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Investing in a Small Business to Diversify Your Portfolio

Back in 2006 I had decided to invest in a small business.  I had already been investing successfully in real estate and the stock market, and decided to tap into another stream to further diversify my investment portfolio.

When I was growing up, my parents had several companies that all dealt with physical or tangible hard goods.  Unlike trading invisible paper in the stock market, there is still a part of me that takes comfort over an investment that I can see, touch and feel.

I am not saying that one is better than the other, I am simply discussing why investing in a small business appeals to me.  When I first contemplated investing, I liked the idea that the business would be near where I lived, and that I could visit it or drive by anytime I wanted.

I would be near enough to establish a relationship with the owner, and if I chose not to buy it outright, can act as a “board of director” that provides input to the business, or at the very least act as an advisor or a sounding board against whom the owner could bounce off ideas.

Because many small businesses are run inefficiently by entrepreneurs who lack the savvy or “know-how”, I also liked the idea that investing in a small business, if run right could develop into a well oiled money machine that appreciated in value and could be sold as an asset for a healthy profit someday.  Anything that makes money is an asset.

When I started searching, I focused on businesses that were not realizing their full potential, which therefore provided me a chance to step in, turn it around and sell it for a healthy profit.

I Bought a Local Dry Cleaners

After reviewing, visiting and considering numerous businesses, I decided to buy a local dry cleaners that was underutilized and therefore underperforming due to an absentee owner who was quite busy and didn’t have the necessary time to dedicate to the business.

The business did not require much time to be managed at all, but that assumes that the owner has in place processes and systems to run the business operationally, while managing it from a high level perspective.  The problem is that the owner did not.

I was willing and able to commit 20 hours per week initially for the first 6 months, putting in place necessary processes and procedures while establishing monitoring systems, and then 5 hours per month collectively monitoring the business from a governance perspective.

I structured a deal so that I paid only 10% down, and had the owner finance the rest of the note so that the business could pay for itself overtime.  I made a relatively low offer (based on the annual earnings of the business) that was accepted and I took over as the new owner early in 2006 (it helps that I found out the real reason for selling and was able to low ball the offer).

I kept the two employees who were running the place day to day. I was heavily involved in the beginning but then cut down to occasional visits throughout the day. Today, I rarely visit. Instead, since I essentially live on the road I send a friend or a relative once in a blue moon who is nearby in the area to physically see if the building is still in place.  You just never know!

Following are just few of the improvements I implemented:

  • Replaced the old manual cash register system with a new automated point of sale system
  • Renegotiated rates with vendors successfully. For example, I was able to lower the credit card processing fees by moving to another merchant processor
  • Replaced store front signage with maximum allowed capacity by the local city jurisdiction
  • Turned all exterior wall surfaces into glass for better visibility into the store by outsiders
  • Installed LED lighting over the entire glass wall parameter, allowing the venue to stick out at night when people drive by
  • Started offering same day dry cleaning service
  • Started offering pick up and drop off dry cleaning
  • Implemented marketing campaigns – local newspapers, radio, direct mail
  • Created a website where customers could sign up for newsletters and receive coupons in the mail
  • Implemented a remote surveillance system
  • Established a reporting structure for my employees (frequency and method of how they reported to me).  I established a set of key performance indicators by which I audited and managed the business remotely
  • Launched a Grand Reopening campaign with lots of fun activity in the parking lot, new banners, balloons and freebies to drive customers in

None of these ideas popped into my head overnight.  These were also thoroughly researched when I first started to evaluate the business.  I had visited several solid performing dry cleaners and observed what they were doing that this business wasn’t. I spent time talking to the owners picking their brains on the ins and outs of the business.

That said, as you can imagine there were some costs associated with implementation of all the ideas.  This cost was reasonably forecasted and considered as part of the overall cost of investing in a small business, which was reflected in the offer to purchase it. In other words, because I knew I had to spend X amount in upgrades, I offered X less to purchase the business.

Before I move on to what you should consider when evaluating investment in a small business, I want to emphasize the importance of establishing Key Performance Indicators (KPI) by which to manage the business.

Depending on the business that you get involved with, there are certain key indicators or KPIs that are most relevant to the business.  The better you get to know these variables and at what levels they should be at for your business, the easier you will be able to manage your business.

For example, for the dry cleaning business, I had obtained historical financial results and could see that it is a cyclical business, with sales picking up from September through December and then dropping in January while stabilizing sometime in April.

I also know that if sales are X, then the blended cost of sales should be Y (it works out as a percentage).  Because vendors bill my business account directly, my employees don’t get to deal with the cost side of things, and that is purely by design. I am in the process of shifting the task entirely over to a CPA.

