26 Feb The Search Fund Model
There are many paths to entrepreneurship, from bootstrapped ventures to startups, and some are definitely easier than others. However, startups have high failure rates, and entrepreneurs are under immense pressure to succeed. It’s against such a backdrop that alternative entrepreneurship models have evolved. One such method is acquisition-based entrepreneurship, otherwise known as the search fund model. While it was once esoteric and obscure, it has recently become more popular among those who understand their own risk tolerance, motives, and financial encumbrances. In this guide, readers will learn about the search fund model, the reasons for its popularity, and why it is the right option for introspective, prudent, and trained entrepreneurs. Read also about a secure dataroom to support business transactions in general.
What are Search Funds?
Search funds are investment vehicles that give entrepreneurs the chance to raise capital with which they can find, purchase, and scale existing businesses. The search fund model got its start in 1984, when entrepreneur Irving Grousbeck touted the idea as a way to give young, talented businesspeople a straighter path to business ownership and wealth creation.
The Stages of Search Funds
The lifecycle of the search fund has four stages: fundraising, acquisition, scaling and operation, and exit, as explained in the sections below.
- Fundraising: During launch, an entrepreneur will incorporate an LLC or limited liability company and create a PPM (private placement memorandum) for distribution to investors. Formal capital is raised to finance the search and acquire the target company. In most cases, multiple investors buy ownership units, and in return, they get the right to make pro-rata investments in acquisition equity.
- Identification and acquisition of the target: Unlike the fundraising stage, which can be quite efficient, the target identification and acquisition stage can be time-consuming and emotionally draining. Targets are often high-margin companies whose founders are looking for a way out, and acquisitions are typically done at fair market value. Not all search funds find acquisition targets, and in such a case, the fund would be dissolved.
- Operation: When a firm is acquired, the entrepreneur usually takes over as CEO. They build the company, creating value through margin expansion, revenue growth, capital structuring, acquisitions, and diversification.
- Exit: After a successful operation, exit opportunities include IPOs, strategic sales, acquisition of private equity, and management buyouts.
Along with competitive annual salaries, successful searchers often receive other advantages as well.
A Profile of the Average Searcher
Search fund entrepreneurs are often young, from a variety of career backgrounds such as general management, private equity, management consulting, sales, operations, investment banking, and the military. More than 80% of searchers have earned MBAs, over 70% work solo, and about 5% are women. Such statistics speak to the fact that search fund entrepreneurs are a diverse group, and that ambition and skills are more important than experience.
Search Funds’ Performance as an Asset Class
The search fund asset class has achieved an ROI (return on investment) of 8.4x and an internal return rate of almost 37%, with the highest-performing funds returning more than 200 times the initial capital investment. Individual fund performance varies widely, and for entrepreneurs themselves, the average exit-based cash return is $9 to $10 million over five to seven years.
The Benefits of Search Funds
Since its inception, the search fund community has grown to include a successful group of advisors, operators, and investors. Entrepreneurs who work in this area can benefit in the following ways.
- Increased credibility: An entrepreneur who wants to acquire a middle-market company without a committed investor group may face skepticism from business owners. However, the search fund model lends credibility by validating an entrepreneur’s abilities and providing capital access.
- Diversified experience: Every investor brings something different to the table, and search fund entrepreneurs find this to be a powerful advantage during the evaluation phase. Post-acquisition, an operator will find the search fund network to be helpful in the execution of operational initiatives.
- Financial support: The operational capital raised to conduct searches provides entrepreneurs with a distinct advantage over those who start the business acquisition process on their own. A search fund entrepreneur is paid a salary throughout the search process, and they have enough capital to finance infrastructure, office space, and due diligence expenses. Furthermore, entrepreneurs have the advantages provided by existing accounting and legal relationships, which allows them to defer certain expenses until transactions are finalized.
The Disadvantages of the Search Fund Model
While the search fund model has many advantages, there’s a not-so-glamorous side as well. Though the asset class can return $9-$10 million to an entrepreneur, distributions are skewed by huge successes. In reality, first-time search fund entrepreneurs only see moderate success, going on to more noteworthy achievements later on.
Another thing to consider is that the search fund model requires the same time commitment as a venture-based startup, but without the high upside potential. In the search fund’s defense, however, the limited upside potential comes with a smaller and more manageable downside, which implies a superior risk/reward proposition.
Finally, in comparison to today’s popular tech and big data startups, search fund acquisitions aren’t as appealing. Acquisitions are often found in non-metropolitan areas, and their industries often lean toward the old-fashioned.
The search fund ecosystem often lacks the robustness and depth of the startup market. There’s not as much available venture capital, there aren’t any training tools for new entrepreneurs, and there are few support systems when things aren’t going as planned. With the search fund model, an entrepreneur is all-in from the very beginning, and finding investors can be taxing. However, when an entrepreneur closes on a fast-growing, profitable business and puts together a team that can help them scale to an IPO, they’ll be in a different place than a startup counterpart who’s always on the edge of failure.
Is the Search Fund Model the Way to Go?
Now that readers have this important information, they can decide whether acquisition-based entrepreneurship is an effective strategy. To answer such questions, entrepreneurs must determine their motives, assess their skills and personality, and evaluate their tolerance for risk. By considering the factors listed above, an entrepreneur can enter the process well-informed.