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Active Investing in Business
Looking to invest in an Australian business? Before you take any further steps, read this. There is a significant difference between passive and active investing. Choosing the right path for you can lead to smart ways to mitigate risk.
Here are the three most important questions you should ask yourself to get the best return on your investment.
Active investing vs passive investing
Put simply, a passive investment means the owner is not involved in the business operations. This can range from a shareholding, to directors and managers appointed.
Under management, can however be a loose term. For example, there’s a term ‘under partial management’ which may mean the owner works 20 hours a week and has a certain defined role. How much will you be hands off in a business if you are the sole owner/investor?
Active investing, on the other hand, refers to investing in businesses where you will be directly involved. An example includes many smaller investments such as bars, cafés and restaurants. Businesses like these are by nature high cash flow businesses, with much higher returns than passive investments. Investors need to have the security of knowing on a day-to-day basis what happens and how the business runs.
The three keys to active investing
When you’re considering investing in an Australian business, the first thing you need to do is look at your return on investment. What is your price/earnings ratio? How much are you paying for the business and what is your earnings capacity going to be? What about your earnings capacity forecast if you don't work in the business? Or if you do work in the business?
From there, assuming the business maintains at its current earnings, you would forward calculate the security of tenure. What are you guaranteed? How long can this business be guaranteed to run for before the lease or major contract expires? This adds another level of depth.
The other biggest consideration is how transferable is the business to you. Is the business going to maintain under new ownership?
That’s where things get more complex; you need to look at the infrastructure, the level of systems and procedures and policies, the staff members, the type of service contracts that the business may have with their customers.
You need to weigh up these considerations before deciding whether to opt for a passive or active investment. Once you take in all these factors you can begin to paint a complete picture as to whether your investment will be a raging success or a bitter disappointment.
Traps for overseas investors
There are always risks when investing in a business from afar, so your best bet is to mitigate possible risks before you purchase the business.
For example, we have a business in a major growth industry that has a very strong return of around $800,000 a year to the owner. However, its top 10 customers make up about 80% of the revenue and there are no forward contracts in place, meaning there’s no guarantee the customers will stay with the business.
While that's a standard within this particular industry, for an outside purchaser this looks extremely risky. Basically, the number one customer, who essentially makes up 30 percent of the sales, is driving the company. If you were to take on the business as a new owner and they were to leave in the first few days, you would be in serious trouble.
How to mitigate your risk
Of course, there are certain sales methods we can structure to mitigate a lot of that risk and share the risk back on the owner. But in a case like this, we would approach the vendor from the start and say, “We need to share this risk a little bit because this person is buying from outside the industry. They're paying a premium price, but for example we're going to accept three quarters of the money up front and you're going to stay on in the business for 12 months. At the end of the 12 months, provided the business maintains, you can get paid the other quarter, and if it doesn’t, you don't get paid. Because we're standing by our business, we're standing by our numbers, we're standing by our relationship with our customers."
We believe taking this approach from the start protects you and the business, which are things we take very seriously at LINK Business Brokers.
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