In this article, you’ll learn 11 things to consider before investing in a small business.

The decision to invest (or not invest) in a small business can have a massive impact on your finances – so it shouldn’t be made lightly. Before you make this decision, you should do a comprehensive assessment of the risks and rewards, relying on quantitative and qualitative analysis.

Here are 11 things to consider before investing in a small business.

1. Business Plan

A business plan tells you about a company’s products and services, marketing strategy, financial planning, and budget. If you’re considering investing in a new business idea, the business plan is going to be a big factor in your decision, as there isn’t any history of performance. But it’s also important to carefully scrutinize the business plan of an established business – the document gives you an idea of the founder’s long-term goals.

A good business plan provides you with enough information to determine the long-term viability of the company. A poor business plan, on the other hand, leaves you with more questions than answers.

2. Financial Statements

A business plan has the potential to inaccurately portray a small business. But financial statements provide a more objective portrayal of a small business. You should ask to see the last three years of financial statements, including tax returns, balance sheets, cash flow statements, and income statements.

By analyzing three years of data, you get a sense of the long-term trends. For example, you have two businesses – Business A and Business B. Business A recorded $200,000 in revenue over the last year, and has grown revenue at a CAGR of 20% over the last three years. Business B also had $200,000 in revenue in the last year… but saw flat revenue over the same period of time. This means, other things being equal, Business A should be assigned a higher valuation.

The cash flow statements, in particular, deserve a lot of consideration. While venture capitalists can be extremely patient with their investments, you probably expect to be cash-flow positive in the early stages – if not from Day 1. So, you should make sure that the cash flow is trending in the right direction.

And here’s another way to derive value from financial statements: calculating ratios. There are several ratios – such as the price-earnings ratio, debt-equity ratio, and working capital ratio – that give you deeper insight into the financial health of a business.

This financial analysis may seem overwhelming, but the good news is that you can get help from a Certified Public Accountant (CPA) if you don’t have the time or expertise to do it yourself – a CPA, contrary to popular belief, can help you beyond tax season.

3. Financial Projections

A company’s book value is its total assets minus total liabilities. This number can be easily calculated by looking at the balance sheet. For example, assets total $100,000 and liabilities total $30,000. The book value is $70,000. This number impacts the amount of money you’d pay to invest in the business. A company with no business plan and no earnings – and a book value of $70,000 – is still worth at least $70,000.

So, book value acts as a starting number for a company’s valuation. The other thing that impacts a company’s valuation – and is harder to determine – is financial projections. The discounted cash flow (DCF) model is commonly used to reach the present value of a company’s future cash flows. Here’s a quick overview of how it works: you estimate the company’s cash flows over the next several years, and adjust them to a present value based on the time value of money.

A DCF model is great in theory, but the problem is that it’s impossible to estimate cash flows for the next quarter – let alone five years into the future. So, the discounted cash flow should be used as one of a few tools in reaching a valuation – price-to-earnings ratio, price-to-sales ratio, and industry comparisons are others.

When making projections, it’s important to consider a company’s market share and the growth rate of the industry.

As a potential buyer, you might want the market share to be lower, not higher, as the company is going to be valued based on its cash flows. Say you’re thinking about investing in a company with a 2% market share and a great product – but the company isn’t doing much marketing. There’s going to be a high upside on your investment in this case.

The growth rate is more straightforward. You want the pie to be growing, not shrinking.

4. Management Team

Depending on whether or not you have a controlling stake, you may have the ability to make changes to the small business’s management team – but in certain cases, no action is the best action.

Here are a few things to consider:

• Is the company underperforming or outperforming expectations?
• Has the management team made good or bad decisions in the past? While hindsight is 20-20, you can look back and objectively evaluate the decision-making of the management team, based on what they knew at the time.
• Are they being paid fairly? Say you have a great management team in place… but you think they’re getting paid triple the market rate. In this scenario, you might want to re-negotiate salaries or bring in new members.

What if you’re investing in a very small business and the Founder/CEO – who is exiting the business – is the only C-level executive? In this case, you have to determine whether or not you should take on the role – this depends on whether you have the required time and expertise. If you want the investment to be completely passive, you’d have to go out and find a new CEO – which isn’t an easy task.

5. Efficiency

“Fix it twice” is a common saying among successful entrepreneurs. Here’s an example that describes this concept: several people call your customer service department each week with the same question. The employees have to spend a total of three hours answering the question. To fix it twice, you’d have to answer the customers who are calling you and put the question and answer in the FAQ section on your website.

