Joseph Drups buys businesses to incubate high return, passive income portfolios. Check out a Financial Freedom Blueprint: DrupsInvesting.com.
There is an investing approach I’ve used for years that I’ve found can be turned into a passive framework and has the potential to generate high returns. What is it? The answer is an often-overlooked asset class that’s hiding in plain sight on Main Street, USA: buying a profitable small business and setting it up to run itself.
To illustrate this, we can use the return on investment formula—returns divided by the cost of the investment. For instance, if a business earns $1 million a year and sells for $4 million, or four times its earnings, that translates to a 25% return. If it sells for $3 million, or three times its earnings, that’s a 33% return, assuming the business maintains its historical performance.
Seven years ago, I decided to test out this theory. Since that time, I purchased, founded and merged eight small businesses. This process earned me consistent triple-digit yields on my capital. But, there’s a problem.
• It requires active management. Purchasing a small company means you become the operator. It’s a job, not truly passive investing unless you turn it passive.
• It’s hard to diversify and scale. Putting all your eggs in one small business basket can be risky. But diversifying across many is extremely difficult and time-consuming as an individual. Over the past decade, I learned that scaling a small business portfolio is a team effort.
MORE FOR YOU
Getting Started
Here’s a system that I’ve used to invest in small businesses successfully:
1. Consider creating or joining an investing community or club. An investing club is a group of people who come together to pool resources and expertise to vet potential investments for members. Being the founder of a club that specializes in small-business investing, I’ve found that if you create or join a club to invest in small businesses, you’ll want to ensure you’re working with operators who have a track record of success in purchasing, operating and vetting businesses.
2. Partner with vetted operators. This step is crucial because small business investing differs greatly from public market investing. While public companies often have thousands of employees and large management teams unaffected by small investors, in a small business, an investor and operator can determine its success or failure through their own knowledge and actions.
It’s important to look at a deal from a place of success and failure. Your operator should understand how to execute a parachute plan that can still protect the investor and stakeholders if things go wrong. Seek to line up risk with control and experience. Operators should have skin in the game and a track record of success.
3. Search for high-quality small businesses. When evaluating potential investments, focus on the quality of earnings. Ask yourself: How long has the business been successful? Does it have consistent earnings? Is it growing? Consider the risk of technological obsolescence, and assess the management team’s experience. Simplicity often pays dividends.
Ensure you perform thorough due diligence and understand the business’s financials. If you’re working with a team of seasoned investors and operators, you can use their expertise to help spot red flags and de-risk the investment.
4. Use borrowed funds responsibly to enhance returns. If using leverage, you can try to get your cash back quickly with preferential treatment on the front of the deal to help de-risk leverage. If you’re considering personal guarantees, consider whether you have the control and experience to successfully judge the risk of the investment first.
5. Set up the business to be self-managed from day one. Turning businesses into self-managed organizations is a complex topic. If you’re not an operator yourself, this is why it’s important to ensure you’re working with one who knows how to stand up processes for this. Having the right people on the bus will help ensure your investment can be passive.
For example, my journey to passive investing was iterative. My initial purchases required hands-on involvement, but with each acquisition, I refined my approach by expanding my team, developing robust processes, improving documentation and implementing automation. Over time, this created a repeatable model. Each new business required less of my daily attention than the last. By my most recent acquisition, I could hand off operations to my team on day one, eliminating the need for my daily involvement. It takes persistence to build and refine your operational framework with each investment.
6. Implement expert oversight and guidance for operators. Review and check in on the business. If you lack the expertise, ask the operators and investors who have skin in the game alongside you to help. Use management scorecards, key performance indicators and periodic audits of the business, financials and operations to bring transparency to the goals and progress of a management team and create a self-managed business.
If you follow these steps and repeat this process multiple times, you could build a well-diversified portfolio of small business investments. A crucial element of this strategy I use is implementing what I call “overwatch insurance.” Bring experienced professionals into your investment club who can audit businesses and step in to course-correct and protect investor capital.
What To Keep In Mind
Passive investing in small companies is a method that holds great potential, however, it’s important to recognize that acquiring small businesses is a team effort, and experience is critical. In my experience operating as a deal maker, investment club partner and operator, success often requires a community of like-minded people, including operators, executives, board members and investors. Unless you’re ready to roll up your sleeves, become the operator yourself and put in the time to gain expertise in running a successful small business, you’ll need to find the right “who’s” to fill out your investing team.
Many baby boomer business owners will retire over the next few years, which I believe presents an opportunity for those willing to seize it. The next time you walk down Main Street, take a closer look at the local businesses. That quaint coffee shop or family-owned hardware store isn’t just part of your community; it could be your next big move.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
Forbes Business Council is the foremost growth and networking organization for business owners and leaders. Do I qualify?