When my employees do the month-end reconciliations and accounting and report the results to me, I quickly do a smell check to see if the revenues they are reporting make sense.  For example, if I know that my costs for the month are 80% and my employees tell me that the business raked in $10,000 this month, I can tell whether they are reporting accurately based on the KPIs and ratios I have established to monitor my business.

Because blended costs are typically 80%, I know to expect $10,000 in sales if my costs are $8,000. This kind of “ballpark analysis” is particularly important if your business is a heavy cash basis business.  A good chunk of the dry cleaning business revenues come from cash sales, therefore the risk of theft is high.

I am usually comfortable as long as my ballpark analysis comes anywhere close to what it should be. I use the term ballpark and I say “close” because you will never have a 100% loss proof business. Whether due to breakage, damage, theft or otherwise, always factor in a percentage for “shrinkage” that you can live with into the overall equation.

What Should You Consider Before Investing in a Small Business?

Having the end goal in mind for every investment objective is important for clarity. With clarity, you can make prudent decisions that are consistent with your investment objective.

For example, do you want your investment in a small business to benefit you from your share of the cash flow as a silent owner? Or do you want to buy and own a small business outright, put it on auto pilot, and either profit from the ongoing cash flow or sell it for a profit?

Determine what is the minimum return on investment (ROI) that you are willing to accept when investing in a small business.  Don’t forget to factor in the time it takes upfront to develop automated systems, and the ongoing commitment associated with accounting, monitoring, governance and tax compliance.

Most relevant to investing in a small business is your stability.  Are you going to be away a lot or are you going to be accessible when the business needs you for whatever reason? Emergencies, both small and big, can occur all the time.  In the event you will be away quite a bit, do you have a system set up in your absence that can attend to the business’ needs if and when they arise?

Many who invest in small businesses like stability and being an active part of the local community.  These folks are typically quite close to their businesses (even if they don’t work in it daily) and are heavily involved in local initiatives.  On the other hand, those who prefer mobile lifestyles and travel frequently (like me) often choose to engage in web based businesses, or freelance consulting work that can be done anywhere.

What I Learned in the Process?

I learned a lot of things in the process of buying, improving, running, managing, monitoring and profiting from the small business acquisition I made back in 2006.  The following is an outline of some points to consider which may help you someday if and when you buy or invest in a small business.

Use Brokers

You can find businesses for sale on your own online, or through brokers.  While it can be fun browsing around here and there, it doesn’t hurt to reach out to a broker.  Dealing with the broker has several advantages.  First, you have someone to blame when the deal goes south (just joking).

Brokers have a healthy listing of businesses for sale.  You can provide your specific requirements to a broker and ensure that you are only bothered when an exact match comes across.  You don’t want to waste your valuable time considering businesses that don’t fit your requirements such as type of work involved, clientele or minimum return on investment.

Similar to real estate, broker fees are typically paid by the seller.  That said, keep in mind the broker is interested in selling his or her client’s business. Always take the word of your broker with two grains of salt.  That is why you should hire your own lawyer to review the deal paperwork.

Get a Lawyer

Lawyers are expensive, but worth every penny of your investment when you are going to be investing 200 times more into a small business.  For an additional $500-1,000, go ahead and get yourself a lawyer who can review the buy/sell agreement for you, lease paper work if applicable, or anything that average Joe’s (you and I included) cannot understand J

Don’t use the broker’s recommendation.  Fetch yourself your own lawyer.  Get recommendations from other business owners who have bought businesses.  Contact the lawyer’s clients and get feedback on the lawyer’s diligence and quality of work.

Certified Public Accountant (CPA)

I’d say the same thing as a lawyer for a CPA.  The Due Diligence (DD) process of the deal is the most critical aspect for you as a buyer / investor.  It is during DD that you validate the information provided to you by the broker / seller.

From my experience, every single sales offering of a business has some level of embellishment or exaggeration in it.  BE VERY CAREFUL and take your time to conduct DD.  If the broker only gives you two weeks (which is standard as they want you in and out of there as quick as possible), demand more time and be firm.

If you are confident in your own DD abilities, go ahead and conduct a thorough review of the business.  Brokers will usually provide you with access to the data room, an online secured website where you can access the seller’s information such as financial statements and tax returns.  Ask for tax returns if not in the data room.  Not having copies of tax returns is usually a big red flag.

