running other businesses, and if so, what was the outcome of that experience? Do they seem adept at forging business relationships and managing staff members? What do they consider to be the biggest risks associated with running this business? How do they mitigate those risks to deliver results?

Speaking with owners directly also helps you to assess passion. As an investor, you want to work with business owners fully committed to the business. When they talk about their company, are they oozing with enthusiasm? Are they filled with ideas for the future? How much have they invested in ways to invest in small business businesses?

The more you know about the customers a business serves, the better you'll understand the business itself. Talk to the customers who use the company's products/services. Understand what they like about the product/service and its effectiveness in solving a problem.

When speaking to these customers, pay attention to which of the following three categories they belong to:

• Promoters are loyal customers who can help grow the business and who will recommend the products/services to others.

• Passives – indifferent customers who are easily swayed by competing brands.

• Detractors – customers who are unhappy with your products/services.

It's important to identify the company's promoters, passives, and detractors because they directly influence the growth of the business you're considering investing in. Think of the promoters as a sales channel. Studies show that referrals from loyal customers have a 37% higher customer retention rate. These brand loyalists also spend 200% more than the average consumer.

The more promoters the business has, the higher its potential value. Detractors, on the other hand, can impede potential sales. Consumers are more likely to share negative experiences and feedback than positive ones, and this could influence the buying decisions of potential new customers.

You've researched and selected the company you want to invest money in small business. Now what?

It's important to fully understand the company's value and your deal structure. The deal structure refers to what the company plans to offer you in exchange for your investment. How do these things compare to those of the company's competitors?

Assess the business's value by comparing it to similar or competing companies and consider the following factors: revenue, growth rate, capital structure, risk profile, and net income. It's also important to remember that good companies don't necessarily make good investments, especially if the business' value is too high.

At this point, you should have at least spoken to the company's owner(s) as part of your evaluation, but now it's time to meet with them and discuss the investment opportunity specifically. This is where you should learn about and assess their intended uses for your funding. Transparency is key. Remember, if you move forward with the investment, these people will become your partners. It's important you feel secure that they're the types of people you want to work with.

You'll need to show a sample financing agreement or a term sheet where you outline the details of your investment and how much you're willing to offer. Review these documents with company principals, and after you agree on the broad points, you can work to finalize the investment terms.

Once you've reached an agreement with the business's leadership, the last step is to close the deal to finalize your small business investment. This is the part where you sign contracts and give them the capital you agreed to offer. In return, you'll receive a signed agreement that outlines the terms of the loan or company shares.