How to Begin Investing in Small Businesses-Stocks or Actual Businesses
Guest contributor, Barney Whistance
The most basic question for any small business investor is where to focus their time, money, and energy. With nearly 27.9 million small businesses in the US alone, and with few research services available, it can be challenging to find the gems in the rough – the businesses worth investing in. In the small business investment market there are going to be great opportunities for above-market returns, but not all companies are worth focusing on. A good place to start are these strategies for investing in small businesses. These fundamental strategies for investing in small businesses are applicable when looking at small business stock market investing as well as when considering investing your dollars as an owner of small business.
So what makes one company better than another? While there is an abundance of investing advice in other critical areas, there is a lack of tips for prospective small business investors.
Here are five fundamentals to look for when evaluating a new company. It’s not an all-inclusive list but it serves as a starting point. Other considerations, like valuation and deal structure, are critical as well, are worthy of an entirely separate in-depth discussion.
Strategies for Investing in Small Businesses
These principles can be applied to all industries, but they’re especially relevant to both consumer and retail businesses.
1. Strategies for Investing in Small Businesses –
Look at the Gross Margin Ratio
According to Ryan Caldbeck, a private equity investor, “Gross margin is a measure of the percentage difference between what a product sells for in the market (revenue) and the actual costs to produce that product (cost of goods sold, or COGS).”
“This number represents the proportion of each dollar of revenue that the company retains as gross profit. For example, if a company’s gross margin for the most recent quarter was 35%, it would retain $0.35 from each dollar of revenue generated, to be put towards paying off selling, general and administrative expenses, interest expenses and distributions to shareholders.” ~Investopedia.com
This is a critical ratio because it’s what allows a company to invest in all the other areas needed to get the product out there in front of consumers. It allows them the funds needed for marketing, advertising, sales, and distribution.
Gross margins can vary by industry (and even inside niche categories within an industry) but keep in mind that razor-thin gross margins leave absolutely no room for error. Focus on investing in categories that have higher gross margins. These companies will be able to weather increased costs more easily. Examples of higher gross margin categories include businesses dealing in premium pet food, personal care, and the whole range of natural and organic products. Luxury goods makers and many tech product makers also exhibit higher gross margins.
Keep in mind that its gross margin expansion is very difficult. Even if the company is focused on creating products with better margins, automating production, or lowering costs, the instances where gross margin improvement will drive outsized investment returns are rare.
2. Strategies for Investing in Small Businesses –
Consider the Brand Strength
Assessing brand strength is often the toughest thing to assess in a small company. But as an investor you need to ask yourself, “Is this brand offering something unique?” The world may not need another green cleaner, or another organic soap, yet companies can create a special brand through beautiful, creative, and distinctive packaging of a quality product.
You can evaluate brand strength by looking at customer and consumer surveys, “earned” media presence, and other third-party data. There are countless products on the market, but the thing to keep in mind is that formulas can be copied, brands cannot. Copy cats will always be able to hack the recipe for Cherry Garcia from Ben and Jerry’s, but in the end is it doesn’t matter. You can’t copy the brand.
You want to avoid “commodity” type producers. These are indistinguishable from one another and make it tough for a company to demonstrate a competitive advantage.
3. Strategies for Investing in Small Businesses –
Consider Who’s Running the Ship
Sound corporate leadership is essential. Some CEOs come from a place of hardship and resilience. Perhaps they started their business after a job loss, illness, personal hardship, or overwhelming debts affecting their credit score and making it hard to secure full time employment. Perhaps they were overwhelmingly successful in the corporate sector but got fed up with climbing the corporate ladder.
Whether you love the founder’s personal story or not, make sure you do your due diligence and conduct both reference checks and third party background checks. In small business you’re investing as much in the leadership as you are in the company, product, or service itself.
There’s no hard and fast way to evaluate leadership, but every investor should take the time to ask some hard questions. Make sure you get on a conference call and probe the CEO on all the issues you think are most important. Does this person have a passion for their product or service, understand their business, and have what it takes to persevere through the growing pains?
For all public company evaluation when considering strategies for investing in small businesses-read the annual report, especially the president’s letter. Look at it with a critical eye for discrepancies and unrealistic expectations.
4. Strategies for Investing in Small Businesses – Look at the Future
Consider the future company’s direction. Are there exit strategies, if needed. Many people erroneously believe that if they grow a successful and thriving company there will always be a home for it. In certain industries, however, that is just not the case.
If the company you are considering has plans or visions of selling to a strategic acquirer the CEO should be able to 1) identify who the expected strategic buyers are, 2) explain what their acquisition approaches have been in the past, and 3) be able to explain the reasons why their business will be attractive to those strategic acquirers.
Does the company seem to have a position in today and tomorrow’s corporate landscape? Notice that recently, Apple’s sales are bottoming out. Does this mean they’ve hit their peak or is this a temporary set-back? Put on your detective hat when evaluating a small business, ask yourself if their business model can endure.Are you interested in learning more about investing? Check out our partner for free investing course trial.
4. Strategies for Investing in Small Businesses – Growth Drivers
Recurring revenue is the portion revenue that’s continuing into the future. It provides a nice base (ideally an increasing base) of revenue on which management can depend while focusing on new ways to grow the business. Understanding and quantifying the recurring revenue is especially valuable because the costs of acquiring a new customer can range from five to 25 times the cost of retaining an existing one.
It’s not always enough to only look at the recurring revenue. The more important question is how frequently that revenue will recur. While some longer-lasting products are great for the consumer, it can become problematic for the company because it will delay the repeat purchase cycle.
Ask yourself what will continue to drive growth into the future? Think about whether the business model is sustainable and where the company falls within it’s competitive landscape. In order to succeed as a small business, the firm needs to have a growing source of new revenue. Make sure to understand where the future growth will come from.
As mentioned before, this list is not intended to be all-inclusive. However, it does include some important steps that should be considered when evaluating whether to invest in a small business. These metrics are helpful if you’re looking to invest in a small public company or considering taking a part-ownership position in a business yourself.
Barbara’s notes-Other ratios to examine when evaluating small businesses are; net income, price/earnings, earnings/share, return on equity, and debt/equity. If you’d like to learn more about stock analysis, you may want to check out our free trial courses.
Guest contributor Barney Whistance is an enthusiastic Finance and Economics blogger who is most interested in global economic climate. His work has been featured in TheChicagoTribune, NewsOK, Blog.AfterCollege, LenPenzo and more. Apart from completing majors in Finance, he is also a Chartered Accountancy Student and planning to complete his Ph.D. in Finance before he turns 30. Currently, he has been blogging for Pac and Copy Plus, a Florida-based digital agency offering top-notch services including SEO and web design and development. For more updates, follow him on Twitter @barneywhistanc1.