A lot of this information, or a summary of it, is or can be provided before you even make an offer to purchase the business.  The broker will make you sign a non-disclosure agreement form (NDA) which basically states that you cannot share or disclose the sensitive seller information you are exposed to during the process.

Marketing Analysts

This one is not critical but if you feel that the business you want to buy or invest in is significantly under marketed, if at all, bring in a marketing consultant / analyst who can give you an idea of the potential impact to the business if specific marketing initiatives were executed.

These services are not cheap, but can be worth it given your industry and the competitive landscape, especially if you are not aware of it.  A local marketing consultant should be able to help with this.  You may just find out that your business can make an additional $60,000 annually by investing $6,000 into specific marketing initiatives.

Table this until the end, and only if you have some spare cash. The primary basis of your investment decision must be based on “what is”, or the actual facts, rather than “what can be”, or speculation.

Training and Observation Period

Demand a two week observation period as part of your contract, and make the purchase or investment in the business contingent upon your conclusion at the end of the two week period.  The two week observation period must allow you the opportunity to be inside the business along side with the owner.  The purpose of this activity is to physically observe the business operations, clientele, volume and everything else.

To see is to believe, and physical observation is the best way to get comfortable over a lot of the information you are told verbally or provided on paper throughout the process.  In fact, before your two week physical observation period, take two weeks and observe the activity in the parking lot of the business.

The owner shouldn’t know you are there or are coming.  Simply take some time each day for two weeks and observe the traffic levels.  I have heard situations where business owners have had friends, family, colleagues and even paid people to come into their business during the two week buyer observation period.  By setting up your observation shop discretely in the parking lot, you will be able to avoid falling for the coordinated efforts to deceive you.

Vendor / Supplier & Customer Confirmation

Depending on the nature of the business you are buying or investing in, there may be a select group of major customers and suppliers.  If so, obtain the contact of these parties through the seller and confirm the amount of business the seller says they are doing with each customer or vendor.

If the seller is reluctant to having you contact them prior to purchasing the business, have the seller obtain confirmations via writing or over the phone in your presence.  A seller that doesn’t provide this information is likely hiding something.

Contract Clauses

Last but not least are the clauses you must ensure your contract or the purchase / sale agreement contains.  It’s better to be on the safer side and incorporate contingency and indemnification clauses, release of liability claims, transfer of business name and the likes.  Your attorney can help you with this.

You want to protect yourself from unforeseen events resulting from actions taken by the seller either in the past, present or future.

Incorporating / Establishing Your Small Business

This is another area where your CPA can help you.  Come see me if you can’t find a good CPA.  I can either help you myself or refer you to someone who knows what they are doing.

Have your CPA incorporate your business as a business entity that is most favorable for you and which meets your goals and objectives for the investment decision.  In other words, do you want a pass through Limited Liability Company (LLC) or do you want a Small Corporation (S–Corp)?

Ensure that the seller dissolves his or her business entity and releases the business name and ownership to your business entity.  Get yourself an Employee Identification Number (EIN) which is going to be your business’ own identification number, the equivalent of your social security number.

With the EIN in hand, you can open a bank account dedicated to your business.  You should keep your business activity separate from personal and never comingle the two.  This helps keep your business legally separate and therefore limits your personal liability to claims resulting from unfortunate incidents.  This also helps keep clean business records and makes tax compliance relatively easy.

You can certainly do all these tasks on your own. In fact at the least, you should read up on them and know about them even if you are going to have your CPA do them for you.

Concluding Thoughts

In addition to the direct benefits of owning a small business, and hence meeting the goals and objectives of your investment decision, there are also significant tax advantages to investing in a small business which are not discussed in this post.

Moreover, investment in a small business, or buying one outright has tremendous advantages from a learning and development perspective.  You grow as an individual, professional, investor and businessman or woman.

As for my investment decision back in 2006, so far the acquisition has paid off very nicely, and I plan on keeping it for now.

Readers: How about you, any experience investing in a small business? Does it seem like something you want to explore someday?  Why or why not?  Does it sound like too much hassle?


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17 Responses to “Investing in a Small Business to Diversify Your Portfolio”

  1. I’ve read somewhere that you can earn $1 per month, per one visitor per day to your blog. That means that if, for example, you have about 100 visitors per day in average, you should earn abot $100 in one month from advertisements (Google AdSense). I am a beginner blogger and I would like to know how far from truth is that statement?

  2. Sunil says:

    I have not heard of such, and based on my experience it is not accurate. There are way too many factors that determine the revenues your website generates, and visitor count is just one of them.

    This also highly depends on your monetization avenues. For example, if you are selling an ebook, then no matter how many visitors you get, if they are not targeted visitors, they won’t convert (turn) into customers.

