Search Funds

Interest in search funds has been skyrocketing the past few years and the number of funds raised seems to go up every year. Perhaps this is owed to the incredible success of Asurion, a company now bringing in $8.5B in revenues with some 20K employees, that started as a roadside assistance company being acquired by two Stanford MBAs. Or maybe it’s the allure of skipping the usual years or corporate politics and becoming a CEO right now. Many might be interested in the possibility of making millions through small business ownership. Veterans, especially seem to be attracted to the possibility of leveraging their blue-collar leadership skills as they transition to the private sector.

What is a search fund exactly

While new models are emerging, traditionally and historically a search fund is a fund of $400K for a recent MBA graduate to spend 2 years searching for a small or medium size business (SMB) to purchase and then operate as CEO. Nearly every searcher does not have the capital to fund the purchase price themselves, so the purchase price is funded through a mix of equity, usually from the same investors who invested in the search fund, and debt from banks.

Terms can vary, however, the $400K is usually split with $100K per year paid to the searcher as salary. The rest is reserved for search costs like getting the business setup, buying databases of information, flights and costs with visiting businesses, and deal costs like a Quality of Earnings reports, broken deals, and lawyers.

Credit for the idea of forming a small fund to help a recent MBA graduate find and acquire a SMB is typically assigned to Irv Groesbeck at Stanford in the 80s. Many of his original students from that time frame are still the most prominent investors in the model.

The core concept of buying a business to take over as it’s CEO, however, is not actually new, it is often referred to as being an independent sponsor. There’s no official definition, but from what I’ve seen, someone calling themselves an independent sponsor today tends to be a more experienced executive looking at larger size deals, whereas people who refer to themselves as searchers tend to be recent grads looking for their first deal and first CEO experience. Banks and other financial institutions also tend to be looking for a bit larger deal and someone a bit more experienced when they say they work with independent sponsors. This is not a hard rule.

The most important search fund deal terms are that the search capital (the $400K to search) is stepped up into any deal the searcher completes, usually at 50%. The investors in the search fund also have first right of refusal to buy into the equity portion of any deal the searcher completes during the search timeframe. When the searcher becomes CEO they will typically receive cash compensation at what the investors determine is “market rate” for a SMB CEO. The searcher (now CEO) will also earn equity when certain criteria are met, this is the big upside potential for the searcher and the real reason behind going through all of this. These criteria tend to vary, but from what I’ve seen a ‘standard’ would be 8.3% vesting 1 year after acquisition, 8.3% vesting quarterly over the next 4-5 years, and 8.4% if certain IRR hurdles for the investors are met. Technically these hurdles could be met by growing the profitability of the company and in turn making distributions to the investors and owners of the business and this does happen, but the most likely scenario for meeting these IRR hurdles (often ~25%) are met by selling the company 5-10 years after acquisition. It’s important to remember that most search investors have investors of their own, so they will need liquidity at some point. Many are willing to do a recap and keep going if things are going well, but these kinds of nuances are beyond the scope of this introductory post.

To be clear, if you are successful searcher, acquire a company, and become CEO, you’re are an employee of the company, not the majority owner. You can be fired by your own investors and this does sometimes happen. This is an important risk to consider, since the equity portion of your compensation is the potential upside that makes this attractive. On the other hand your cash and other compensation will typically be significantly below what you would make for a recent MBA graduate, especially during the search phase.

Who is a typical searcher

Historically, it’s a recent graduate of a top MBA program. There is probably nothing particularly special at a top program that makes you a “better” searcher, however, this was a filter used by search investors, many of whom were graduates of the same programs.

This aperture has been opening in recent years, however, as interest in the space has increased substantially. Some investors are not requiring an MBA at all, believing they can take talented people and teach them what they need to know out of a typical MBA curriculum along the way.

What’s it like to Search

Anyone contemplating searching should prepare themselves carefully for the rigors of the search phase itself. Personally I thought I had done all my homework, gone to all the conferences, talked to many successful and unsuccessful searchers, thought I was ready and it was still much harder and more stressful than I was prepared for.

I cannot emphasize this point enough: be sure your significant other, friends, and family are all fully onboard and understand what you will be going through as well. Especially your significant other, if you want them still around after several hard years!

