Interesting complementary investment for your portfolio

[Seth Coyne]

Chances are you already understand that real estate investing offers tremendous opportunities for building your wealth and income.

in the vast majority of cases, the value of real estate investments tend to grow over time (even if they do occasionally fluctuate during economic downturns). If done properly, real estate generally provides a MUCH better ROI then something like a savings account. Although not always available, there are plenty of good funding options that can help. And finally, gaining a reasonably competent working knowledge of real estate investing is much easier than several other types of investments.

But there’s another type of investment towards which I would suggest real estate investors keep an open mind.

Unlike stocks and bonds, this is an investment over which the investor can potentially exercise a great deal of influence… much like real estate.

I’m talking about investing in small businesses. 

To be more specific, I’m not talking about your friend’s tech startup that he plans to launch in his mom’s basement. I’m not saying you definitely shouldn’t invest in his startup. Maybe he has the best idea ever. But statistically speaking, investing in a pre-revenue startup is extraordinarily risky. Please proceed with caution.

What I’m talking about is acquiring a portion (and possibly even 100%) of small, functioning, profitable, stable businesses.

Why should you consider doing so?

Two huge advantages are: cashflow and growth potential

Let me explain. If you are buying a company that has revenue in the six or seven figure range, then it’s reasonably likely that you will pay somewhere between 2.5-5 times annual profit for the business.

So, let’s say that you buy a company that has $1 million in annual revenue with a 20% profit margin i.e. $200,000 in annual profit. At that size of a company, there’s a decent chance that you’ll pay about three times annual profit for the business, which comes to $600,000.

If you spend $600,000 buying rental real estate, you would probably hope to get at least somewhere around 10% annual ROI and cash flow which comes to $60,000. If you do really well, you might be able to expect twice that, or $120,000. Certainly not too shabby. And that number will probably grow over time. Depending on where the property is, it may grow quickly or it might take a while.

Now let's move back to the business example. That same $600,000 is buying you a business that has $200,000 in annual profit, or in other words a 33% annual ROI. And what's more, businesses tend to have much more flexible growth potential. If you were to hire a financial consultant, they might be able to help you make a few tweaks that allow your business to save $50,000 a year, bringing your profit margin to 25% and your total profit to $250,000. A good sales and marketing specialist might help you to increase sales by 50%. This would bring you to $1.5 million in sales and (if we assume that you still have a 25% profit margin) annual profit would be at $375,000. Afterwards, a strong operations specialist might help you recognize how you can accomplish 30% more without having to hire more people. That could allow you to up your sales and marketing efforts even more and bring in 30% more revenue without having to hire new people. This would put you at $1.85 million in sales and (still assuming a 25% profit margin) $462,500 in annual profit.

In case you're paying attention, that's about a 77% annual ROI for your original $600,000 investment. 77%! And that's just the beginning! If that business continues to be run well, you can expect it to continue to grow and produce more and more profit year after year.

So why isn’t everyone doing this?

Despite the advantages, there are at least two big dangers to this type of investing, when compared to real estate investing.

The first danger is the worst case scenario versus the worst case scenario in real estate investing. In real estate investing, even if there’s a huge recession, your property is still most likely going to be worth something… Or at least it will be eventually. In the short term, it might actually be a serious cash drain. But eventually, the market will probably pick back up and your property will be worth something. In business it’s different, plenty of businesses are one bad month away from extinction. If sales drop for a few weeks, it’s possible that the company won’t be able to pay rent or pay their employees. When that happens, it’s entirely possible that the business will go from being valued at millions of dollars to absolutely nothing. It doesn’t always work out like this. But it is a possibility that one must be aware of. 

The other danger is how easily the worst case scenario can arrive, if the business is not being managed well… And unfortunately, that’s often the case for small businesses. This is particularly important for real estate investors to be aware of. Just because you’re a great real estate investor, does not mean that you have the slightest clue about how most small businesses should be managed.

But there are a few options. 

Option number one is to educate yourself. Read books, watch videos and attend conferences that teach about how to successfully grow small businesses.

Option number two is to partner with someone who understands how to properly manage and rapidly grow small businesses. If you have the capital to invest, there are probably a decent amount of small business consultants (I happen to be one of them) that would be happy to partner with you in an arrangement where you would provide the capital and the consultant provides the know how that would help your business survive and thrive. Of course this would mean that you would have to share the rewards with your partner. But to put that in perspective, with the above example, everything else being equal, you would start out with $100,000 in annual cash flow and after making the tweaks mentioned you would be up to $231,250. In ROI percentages that would put you at about 16.7% ROI to start with. And eventually you would be up to 38.5%. Nothing to scoff at if you ask me.

So to sum things up, real estate is an outstanding way to build cash flow and wealth. But investing in small businesses, can also be a great way to complement that wealth and cash flow.

Any thoughts? Does that sound interesting to you? Any questions? I’d love to hear from you in the comments! ;-)