    Similarly, even if you have thousands of visitors to your website, if your niche is one that does not command top dollar for adsense/adword revenue, you will not benefit as much as had your website been about a niche that is more profitable from an ads perspective.

  3. Wow. Talk about a ton of info! I loved the real-life experience about the dry-cleaning business. My friend and I were actually just talking about this the other day.

    Thanks again. It helped tremendously.

  4. Samantha says:

    Awesome information Sunil, I love it. I am also contemplating a beauty salon or an ice cream parlor. Would love to hear more business advice from you.

    PS: How long did it take you to write the post?


  5. Sunil says:

    @ LAMF – You are most welcome. Curious, what business(es) are you guys contemplating? Do you intend to work in it? Or have it as an income producing asset?

    @ Sam – Welcome to the Blog Sam. I put a lot of thought into my post to ensure they are on point and flow well for the reader. That said, it’s hard to put a number to it. I want to say this one took an hour, or a little more?

    More entrepreneurship topics coming up indeed.

    • Really, we were just talking about starting a business in general. Down the road, we would love to start our own mutual fund, but I know this is incredibly involved, and I honestly have a ton of research to do before this is even considered as an option. 🙂

      As for myself currently, I am focusing on my website for income, and my wife is beginning photography. Once these take off, we’ll get more creative.

      • Sunil says:

        Oh yeah, trust me I don’t think you want all that regulatory compliance to deal with, and that is the least of your worries

        Website and photography sound better 🙂

        Keep me posted on how those ventures are doing. Would love to hear and discuss more, and do let know if there are specific areas you’d like to see more coverage on.

        All the best to you and the wife

  6. Very comprehensive article. To run a small business well, as you described, there is quite a bit of time and oversight required. Personallly, I prefer investing in financial assets for long term growth. Very enjoyable and informative read.Although, my dad always thought about vending machines and car washes as high cash, low management ideas.

  7. Sunil says:

    True Barb – there is a good amount of work involved indeed. I too prefer building other, easier to manage income producing assets. I know a couple people in the vending business. They bought the machines used (apparently that is the way to go). Both are doing extremely well, and both spend a lot of time managing the services (employees, stock, routes, etc). It is by no means passive.

    What are some of the financial assets you prefer to invest in?

  8. Wow! Simply phenomenal amount of info! Well done and gutsy to invest!

    If only I knew I had to do no work and have no risks, that would be amazing 🙂

  9. Sunil says:

    Not sure I understood the statement?

    It woud’ve been lot more gutsy had I know very little or not done nearly as much due diligence.

    One way to mitigate risk further is to specific earn out language in the buy/sell contract. This also commits the seller/owner to confidence / legitimacy of the business. The clause essentially says that you will remit installments based on business performance.

    If business earns, so does he/she. It’s difficult to pull this off, especially for any period longer than 6 months because things can change so fast, especially if the new owner implements drastic changes. But a motivated seller is a good one to deal with. Also always include indemnification and restitution clauses to protect.

  10. Jim Smith says:

    Hi Sunil
    Great article. As a CPA myself who has seen a lot of people buy and sell businesses, I found your “what I learned” about as complete as you could get. One of the biggest red flags I have come across is, as you mention, tax returns. If the company is behind in paying its tax or has missing tax information (at federal, state and local levels as apporpriate) then run – or at least knock down the price. The first thing a company stops doing when it gets into trouble is paying taxes.

    • Sunil says:

      amusingly true Jim, amusingly true. not for the business owner by any means, but the visualization I had when I first read your comments.

      you are absolutely correct, a buyer can use such flaws to their advantage by knocking down the purchase price. since purchase prices are typically viewed as a multiple of earnings, even a slight adjustment to earnings can lead to significant savings on the business purchase.

      welcome to my blog Jim, great to see you here and hope to see you more often

  11. Great article Sunil. Loved your real life business experience. That was an in depth and most interesting article that I have come across in recent times. There is lot we new entrepreneurs can look up to you.

    Looking forward for more from you Sunil.

  12. Mike says:

    This is a great post. In fact, now that I’m going to be in the same location for four or more years, it has prompted me to open up my aperture and consider starting or investing in a local business. My wife and I have talked about starting a business after I retire from my current career, but I’m not sure there’s a good reason why we couldn’t start one in the next couple of years, before I retire.

    Thanks for the spark. We’ll see if it leads anywhere.

    • Sunil says:

      very interested in hearing more. with all this online talk and focus, we often loose perspective of the basics, which still work and in some cases very well

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