Introduction
Investing in small business stocks is merely an extension of buying a small piece of a business run by someone else and enjoying your share of the profits. Sometimes, small businesses are considered wonderful gifts that can lead to financial independence and a much higher standard of living than average. Investment opportunities in small businesses and startups often come in the form of stocks with low value, which exposes the investor to higher risks.
Who Invests in Small Business Stocks
For the right person, with the right skills, temperament, and profile, investing in small businesses can be a profitable opportunity. Typically, there are only three mechanisms through which you can generate profit in net worth from a private company. It is important to know these three mechanisms for wealth generation because new investors can sometimes be too quick to engage in potential investment opportunities without having clear ideas about how the economic engine drives the financial benefits they seek.
The Salary You Pay Yourself
For many small business investors, the company may generate just enough for them and their families to live off the salaries taken from the company in exchange for work at the payrolls. While this can be considered a success, the small company isn’t really an investment at this stage. Instead, the founders may have created a job for themselves, which includes the benefits and drawbacks related to self-employment.
Dividends
When investing in small businesses becomes successful, there is profit left over for the business owners – above and beyond the amount withdrawn in salaries and wages. Business owners can then decide to reinvest the profits for future expansion, or they can declare a dividend. In the case of the company, the distribution is a payout to shareholders. This payment takes the form of a draw for an LLC or limited partnership. The small business owner may use the money in their personal life, often to build savings and acquire other investments – such as stocks and bonds or real estate – and to pay off debts.
Concentrated Profits from Selling the Company
Once the company grows beyond a small business, it can become attractive enough to attract outside investors wishing to own it. When this happens, these investors may offer to buy the company. With a few exceptions, the primary source of value in a profitable operating business that generates good returns on capital is the earnings power, not the assets on the balance sheet. For instance, a manufacturing plant machine may not have much value when bought in a liquidation market. However, when it is acquired as part of a continuing company that is making significant profits, it is valuable.
Investors will look at the company’s earnings and consider growth, debt levels, and the overall economics of the industry. If things are appealing, they often apply a multiple valuation on the earnings flow. This valuation is akin to the price-to-earnings ratio you hear about often in the stock market. Consequently, a company earning $1 million annually could be sold for $10 million or $15 million as profit. This number represents the concentrated earnings value of the company.
Some small business owners may form new ventures with the goal of growing them until the capital can realize concentrated profits and sell the company. This change in ownership is referred to by the term “liquidity event” in financial circles. Even there are special types of investors who focus on this investment strategy, such as “venture capitalists” who support startups hoping to have an initial public offering or be sold to a market player.
Source:
https://www.thebalancemoney.com/small-business-investment-357245
Leave a Reply