Joshua Kennon Updated November 12, Investing in stocks of a small business is merely an extension of buying a small portion of a business run by someone else and enjoying your cut of the earnings.
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. Small business and start-up business investment opportunities often come in the form of penny stocks, which can expose the investor to higher risks.
Who Invests in Small Business Stocks For the right type of person, with the right type of skill, temperament, and risk profile, small business investment can be a lucrative investment.
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The Salary You Pay Yourself 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 small business salary needs. Distributions From Profits When a small business investment has become successful, there is remaining profit for the owners—above and beyond the amount taken out in salaries and wages.
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The owners then can decide to reinvest the profits for future expansion, or they can declare a dividend. In the case of a corporation, the dividend is a distribution to shareholders.
This payment takes the form of a draw for a limited liability company or limited partnership. A sole proprietorship small business may use the money in their personal lives, often to build savings, acquire other investments—such as stocks, bonds, or real estate—and pay down debt.
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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.
In any event, when you move beyond having a job, dividends from profits are the second most common source of wealth for small business what business to invest in to earn. 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. Still, what business to invest in to earn 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.
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If things are attractive, they often apply a valuation multiple to the profit stream. This valuation is the equivalent of the price-to-earnings ratio you hear so much about in the stock market. That figure is the "capitalized" earnings value of the firm.
This change of ownership is known in financial terms as a "liquidity event.