If you’ve started your own business recently, you’ve already figured out that whatever amount of your initial business investment, it wasn’t enough. It just seems to be an immutable law with business ownership: there’s never enough money. Your company needs updated sales materials, including a complete redesign; you need to move the firm because it has outgrown its current space; you need to buy more efficient equipment, or you’ll lose a large customer order; you need to hire and train additional production employees, but they won’t contribute to revenues for at least six months. All these demands for additional investment, and many more like them, increase the pressure by raising the stakes. Again and again, you’re faced with the issue of whether or not to continue to put even more money into your venture, money that you never thought your business would call on you to put at risk. And each time you ask yourself, “Does this make sense, or am I throwing good money after bad?”. That’s a good question – so how do you answer it?
Unfortunately, many small business owners don’t even try to answer the question. We just figure that the business must have the additional investment, or the risk of failure becomes unacceptably high, and there go more of our life savings. There are, however, other ways to consider whether or not to invest additional cash into our business.
Probably one of the simplest ways is to conduct an elementary return-on-equity analysis. Sounds like fancy finance talk, I know, but the idea is quite simple and can be reduced to a concept we’re all familiar with – should I put my new savings dollars into a 5-year CD at 5½ percent or into my money market account at a 3 percent return?
Here’s how it works. Figure the total dollars of true profit your business can be expected to earn for the next year or two after you have made the additional investment under consideration and convert that into an expected annual profit (1 year). Next, divide that amount by the total money you and any partners will have invested (your equity) since startup. That will give you a rough percent return on your investment. How does the number compare to the return on a CD, a savings account, or a money market account? If it’s pretty close, then maybe you should think twice about putting more money into your company.
Maybe you feel you have to add to your investment regardless, that you have no choice, but this simple exercise can be cautionary and can place your decision into a more real-world context.
A standard concept in finance is that the rate of return on invested dollars is directly related to the risk of not being paid back and the degree of ease of getting your money back on demand. For your additional business investment consideration, think of the money you would invest as a loan to the company.
What rate of return (return on equity) will the firm pay you?
Is yours a “sunk” investment – meaning you can’t get your money back until a major event occurs, such as selling the business – or can you get your money back on demand?
Is there a guarantor who will pay you if the original borrower (your firm) doesn’t?
What lower-risk investments are available to you as an alternative to making this “loan” to your company?
When applied to your own business investment, you can see that these factors would dictate that you should receive a rate of return at least twice that of a CD, a money market account, or other debt investments such as government or high rated corporate bonds. Several business owners I know would be dissatisfied with less than a 20% pre-tax return on an investment in their own firm.
Here’s an example of how a business investment in your own company can seem like a good idea but probably isn’t. Over the past ten years, an acquaintance living in another city gradually invested over $1 million into a specialized packaging business started by him and some partners (his partners are not co-investors). Although the money really hasn’t been his hard-earned dollars (we call him “the heir”), he nevertheless has expressed concern about the wisdom of his investment. When asked about the profitability of his business, however, he brightens and says that his enterprise is nicely profitable. Yet, from conversations with him, I’ve estimated that his annual profit is only about $50,000, or a 5% rate of return on his investment if his salary is appropriately excluded as “profit.”
Small companies in his industry (special freight packaging) have rarely changed hands, so it’s doubtful he could sell his firm for the amount of his investment. In the meantime, of course, he’s earning a 5% rate of return but experiencing a substantially higher level of risk than a simple insured CD would bring. So far, his investment in his business doesn’t make much sense, does it?
So, hang on to your checkbook just a little bit longer the next time your business dictates its need for money to you. Be skeptical, take a hard look, and use this simple test.
Tuck Aikin was a former SCORE colleague of mine for many years until his retirement. Tuck is a prolific writer and wrote small business-themed articles for the Colorado Springs Gazette for many years. As a co-mentor, Tuck was my inspiration for me starting this blog. The preceding post is reproduced with permission from the author.
