How to Diversify Your Portfolio by Investing in Small Businesses
When investors think of ways to diversify their portfolio, they often think about adding bonds to a stock portfolio, or foreign equities to a domestic portfolio. However, one way to diversify a portfolio that doesn’t involve adding publicly traded securities is to invest in a small business. There are three main ways to invest in a small business: starting your own, buying equity in an existing business or helping finance one through debt. Here’s a look at how each can help diversify your portfolio.
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Starting Your Own Business
Perhaps the best way to invest in a small business is to start your own. When you run your own business, you’re the boss and you don’t have to worry about partnering with other investors — unless that’s your desire. You can also choose a business that pursues your passion, rather than having to invest in someone else’s vision. Having your own business can also be a great diversification tool for your other investments, as the fortunes of your company aren’t likely to track the precise ups and downs of the stock or bond markets.
Starting your own is likely the highest-risk, highest-reward option when it comes to investing in a small business. In addition to the initial capital you invest, you’ll have to contribute ongoing funds for equipment, inventory, rent/mortgage, insurance, licensing and potentially many other costs, depending on the type of business you have. In other words, your potential loss may exceed your initial investment, which is likely to be thousands or even tens of thousands of dollars. However, you will have complete control over the business, including rights to all of the profits.
Equity investing is one of the primary ways to acquire an interest in a small business. As an equity investor, you own a certain percentage of a small business, just as if you bought a stock on the stock exchange. If you’re a minority investor, you won’t likely get much of a say in how the business is run. However, you will partake in the profits of the company according to your percentage share in the business. Depending on the type of business you invest in, you might be able to benefit from a thriving local business that can grow faster than some of the big-name stocks you might buy on the stock exchange. Meanwhile, your potential downside is limited to the funds you initially invest, which can be anything from a few hundred dollars to tens of thousands.
Debt investing is different altogether from equity investing. Rather than buying a percentage of the profits of a company through an equity investment, a debt investment is essentially a loan. You’re giving money to a company anticipating that its future cash flow will be more than enough to both pay you regular interest and return your initial investment after a specified period of time. Debt investing is typically lower-risk than equity investing as it ranks higher in terms of capital structure. In other words, if the company has financial difficulties, its first priorities are to its bondholders/investors, rather than to its stockholders. Loans that are backed by specific assets of a business, such as its inventory or equipment, are generally the safest type of debt investments.
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Choosing Your Investments
Unlike stocks that trade on an exchange, you can’t just buy into any small business you’d like. Many small businesses are not open for investment, so you’ll have to deal with a broker or otherwise get an introduction to meet with a business that’s ready for a debt or equity infusion. Just as if you’re buying a publicly traded stock, you’ll have to do your due diligence to make a smart investment in a small business. However, the right business can be a great diversification tool for the rest of your portfolio.
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Last updated: June 15, 2021