Best Practices When Investing In Main Street Businesses

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Joseph Drups, founder of Drups Ventures, buys businesses to incubate high-return, passive income portfolios.

I escaped cubicle life at 28, quit my job and achieved financial independence by 30. I didn’t do it by founding a tech startup or joining a unicorn. Instead, I used an investment strategy hidden in plain sight: Main Street businesses.

While many investors were chasing the next big app or meme stock, I bought businesses most people drive by without a second glance. Now, at 36, I’ve acquired, merged and handed off seven small businesses for employees to run.

It’s often said that most startups fail and the majority never deliver positive returns to their investors. Stanford’s Graduate School of Business shows that search funds, a model for acquiring and operating small businesses, had a 35.3% aggregate pre-tax internal rate of return for investors in 2022. By comparison, the average annual return of the S&P 500 hovers around 10%. From my view, this shows Main Street businesses may offer returns that compete with or even exceed traditional investment options such as tech startups or the stock market.

However, success in this asset class requires careful consideration of multiple factors that impact business value and performance.

Evaluating Potential Investments

When evaluating small businesses, careful due diligence is essential. Look for businesses with:

• Strong fundamentals

• Established customer bases

• Proven cash flow

Let me break down how to evaluate each of these critical elements.

Strong fundamentals start with the numbers. Look for businesses selling at three to four times their annual earnings. I’ve found this to be a good benchmark for a healthy business valuation. But go beyond just the numbers; examine how dependent the business is on the current owner. A truly strong business should be able to run without the owner being involved in every decision.

For customer base evaluation, focus on the top clients. How long have they been around? What percentage of revenue comes from each? A red flag would be too much concentration on just a few customers. You want to see a diverse group of recurring customers providing steady revenue.

When it comes to cash flow, don’t just look at profits. Understand the timing. When do they pay suppliers versus getting paid by customers? Look for consistent monthly income rather than sporadic large payments. A healthy business should cover its expenses, debt payments and still have room to grow.

This understanding of cash flow becomes crucial when structuring the purchase. Smart financing can enhance returns while managing risk. Consider these key approaches:

• Certain SBA loans can provide up to 90% financing, which can reduce your initial capital needs while providing longer repayment terms.

• Seller financing lets the previous owner finance part of the purchase, so they can align their interests with your success.

Using leverage strategically, when buying at three to four times the business’s earnings, can help boost your return while keeping payments manageable through existing cash flow.

The Differences Between Main Street And Silicon Valley Investing

Let’s break down how Main Street investing differs from the Silicon Valley perspective:

• Risk profile: Established businesses with proven track records may offer a lower risk profile vs. the “move fast and break things” mentality I’ve found is common in Silicon Valley. However, Main Street businesses still come with their own risks. They can be more sensitive to local economic shifts, and many are heavily dependent on owner relationships. Look closely at customer concentration and management depth. These factors often indicate a business’s true risk level.

• Tangible assets: Business investments have inventory, equipment and customer lists vs. lines of code or other intangible assets often associated with tech investments.

• Time to profitability: While established Main Street businesses have the potential to generate revenue quickly and tech startups often take a few years to become profitable, the transition period matters. Leadership changes and cultural shifts during ownership transition can temporarily impact performance. Before purchasing, evaluate the business’s dependence on the current owner, key employee stability and existing systems to minimize disruption to profits.

• Local opportunities: Tech startups are still largely concentrated in Silicon Valley. By comparison, Main Street businesses are in most cities across the nation. To find the right investment opportunities for you, I recommend building relationships with local business owners and joining professional networks. Start by getting involved in your local business community. Join business organizations, and focus on building genuine relationships. Successful acquisitions often come through trusted connections rather than cold outreach.

• Lifestyle opportunities: For tech startups, it’s often win big or bust. Main Street businesses can offer many lifestyle options depending on the investor’s goals, such as holding for cash flow, selling to an operator or passing as legacy holdings to family members. This might make Main Street businesses an attractive investment opportunity for entrepreneurs, especially for those seeking a more predictable return on their capital or who want to complement a traditional investment portfolio.

Conclusion

The Main Street investing approach focuses on leveraging established businesses to create sustainable, long-term value. And with many Baby Boomers retiring and selling their businesses, I believe this is creating a buyer’s market for investors. Meanwhile, technology—such as e-commerce, digital marketing, artificial intelligence and automation—is helping level the playing field.

The multi-trillion-dollar transfer of small business wealth over the next decade represents a significant shift in the American business landscape. However, success in this space requires careful evaluation, proper due diligence and a long-term perspective on value creation. Are you prepared to understand and evaluate these opportunities?

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.


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