Before investing in a small business, you want to make sure that it has excellent processes and systems in place. Here are a few questions to ask:

• Are there standard operating procedures (SOPs) to train new employees?
• Does the business use a customer relationship management (CRM) system, accounting software, and other types of software necessary for smooth operations? Is the software integrated?
• Does the business use KPIs to evaluate its performance?

You should ask additional questions based on the specifics of the business, but those are a few to get you started.

6. Margin of Safety

So, you’ve evaluated a small business, looking at its business plan, financial statements, financial projections, management team, and efficiencies. You came up with a valuation for the small business – let’s say it’s $500,000. Does this mean you should make an offer that values the business at $500,000? Not necessarily. By offering what you think the business is worth, you don’t give yourself a margin of safety, in case things don’t go as expected.

Warren Buffett popularized the idea of a margin of safety, and it has allowed him to become one of the most successful investors in history. He usually applies a margin of safety to his investments in publicly traded companies, but you can do the same for a small business.

Let’s go back to that small business you think is worth $500,000. If your offer values the company at $400,000, you would have a built-in cushion for some unexpected losses.

7. Opportunity Cost

It might seem like an amazing deal to get a $500,000 company at a $400,000 valuation, but it’s possible that you shouldn’t invest in the business. Before you stop reading, consider this: what if there is another $500,000 company that could be had for $300,000… and you only have enough time and money to invest in one of them. In that case, you should go with the latter business.

The opportunities that are foregone to invest in a company are the opportunity cost. With that in mind, you should evaluate several businesses on the market before investing in a small business.

8. Downside Risk

When you’re thinking about investing in a business, it’s easier to only consider the upside, but you shouldn’t overlook the downside risk. Here’s an important question: how would your personal finances be affected if the investment doesn’t work out? It’s cliché, but only invest what you can afford to lose. This means that if an investment represents a high percentage of your net worth, you might want to give it a second thought.

In addition, you should have a plan for the worst. If the business goes south, would you seek additional funding from potential investors? Or possibly invest more of your own money? By thinking about these possibilities ahead of time, you set yourself up to make the right decisions in pressure situations.

9. Long-Term Outcome

Are you certain that you want to stay invested in the small business forever? The answer is probably no. This means that you should come up with an exit strategy.

Let’s say you want to sell your stake in the business in 3-5 years. In this case, you should project how much the business is going to be worth in that period of time and identify potential investors.

What if you aren’t sure about your long-term plans? There’s nothing wrong with a little uncertainty, but this means that you should take the time to come up with a few exit strategies. If you’re comfortable with each possibility, there’s a better chance that you’ll ultimately be happy with your small business investment.

10. Investment Portfolio

Before investing in a small business, consider how it would fit in your investment portfolio. In real estate, it’s “location, location, location.” With investing, it’s “diversification, diversification, diversification.”

Ideally, you’d own companies in a variety of industries, so that a downturn in one industry isn’t catastrophic for your personal finances. A good way to get diversification at a low price is through mutual funds.

11. Financing Options

There are several ways to finance the purchase of a small business, with angel investors, venture capitalists, crowdfunding, small business lenders, and your own money all being options. But it boils down to two categories: equity and debt financing.

The advantage of equity financing is that you don’t have to make monthly payments out of your cash flow. But in return, you don’t get all of the upside if the investment is successful.

With debt financing, you have to make interest payments every month, but if the value of the company skyrockets in the future, you don’t have to share the upside.

There’s no right or wrong financing option – it depends on your circumstances.

The Bottom Line

A small business investment should be based on several factors, as there’s no single way to accurately assess investment opportunities. While it’s going to take a long time to reach an investment decision, that time is going to be well worth it over the long run. Say you spend 50 extra hours evaluating investment opportunities and you find $50,000 in additional long-term value – you would essentially get $1,000 an hour for your time. You won’t be able to assign exact numbers, but the point is that your due diligence is likely to be rewarded since the stakes are so high.

Want to use debt financing to finance your investment? Consider using Biz2Credit.

We’ve helped several small business owners make business acquisitions, including Dharmendra Patel. Patel saved money in a 401K for his first business acquisition, ultimately funding the investment through a combination of his savings and a seller note. But he turned to Biz2Credit for subsequent acquisitions, and we were able to quickly facilitate an SBA loan for the remainder of the funds required.