In the past, we have talked about the ways you can make money from investing in stock. Going one step further, if you or your family is considering making a small business investment, there are typically only three mechanisms through which you can experience a gain in net worth from the position. Knowing this is important because, too often, new investors jump head-first into a potential opportunity without a clear idea of how they will experience the financial benefits, only to find themselves overworked and, in some cases, broke.
1. Salaries Paid for Working at the Small Business on Payroll
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, 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, explaining 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.
2. Dividends Paid from Profits Generated By the Small Business
Once 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, 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 lifestyle, 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 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 mere job, dividends from profits are the second most common source of wealth for small business investors.
3. Capitalized Earnings When You Sell the Small Business
Once a company has grown beyond the realm of the small business, it may be attractive enough that outside investors want to own it. When this happens, they 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, especially those around Silicon Valley, often 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, called venture capitalists.
Other 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 not taxes are paid on these alternative sources of income, such as having the building owned by a retirement trust.