Introduction
Have you heard of search funds, but you want to know more how they really work? If you’re an entrepreneur or investor looking to explore search funds as an asset class and a path to business ownership, this post will hopefully give you some insights. The search fund model has gained traction over the past few decades, offering a unique way for aspiring business owners to acquire and grow existing companies. In this blog post, we’ll dissect the mechanics of the search fund model, explain its relevance to entrepreneurship, and provide insights into its key components, including the search fund process and capital structures.
What is a Search Fund?
A search fund is an investment vehicle designed to provide entrepreneurs with the capital they need to find, acquire, and manage a privately held company. Unlike traditional startups, where a new business is created from scratch, search funds focus on buying and scaling existing businesses. This model was first developed at Stanford Graduate Business School in 1984 and has since become a popular avenue for entrepreneurial finance.
The Phases of a Search Fund
Search Phase
The search phase is the initial stage where the entrepreneur looks for a suitable company to acquire. Search funds are typically funded by a group of investors who believe in the potential of the entrepreneur leading the search. In a traditional search fund (as opposed to a self funded search), these investors provide the initial capital (known as search capital) required to cover the entrepreneur’s living expenses and search costs for a specific period, usually up to two years. This process involves extensive research, networking, and due diligence to identify businesses that fit the search criteria. The entrepreneur, often referred to as the “searcher,” uses the initial capital to finance this phase, which includes travel, legal fees, and other related expenses to operating their search fund.
This phase is crucial because the success of the entire venture hinges on finding a company with solid fundamentals and growth potential. The searcher will often focus on industries they are familiar with and look for businesses with stable cash flows and a strong customer base.
Here is a helpful interview with a searcher which looks at the search capital phase in more detail:
Acquisition Phase
Once a target company is identified, the acquisition phase begins. This stage involves negotiating the purchase price, securing additional financing, and closing the deal. The searcher typically raises additional capital from the original investors and may also seek out debt financing to complete the acquisition.
The equity structure during this phase usually involves the searcher receiving a significant ownership stake in the company as an incentive to drive its growth and success. The investors also receive equity in the acquired business, proportionate to their initial investment and any additional funds they provide as acquisition capital.
Operation Phase
After acquiring the company, the searcher transitions into the role of CEO, taking on the responsibility of managing and growing the business. This phase can last as number of years and focuses on implementing new strategies, improving operations and profitability, and driving revenue growth.
The success of this phase is critical to the overall return on investment for both the searcher and the investors. Effective leadership, strategic planning, and operational excellence are essential components for achieving the desired outcomes.
Equity Structures in a Search Fund
Initial Equity Allocation
In a search fund, equity allocation is a vital aspect. The initial equity is usually split between the searcher and the investors. By the end of a search fund’s lifecycle, the searcher typically receives about 20-30% equity in the acquired company, while the remaining 70-80% is held by the investors. This allocation incentivises the searcher to achieve the best possible outcomes for the business, aligning their interests with those of the investors.
Equity Incentives
To further motivate the searcher, additional equity incentives are often provided based on performance milestones. These milestones may include achieving specific revenue targets, profitability benchmarks, or other key performance indicators (KPIs). Performance-based equity grants ensure that the searcher remains committed to the long-term success of the company.
Investor Returns
Investors in a search fund expect to receive a return on their investment through equity appreciation and dividends. The goal is to grow the acquired company, increase its value, and eventually achieve a successful exit, such as selling the company or taking it public. The returns for investors can be substantial if the searcher effectively scales the business and achieves significant growth.
Debt Structures in a Search Fund
Leveraged Buyout (LBO)
One common approach in search fund acquisitions is the leveraged buyout (LBO). In an LBO, the searcher uses a combination of equity and debt to finance the purchase of the target company. This allows the searcher to leverage the company’s assets and cash flows to secure additional funding.
Debt financing in an LBO typically comes from banks, private lenders, or other financial institutions. The searcher needs to carefully manage the debt load to ensure that the company’s cash flow can cover interest payments and principal repayment.
Debt Service
Properly managing debt service is crucial for the success of a search fund acquisition. The searcher must ensure that the company’s cash flow is sufficient to meet debt obligations while also funding growth initiatives. This requires careful financial planning and risk management to avoid over-leveraging the business and jeopardising its financial stability.
Refinancing Options
Over time, the searcher may explore refinancing options to optimise the company’s capital structure. Refinancing can involve securing more favourable loan terms, extending repayment periods, or reducing interest rates. This can enhance the company’s financial flexibility and support its long-term growth objectives.
Benefits of the Search Fund Model
Reduced Risk
One of the significant advantages of the search fund model is the reduced risk compared to starting a business from scratch. By acquiring an established company with a proven track record, the searcher can mitigate many of the uncertainties and challenges associated with launching a new venture.
Access to Expertise
Search fund investors often bring valuable industry expertise and networks to the table. This support can be instrumental in helping the searcher make informed decisions, overcome challenges, and unlock new growth opportunities.
Financial Upside
The potential financial upside of a successful search fund acquisition can be substantial. Both the searcher and the investors can benefit from equity appreciation, dividends, and a profitable exit. This makes the search fund model an attractive option for entrepreneurs and investors looking to achieve significant returns.
Challenges of the Search Fund Model
Lengthy Search Process
The search phase can be time-consuming and uncertain. Finding the right company to acquire may take several months or even years, requiring patience and persistence from the searcher. The pressure to identify a suitable target within the allotted time frame can be intense.
Management Transition
Transitioning from the search phase to the operation phase can be challenging. The searcher must quickly adapt to their new role as CEO and effectively manage the acquired company. This requires strong leadership skills, strategic thinking, and the ability to build and motivate a high-performing team.
Financial Risk
While the search fund model offers reduced risk compared to starting a new business, there are still financial risks involved. The success of the acquisition depends on the searcher’s ability to grow the company and generate returns. If the business underperforms, both the searcher and the investors may not walk away having made any money.