A few thoughts:

• You will likely be making significantly less than your peers if you’re coming straight out of b-school. Way less, if you’re self-funded.
• It will be incredibly lonely, especially compared to the intense social levels of school and the military you may be used to. This is mitigated in the accelerator and partnered search models described below.
• The stress will be very high. You will need to juggle many things simultaneously, such as potentially multiple deals, constantly generating deal flow, recruiting and managing interns, keeping your investors informed and soliciting mentorship & guidance when needed, raising debt and equity financing, and due diligence. All against the backdrop of severely limited funds and time.
• Remember that even if your raise a fund and have investors who have first right of refusal for the equity piece, that does not mean they will be an easy sell on any deal you might like or want to buy. Investors in this space tend to be very disciplined. Almost all of them are focused on taking a risk on YOU, the freshly minted MBA who is going to skip the usual steps and become CEO, not the company they are buying. This is NOT distressed investing and they’re unlikely to be interested in anything that is not producing reliable cash flow with strong upside potential.
• Ego check: even though you may be coming from prestigious schools and/or companies it will be surprising to many how the brokers/bankers/sellers at this level treat you. Most searchers have little track record or capital behind them (having well-known investors helps a bit, but not totally, with this problem) and you’re essentially a backup buyer in most scenarios. Remember when they start the sales process brokers/bankers/sellers are hoping for a strategic acquirer with deep pockets who is going to pay an above market multiple to quickly get a deal done and snap them up. A searcher is a LONG way from that.
• Self-funded is extraordinarily mentally tough as you are spending your net worth (same money you plan to use on an acquisition) on basic living expenses.
• Dealing with people at this  size range can be mentally taxing. Oddly enough, the egos involved can be inversely proportional to the size range. Many ‘business brokers’ are just RE agents who decided that selling a small business isn’t that different than selling a house and are completely inept, unethical, or both, yet somehow think they are Gordon Gekko because they sold a few nearly bankrupt restaurants and franchises. Most sellers on the other hand are actually pretty great once you get past their representation to talk to them, though most are pretty stressed as it is usually their life’s work up for sale and this is the only time they have (or will) go through this process. To be fair, (we) the fresh MBAs are probably just as bad, thinking we know everything despite only trying to get our very first deal done and having little track record or capital to back us up. I am sure the other side would say we are terrible to deal with as well! Many searchers relegate dealing with brokers to their interns and instead focus most of their time on proprietary search.

What Kind of Company Will You Buy

To be clear, you are NOT looking to find and buyout the next Facebook, this is not the same as VC style investing. You are looking for a boring but stable business with steady cashflows, with some upside growth potential. Ideally in a growing industry that will lift all boats. You will be using a ton of debt to make the initial acquisition, so your biggest concern will be ensuring you’re confident the company will produce enough profits to service that debt.

Many/most success stories are of acquiring blue collar companies. The past couple of years the rage seems to be lawn care and landscaping companies. Before that it was pest control companies before the multiples there got out of control. Healthcare related companies like nursing homes and home healthcare have been popular lately as well. Many search investors prefer B2B companies. To get a quick sense you can go to the website(s) of the investors listed below and peruse theirs lists of portfolio companies. Many searchers would love to acquire a SaaS company, and some do, although it can be very challenging to do given today’s multiples on that industry.

You might have the CEO title, but remember CEO does not equal majority owner. You are a moderately compensated employee, with unusually high upside potential in case of a liquidity event. Economics are such that you probably won’t make a ton of money (more than your MBA classmates) unless you have a sale where you increased EBITDA and expanded the multiple compared to purchase price.

Most people contemplating a search fund dip their toes in the water by completing a search fund internship first. This lets you try it out and will also demonstrate to future potential investors your seriousness of purpose and that you know at least something about what you’re getting yourself into. How the internship is structured can vary widely, based on what you negotiate with the searcher, but expect to commit to at least 3 months of part-time, UNPAID, very unsexy and boring grunt work like compiling databases of company CEOs to reach out to.

What if you fail to acquire a business

I have not found an actual data source on this, so on a anecdotal basis only, failed searcher outcomes still tend to be reasonably good. Most commonly I’ve seen failed searchers end up (1) working for one of their investors’ fund or portfolio companies, (2) one of the companies they contemplated buying in an executive role, or (3) returning to a ‘typical’ post-MBA role like Consulting or Tech PM.

For example, after realizing that I didn’t actually want to own a small business and closing my (self-funded) search after a year, I went to work for one of my MBA programs largest employers a couple of months later. I had the huge advantages of that company being used to hiring from school (easier to get past initial screening), having referrals (easier to get into interview pipeline), and classmates who helped me prep for that companies specific interview process (easier to get the offer).

For Veterans thinking about searching directly after the military, I would think carefully about what you will do if you fail before going all in. Unlike the military where we like to say “failure is not an option,” failure here is a very real possibility that you need to have a plan for. I have known searchers who had super impressive military careers, then went to the best b-schools, partnered with the top investors, and still came up short and did not even make an acquisition.

The above paragraph mentioning that things usually work out is largely based on searchers who have attended elite b-schools and have both a pedigree and network to fall back on. Make sure you have a reasonable Plan B too. (And maybe a Plan C).

Models of Searching

Traditional Search: largely described above

Partnered Search: mostly the same as traditional search, but done with a  partner. Usually you raise a bit more money for the search so that both searchers can draw a reasonable salary. Also, you’re usual best case equity reward is raised to 30% instead of 25%, but of course that’s split two ways.

