How a Small Business Investment Can Make Money
Small businesses sometimes are seen as wonderful gifts that, when well-nurtured, can produce a lifetime of financial independence and a standard of living much higher than average. Investing in stocks is merely an extension of buying a small portion of a business run by someone else and enjoying your cut of the earnings.
For the right type of person, with the right type of skill, temperament, and risk profile, a small business investment can be a lucrative investment. Typically, there are only three mechanisms through which you can experience a gain in net worth from a privately held firm.
Knowing these three sources of wealth generation is important because new investors are sometimes too quick to jump head-first into potential opportunities without clear ideas of how they will drive the economic engine to gain the financial benefits they desire.
For many small business investors, the company never generates more than enough for them and their family to live upon from salaries taken out of the company in exchange for working on the payroll. Though this can be considered a success, the small business isn't really an investment at this stage. Instead, the founders have essentially created a job for themselves, which includes the benefits and drawbacks of self-employment. These payroll distributions can limit the total capital the company has to expand, which can explain why many small businesses are never able to move beyond a single location or increase sales significantly.
It is isn't unusual for more successful small businesses to begin as part-time ventures, allowing the founders to continue their day jobs until the company grows large enough to support their salary needs.
Distributions From Profits
When a small business investment has become successful, there is profit remaining for the owners above and beyond the amount taken out of the business in salaries and wages. The owners then can decide to reinvest the profits for future expansion or they can declare a dividend (in the case of a corporation), a distribution (in the case of a limited liability company or limited partnership), or a draw (in the case of a sole proprietorship), using the money in their personal lives, often to build savings, acquire other investments such as stocks, bonds, or real estate, pay down debt, upgrade their lifestyle, go on vacation, or give to charity.
Whether or not a small business investor reinvests his or her dividends can have an enormous effect on their ultimate net worth. There is no right or wrong answer. If you desire to live better now and give up more wealth in the future, taking dividends can be a rational course of action. If you would rather be richer in the future and are willing to risk additional capital in that pursuit, reinvesting dividends can be the more intelligent strategy. In any event, when you move beyond having a job, dividends from profits are the second most common source of wealth for small business investors.
Capitalized Earnings From Selling the Firm
Once a company has grown beyond the small business realm, it could become attractive enough that outside investors want to own it. When this happens, these investors may offer to buy the company. With few exceptions, the primary source of value for an operating business that generates good returns on capital is the earnings power, not the assets on the balance sheet. For example, manufacturing plant machinery isn't worth much when bought on the liquidation market, but when acquired as part of an on-going company that produces large profits, it is valuable.
Investors will look at the earnings of the business and factor in growth, debt levels, and the economics of the industry as a whole. If things are attractive, they often apply a valuation multiple to the profit stream. This is the equivalent of the price-to-earnings ratio you hear so much about in the stock market. Thus, a business that earns $1 million per year in profit might reasonably sell for $10 million or $15 million. That figure is the "capitalized" earnings value of the firm.
Some small business owners form new ventures for the sole purpose of growing them to the point the earnings can be capitalized and the company sold. This is known in financial terms as a "liquidity event." There are even special types of investors that focus on this niche investment strategy, such as so-called "venture capitalists" who back nascent enterprises in the hopes of someday taking them public in an IPO or selling them to an established player in a market.