The Ways a Small Business Investment Can Make Money
Know How You Plan on Profiting from Your Small Business Ownership
Much of my early success in life was due to founding and running small business investments that were able to grow and produce cash flow to fund other investments. Entrepreneurship has been a part of not only my life, but my family's life, for generations. Some of you know about a letterman jacket awards company my husband and I own. Others of you are aware that, in 2016, we launched an asset management group for affluent and high net worth individual, families, and institutions who want to invest alongside us.
Throughout the family tree, various members of the clan have started everything from a bank to a jewelry store, built car washes and storage units, ran sporting goods companies and retail shops, started a manufacturing plant and a concrete company. Small businesses were seen as money machines; wonderful gifts that, when well-nurtured, could produce a lifetime of financial independence and a standard of living much higher than those around you. Investing in stocks was merely an extension of this business ownership mentality; 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 set, temperament, and risk profile, a small business investment can be one of the more lucrative investments made over an entire lifetime. Typically, there are only three mechanisms through which you can experience a gain in net worth from a privately held firm, which I want to explore in this article.
Knowing these three sources of wealth generation is important because, too often, new investors jump head-first into a potential opportunity without a clear idea of how they will drive the economic engine to gain the financial benefits they desire, only to find themselves overworked and, in some cases, broke.
The First Source of Income from a Small Business Investment is the Salary You Pay Yourself Working for the Company
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 in and of itself - you have a career and you answer only to yourself - the small business isn't really an investment per se 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 do more than a few hundred thousand dollars in sales. It is isn't unusual for more successful small businesses to begin as part-time ventures, allowing the founders to continue their day job until the company grows large enough to support their salary needs.
When a small business is structured as a limited liability company, the salary paid to the founders for their efforts is known as a special type of accounting entry called "Guaranteed Payments".
Guaranteed payments have unique tax and financial statement implications, so it would be wise for you to research and understand them.
The Second Source of Income from a Small Business Investment Arises from Distributions Made from Profits Generated By the Firm
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 can then 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, or any investor for that matter, reinvests his or her dividends can have an enormous effect on their ultimate net worth, as illustrated in this 50-year case study of shares of The Coca-Cola Company. 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.
The Third Source of Income from a Small Business Investment Arises from Capitalized Earnings When You Sell 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 $1,000,000 per year in profit might reasonably sell for $10,000,000 or $15,000,000. 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.
More Ways to Profit from a Small Business Investment
There are a handful of additional methods of making money from a small business investment that go beyond the basic three we have already discussed. One particularly popular technique is for the founding family to acquire real estate and then lease the facilities or properties to the business. Many of the most successful publicly traded retail companies, which began as small mom and pop stores, still have controlling families that lease real estate to the firm, providing rental income. This can be an intelligent technique, keeping wealth in the hands of the business founders instead of sending it to third-party landlords, provided the deals are fair to the small business; e.g., the agreements are made at market rents, the terms are comparable to other, similarly-situated properties, and the lease agreement term is of a reasonable duration. There are even complex ways to structure it so that little or no taxes are paid on these alternative sources of income, such as having the building owned by certain self-directed retirement plans.