Using your tax return to fund a small business

Tax refund checks have flown through the air as so many homing pigeons, returned to the roost as their owners weighed possible uses.

A family vacation, student loan or credit card payment, or the purchase of something you’ve been eyeing for some time. While it is generally best to pay down debt first, for those that may not have any debt to pay, consider another possibility — investment in a local or small business.

Consider investing in a small business. Between 25 million and 27 million small businesses in the U.S. account for 60 to 80 percent of all U.S. jobs. You may be a business owner yourself, invested in several businesses, or considering starting a business. Regardless of the situation, you may look for a new investment opportunity or diversification of an existing portfolio.

If you are considering investing, there are things to keep top of mind. When determining investing in a business, do your research. For a first-round investor, identify a business that merits investment. Whether the goal of your investment is to build out an industry, support a friend’s budding venture or grow a portfolio, research the sectors that would serve your purpose. (Of course, always be aware of potential risk. For any number of reasons, a new business might fail to thrive, putting your investment in jeopardy.)

Once a candidate is selected, consider doing some research into the business you select. Look at the earnings and factor in growth, current debt and the health of the industry. Work with a financial adviser to review analyst recommendations, the valuation for the business — a price-to-earnings ratio that arrives at a “capitalized” earnings value.

Typically, there are two times to invest in a business or start-up, and two methods for doing so.

A budding business may need a first round of capital early on, at the early or seed stage, for expenses such as a facility, design, packaging, equipment and other initial costs. Getting in on the ground floor of a burgeoning company might be lucrative; before doing so, investors should ensure that they and the new business owner are aligned in

terms of mission and values, just as investors would research any other type of company before investing.

Businesses often need an infusion of capital at a later stage, even when a revenue stream has been established. For example, a business might be ripe for expansion with a larger footprint, additional equipment or staff, and increased demands for product from new or larger markets.

There are various vehicles to invest in a company you select. One method is via equity. An equity position, usually purchased in cash, may give the investor a stake in the company in return for a commensurate share of profits. Thus, providing ten percent of the needed capital might entitle the investor to ten percent of the profits. It also, however, could lead to ten percent of the losses.

In other cases, though, the proportion of investment to ownership might not be equal.

An investor who contributes expertise, mentoring or some other intangible might take a bigger share, as would the investor who provides some needed component, such as an office within a larger complex.

The other vehicle for investing in a business is via debt, that is, a loan made in exchange for the promise of receiving payments, with interest income, until the principal is eventually repaid.

In case the business goes south, a debt position typically gives the financer a priority position in the capital structure of the company such that if it fails, the debt takes priority over the equity partners for repayment.

Looking at nascent enterprises for possible investing requires careful deliberation and a thorough knowledge of the business, the owner and the industry. Such direct investments may

become lucrative, but there is risk of failure: from competitors, from the political or economic climate, from industry changes … and of course, from the people involved. After all, investing in a small business means, to some extent, investing in those who operate it, and that means significant risk due human frailty.

Experts recommend approaching this type of investing with the same eye toward diversification with which an investor would view stocks. Investing in several different businesses, rather than just one, increases the chances that at least one of them will succeed and, hopefully, pay for the others as well.

Contributed photo Joseph Matthews