Reviewed on 19 February 2020
Many people have the mindset that being an entrepreneur necessarily means being able to make money. It can also be seen as being able to produce a lifetime of financial independence and a higher-than-average standard of living. Investing in stocks is merely an extension of 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, temperament, and risk profile, investing in business can be a lucrative investment. Typically, there are only three mechanisms through which you can experience a gain in net worth from a privately held firm.
Knowing these three sources of wealth generation is important because new investors are sometimes too quick to jump head-first into potential opportunities without clear ideas of how they will drive the economic engine to gain the financial benefits that they desire.
1. The Salary You Pay Yourself
For many small business investors, the company never generates enough for them and their family to live upon the 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 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 salary needs. In many cases, the right thing to do is to set aside a fixed market rate salary for the founders and pay themselves as if they are just an employee. This is to cultivate discipline and regulation.
There is a saying – “if you wish your business to be a multinational corporation (MNC) one day, behave like one now.”
2. Distribution of Profits
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 the form of salaries and wages. The owners then can 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 life, often to build savings, acquire other investments (such as stocks, bonds, or real estate), pay down debts, upgrade their lifestyle, go on vacation, or even contribute to charity.
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. 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.
3. Capitalized Earnings from Selling 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 aren’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. If things are attractive, they often apply a valuation multiple to the profit stream. This is the equivalent of the price-to-earnings (PE) ratio you often hear in the stock market. Thus, a business that earns $1 million per year in profit might reasonably sell for $10 million or $15 million. That figure is the “capitalized” earnings value of the firm. If the business is sold for $10 million, it means that its price-to-earnings ratio is 10 times.
In the new edge arena, many investors are looking at the spectrum of data and customer base that the business has, that can significantly increase its valuation. The branding, marketing effort, and other goodwill value also contributes to the business. Many loss-making companies or start-ups that have not made profit in their business, have already become multi-million in worth and they are being acquired by venture capitalists and private equity guys in the market.
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 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 the market.
Written by Melvin Ho, CEO and Co-Founder @bizsquaremc
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