Small-business owners are integral to the fabric of the US economy, generating millions of jobs and providing identity to the communities they serve. By fostering entrepreneurship and innovation, small businesses keep local economies healthy and vibrant.

Despite these benefits, many small businesses often lack funding to sustain and expand their operations, relying on local investors to get the capital they need to grow. Investing in small businesses offers potential returns, diversification, and an opportunity to participate in the success of the American economy.

This handy guide explores how retail investors could bolster their portfolios by investing in local businesses.

Small business investing by the numbers:

  • Over the past 25 years, small businesses have accounted for 66 percent of employment growth, according to the US Small Business Administration.
  • A study by the 3/50 project, an advocacy group, shows that for every $100 a customer spends at an independent store, $68 returns to the community through taxes, payrolls, and other expenses. In comparison, when you spend $100 at a national chain, only $43 stays in the community.
  • There are 31.7 million small businesses in the US, accounting for 99.9 percent of all companies, according to the US Chamber of Commerce.
  • Small businesses employ about half of America’s private sector workforce, according to Dataman Group.
  • A 2020 study by Union Bank revealed that 72 percent of Americans said supporting a small business was more important than getting the best deal elsewhere, with many respondents willing to spend $20 more for an item at an independent shop.
  • Non-profit organization SCORE found that 91 percent of Americans shop at local stores at least once a week, while 47 percent frequent a local shop between two to four times weekly.

Whether you are considering funding a new business venture or taking ownership of an existing one, there are typically two main options:

  • Equity investments involve offering money in exchange for a share of the business. Through this approach, you become an owner of the company, sharing its profits or losses and possibly even participating in business decisions.
  • Debt investments are loans given to small business owners in exchange for interest payments over a predetermined period. By agreeing to pay back the total balance plus interest, entrepreneurs maintain full ownership of the business.

While each deal is unique and may include a combination of equity and debt, these two principles are the foundation of most transactions. Like any other investment, though, each option carries pros and cons.

For example, potential returns on equity investments can be substantial should the business take off. With debt investments, however, investors are guaranteed a specific return regardless of the business’s profitability.

Similarly, some laws give precedence to debt repayments over equity investments if the business fails – depending on the corporate structure and other factors. Hence the importance to review and understand all the terms and conditions before investing.

Apart from the motivation of making someone’s dreams come true, many investors choose small-business investments to generate passive income and diversify their assets outside of the stock market and real estate holdings.

For a long time, investing in small businesses was reserved for accredited investors or individuals with a net worth of at least $1,000,000 and an annual income of $200,000 or more. Depending on the deal, federal regulation prohibit retail investors from accessing what officials considered to be highly risky investments.

However, the 2012 Jumpstart Our Business Startups Act, or JOBS Act, lifted some restrictions, allowing retail investors over 18 years of age to invest in crowdfunding platforms like Mainvest or Honeycomb Credit. Both startups vet small business owners and provide access to credit.

Nevertheless, because of regulations, most investors can only invest up to $2,500 or 5 percent of their annual income over 12 months if their yearly salary or net worth is less than $124,000. For those with higher incomes, the limit jumps to 10 percent of their annual salary or net worth, whichever is higher. There are no investment limitations for accredited investors.

The Securities and Exchange Commission periodically adjusts these limits based on inflation.

Because small businesses are more susceptible to economic shifts, overhead costs, changes in supply and demand, and other conditions, investors must exercise due diligence when selecting a potential investment. One advantage of investing with crowdfunding platforms is that these companies do much of the legwork upfront, such as reviewing tax returns, credit scores, and other essential documents.

Before deciding on an investment, here are some of the questions you may want to consider:

  • What is the business plan and strategy?
  • What is the current state and future potential for that industry?
  • What does the competitive landscape look like and what are the top barriers to entry?
  • How much money does the business need to raise?
  • How much equity, debt, and liabilities does the business hold?
  • When can you expect to see a return on your investment?

Of course, there are plenty of other considerations, including non-tangible ones. For example, what is the small business owner’s story, and what value does the business bring to the community? For many investors, investing in small businesses transcends monetary factors.

All investments carry varying levels of risk, and it’s no different when it comes to small businesses. Apart from potentially losing your entire investment, these deals are inherently risky — especially since many entrepreneurs don’t qualify for funding from traditional banks. Therefore, many financial professionals suggest only investing what you can afford to lose.

Target returns can range from 10 percent to 25 percent to compensate investors for that risk, according to the crowdfunding platform Mainvest.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.