Search funds have emerged as a powerful vehicle for entrepreneurs looking to acquire and manage a small to medium-sized business, and an ever more attractive asset class for investors.
They generally come in two distinct forms: traditional search funds and self-funded searches. Understanding the differences between these two methods is crucial for aspiring entrepreneurs as each path offers unique advantages and challenges.
Traditional Search Funds
A traditional search fund begins with an entrepreneur raising capital from investors to finance the search for an acquisition target. The process generally unfolds in two phases: the search phase and the acquisition phase.
Search Phase
In the search phase, entrepreneurs raise initial capital (known as ‘search capital’), specifically designated for the purpose of searching for a business to acquire. This initial funding typically covers salary for the searcher, administrative costs, travel expenses, and other related costs. The investors who provide this capital gain the right of first refusal to invest in the final acquisition, aligning their interests with those of the entrepreneur.
The search phase usually lasts between 18 to 24 months, though it can vary. During this time, the searcher is expected to identify and vet potential businesses for acquisition. The key challenge here is finding a suitable business that aligns with the investment criteria agreed upon with their investors.
Acquisition Phase
Once a suitable acquisition target is identified, the searcher returns to the fund’s investors to raise additional capital for the acquisition itself. The searcher may also bring in new investors to provide acquisition capital, particularly if any of the investors who provided search capital don’t wish to take part in the acquisition of the company the searcher has sourced. The terms of the ac
quisition can vary, but investors typically provide the bulk of the equity required, often supplemented by debt financing. As part of the deal, these investors usually receive equity in the acquired company, and the searcher gets an equity stake as well as a management position within the company.
Advantages of Traditional Search Funds
- Reduced Financial Risk for the Searcher: Because the initial capital is raised from investors, the entrepreneur does not have to bear the financial burdens alone.
- Access to a Network: The investors and their networks can provide valuable resources, advice, and connections.
- Focus on Searching: The upfront capital allows the entrepreneur to devote their full attention to searching for a suitable acquisition target.
Challenges of Traditional Search Funds
- Investor Alignment: The searcher must align with investors’ expectations and investment criteria from the beginning of the search, which can sometimes limit flexibility.
- Dilution of Ownership: The entrepreneur usually has to give up a more equity to investors in return for them backing their search, diluting their ownership in the acquired business.
- Time Pressure: The investor’s money typically comes with a timeline, putting pressure on the searcher to find a suitable acquisition within the stipulated period.
Self-Funded Search
In contrast, a self-funded search involves the entrepreneur (searcher) using their own resources to finance the search for an acquisition. This approach eliminates the need for initial outside funding and provides the entrepreneur with complete control over their search process.
Search Phase
During the search phase in a self-funded search, the entrepreneur bears all the costs related to the search, including salary, travel, and administrative expenses. While this increases personal financial risk, it also means that the searcher retains full control over the process and the criteria for selecting a target business.
This phase also includes the due diligence process, where the entrepreneur evaluates potential acquisition targets. Since there are no external investors involved at this stage, the entrepreneur has the flexibility to move quickly and make decisions independently.
Acquisition Phase
Once a target is identified, the self-funded searcher transitions to the acquisition phase. At this point, the entrepreneur typically raises capital from outside investors to finalize the purchase. These investors are investing in the entrepreneur and the acquisition for the first time, given they haven’t provided capital for the search as would have happened in a traditional search fund model.
Advantages of Self-Funded Search
- Full Control: The entrepreneur retains complete control over the search process and decision-making, without needing to align with investor criteria during the initial search phase.
- Higher Ownership: Because there is no investor involvement initially, the entrepreneur ends up retaining a larger equity stake in the acquired business.
- Flexibility: Self-funded searchers can adapt their search criteria and process more freely, reacting to market conditions and opportunities as they arise.
Challenges of Self-Funded Search
- Higher Financial Risk: The searcher bears all the financial risks associated with the search, which can be significant.
- Resource Limitations: Without external capital, the searcher may have fewer resources for salary, travel, and other expenses related to the search and less support from experienced investors who may bring valuable experience and industry connections.
- Funding the Acquisition: Although not impossible, raising capital for the acquisition without having an established relationship with investors can be challenging.
Recommended watching/listening
This lively podcast debate from Acquiring Minds gives listeners some great insight into the difference between the two search fund models:
Recommended reading, sources and citations:
- This substack post from ‘Big Deal Small Business’ goes deep into the maths of explaining how traditional and self funded searches differ from a maths perspective: https://bigdealsmallbusiness.substack.com/p/the-math-of-traditional-vs-self-funded
- Private Market Labs provides a strong summary of the difference between the two models here: https://privatemarketlabs.com/traditional-vs-self-funded-business-acquisition/#:~:text=TL%3BDR%3A%20Self%2DFunded%20Searches%20are%20best%20for%20those,and%20the%20backing%20of%20investors.
Conclusion
Both traditional search funds and self-funded searches offer viable paths for acquiring a business, but they come with distinct advantages and challenges. Traditional search funds are the most common form of search fund. They provide a lower financial risk and access to a valuable network of investors, but they require alignment with those investors’ expectations and typically result in a more diluted ownership stake. On the other hand, self-funded searches offer greater control and flexibility, albeit with higher personal financial risks and potentially fewer resources.
Ultimately, the choice between a traditional search fund and a self-funded search will depend on the entrepreneur’s financial situation, risk tolerance, and personal preferences. Understanding these differences thoroughly will enable aspiring entrepreneurs to make an informed decision on the best path forward in their journey to acquire and manage a business.
