Investing in Main Street: How to Invest in Small Businesses

When people say that small businesses are the country's backbone, they mean it. There are 31.7 million small businesses in the U.S. compared to 21,139 larger businesses.

That means small businesses make up 99% of all companies in the U.S.

Unlike larger companies, smaller ones don’t always have access to direct lending. This is especially true for sole proprietorships or general partnerships.

Getting access to private capital like venture capital or private equity can be difficult for small companies. Often, private companies don’t even know they can get private credit without a bank loan or by fundraising from the community. This can make it difficult for companies to expand, reduce debt, or hire new employees. 

This happened during the global financial crisis as many smaller companies struggled to maintain growth after the economic slump. Still, banks were unwilling to create flexible loan terms for struggling businesses. So many turned to the world’s private debt markets, such as Funding Circle and Honeycomb.

The two main ways to invest in small businesses are private equity and private debt.

Equity investors

A private equity investment is when you buy a stake in a company in exchange for capital—usually cash. An equity investment gets you a percentage of the profits or losses of a business. It’s similar to how stocks work on the public markets, but it’s a deal between an investor and a private company.

The percentage of a business an investor owns is usually proportional to the total capital provided. For example, if a small business raises $1 million and you invest $100,000, you can expect 10% of the profits or losses.

However, in some cases, the percentage of ownership of an investment can differ from the amount of private equity. For example, when Warren Buffet started his Buffet Partnership Ltd. at the age of 25, he received 25% of any gains beyond a cumulative 6% despite his partners putting up more money. This was mainly because they weren’t just investing in the partnership but in Buffet’s investing expertise.  

There are even private equity ETFs, like the Invesco Private Equity ETF, that retail investors can use to gain exposure to private companies without needing to be an actual investor. 

Private debt investors

Another way small companies can build their business is through private debt investments. Private debt refers to money lent to a private business, whether that is a bank loan or some funds from a family member.

A private debt investor will commit private credit to a company in exchange for interest income and principal repayment in an agreed timeframe. Private debt funds are often from direct lenders as opposed to banks. While banks do participate in private debt, it’s less common due to the risk involved.

Most of the time, alternative financial institutions such as debt investors, wealthy individuals, or business development companies (BDC) are the ones who loan to private companies.

A Small Business Investment Company (SBIC) is another way for private debt investors to lend to small businesses. An SBIC is a private investment fund licensed and regulated by the Small Business Administration (SBA). SBIC fund managers use their own capital and funds borrowed from the SBA to make loans to small companies.

Like private equity, private debt isn't traded on the open market, but investors can lend to both private and public companies. A private debt investor isn’t looking for ownership in the company but is looking for a return on their investment. These loans are also often more flexible as they tend to be open-ended.

The private debt market is growing, with assets under management for private debt funds at $1.21 trillion and expected to grow to $2.69 trillion by 2026.

Private debt investors stand to make a decent return. For one, private debt investors are more protected than other types of investors, such as equity investors. That’s because of how the capital structure of a company works. A business is financed based on this proportion of debt and equity on its balance sheet. This determines how and in what order capital is repaid if the company ever goes bankrupt.

At the top of the food chain is senior debt, then unitranche debt, etcetera, until you get to equity at the very bottom. In other words, a private debt investor is more likely to get paid back first than an equity investor, who may not see any funds if the company goes belly up. 

Since private debt does not have the same reporting requirements as other types of assets, it’s hard to know exactly how much the returns on private debt are, but some data indicate that returns are solid.

The Cliffwater Direct Lending Index (CDLI) is one of the most comprehensive indices in the sector, with $247 billion in assets and 10,868 individual underlying loans. The CDLI generated annualized returns of about 9.2% in the past ten years, which is a favorable return compared with other investment-grade bonds.

For businesses, private debt funds are a critical means of support. Private credit can be a lifeline to a struggling company and give them a way to seek funding without the often rigorous qualifications of banks.

A private debt investor can fill the gap and provide small businesses with necessary private credit. Besides simply helping local businesses, debt investors might want to lend to companies for a few reasons.

Diversification

Private debt is one way for investors to diversify their portfolios. Private debt is often backed by floating rate securities, which means the interest payments float or adjust based on a predetermined benchmark. This helps assure investors that rising interest rates won't impact their small business debt portfolio.

The private debt market can also give investors access to markets they couldn’t invest in otherwise, such as infrastructure debt and renewable energy.

Potential for high yields

Private debt is a viable alternative to a fixed-income investing asset class. It offers attractive risk-adjusted returns with a low correlation to public markets. Investors also have the potential for higher yields because they receive a higher premium than traditional fixed income streams.

Lower risk than equity investing

Private debt is considered low risk compared to other alternative asset classes. Debt also sits higher on the capital structure than equity, so if something happens to the company that causes it to go bankrupt, a private debt investor will get paid first before a private equity holder.

If you want to expand your portfolio by lending private credit to small businesses, you should do your due diligence first. Like any investment, there are risks involved.

You could end up losing your investment if the business fails, although if you're a private debt investor you're more likely to get back at least some of your private debt funds. It’s also less liquid when compared to another asset class because private debt funds are tied to the company and can’t be quickly sold or accessed.

And if you invest in a friend or family member’s business, you could risk your relationship souring if things don’t turn out the way you expect.

A private debt investor has a few options for lending to small businesses. You can decide to loan money to friends or family or to your favorite local businesses. It’s also a good idea to network with other investors and learn all you can about investing in local startups. Your local chamber of commerce is a good place to find out about the companies in your area and start exploring small business investing opportunities.

You can also invest in small businesses through crowdfunding platforms like Mainvest. With Mainvest you can invest in vetted small companies in your local community or elsewhere in the U.S. It provides a passive investment opportunity with a target return of 10% to 25%. You can get started with as little as $100 and you can build a diversified portfolio of small businesses across America, from breweries, to restaurants, bakeries, and more.

Another way to lend private debt to businesses and people and earn up to 8% APR is through P2P lending platform MyConstant. You can also lend out your cryptocurrency holdings to get a return on your idle assets. All lending is backed by the borrower's collateral or a buy-back guarantee. They offer flexible terms so you have more liquidity options than other traditional types of private debt investments.