Accelerator: accelerators have been increasing popularity recently as a solution for increasing the successful acquisition rate of searchers. While in the traditional model you are mostly on your own to search, albeit with some guidance, mentorship, and best practices from your investors, accelerators aim to surround you with resources and give you intense mentorship. Most accelerators have a cohort model where you start at the same time as several other searchers and receive a few weeks of training. You are then usually co-located with those other searchers and your investors while you search, with the idea being that this will ‘accelerate’ you’re learning and mentorship. Many accelerators also have a feature where you will share a small equity portion (think 1-2%) of any deal you make into a common fund with your other cohort members, in order to foster cooperation and incentivize you to help each other.

Self-funded Search: a self-funded searcher looks for a business in the same way as a funded searcher, but simply uses their own money to pay for their search costs. Usually this is done with a belief that if they find a business to acquire, they will be able to get better economics than a traditional searcher. From what I have seen, even if you don’t raise a fund, but do find an acquisition, if you go to the traditional search fund investors you will still get a traditional deal terms (less the stepped up basis of course). However, if you are able to raise money from non-traditional investors, there is the possibility of getting significantly better terms and ending up with significant ownership (all the way up to 100% if you use all of your own money). These outcomes seem to be from searchers who had a significant amount of their own money to put into their deal, were able to secure great bank financing like a 7a (described below), and only needed to raise a bit of extra equity/debt financing to round out the deal.

Most self-funded searchers are trying to use an SBA 7a loan to make their acquisition. Although this is certainly not a requirement, it’s a great deal if you can get it. It allows you to only put down 10% of the purchase price. An SBA lender bank provides the rest in a senior loan, which is in turn guaranteed (to the bank) by the government.

There are drawbacks, however. SBA financing has many requirements and most businesses do not qualify. Sellers (and their representatives) tend to be weary of buyers using SBA financing since it usually means you (probably) don’t have the cash to come through and complete the deal if the bank does not give you the loan and because the approval process has a reputation for being longer than other types of acquisition financing. SBA lenders will also not always go up to the full 90% of acquisition price loan for several reasons. First, they will make their own assessment of what the business is worth and how much debt it can sustain, which might differ from what you and the seller have agreed to. Next, SBA lenders will typically only use tax statements instead of accounting statements to make those judgements. Since most SMB owners go out of their way to reduce their taxable income, oftentimes the income reported on their tax statements will not accurately represent the economic value of the business, which is likely what you and the seller have agreed to a price on. Lastly, going up to the full 90% increases the risk to the bank that they might one day need to attempt to foreclose on you, and if they can’t get their money back from you, go through the difficult task of recovering the government guarantee, not a great outcome for them either way.

Additionally, you will likely still need to gather commitments from both equity investors and debt providers (banks) before you are able to seriously look at any deals. Why? Because the first screening question any broker or seller is going to ask is: how are you going to pay for this? Since you (probably) don’t actually have the funds to consummate a purchase, you’ll need to provide some kind of reasonable financing plan. Usually a commitment letter from equity investors and pre-qualifications from bank(s) is enough to get you into consideration as a buyer. If you get farther along in the deal (LOI etc.) these docs may be scrutinized more closely, the seller and their reps may want additional proof of funds and/or to speak with the investors/banks claiming they are going to provide you funding. I have at least one friend who’s seller demanded to meet their main equity investor in person before signing an LOI. Fortunately, the investor acquiesced, flew across the country on short notice, had dinner with the seller, and the LOI was signed the next day.

Who are the main Investors?

• Traditional: Anacapa Partners, Pacific Lake Partners,  WSC & Company, Lexington Search Fund Capital, Search Fund Partners, Relay Investments

• Accelerator: Search Fund Accelerator, NexGen Growth Cap, Alpine Investors

• Sell-funded (for the equity portion, not the search itself remember): This tends to be individual investors, often part of the search community, though there are some small institutions starting to emerge to focus on investing in this kind of searcher

Compensation

First thing to consider here is expected value. According to the Stanford GSB search fund study about 1/3 of searchers never acquire. Another 1/3 do make an acquisition but have a very mediocre or even a negative outcome, after all distributions to investors etc. they might be left with less than what they would have made in typical post-MBA career. The remaining 1/3 have a “good” outcome, but consider in this context that might mean something like walking with $5M - $20M after ~10 years of work. Enough to never have to work again if you don’t want to? Yes. Obscenely wealthy by global standards? Yes. But, go into it realizing that this amazing outcome still wouldn’t be enough to own a private jet or probably even open a Private Wealth account at Goldman, after taxes.

 (Note: these are very rough numbers and breakdowns, you can see a ton of data sliced and diced in interesting ways in the 2020 Stanford Search Fund Study, highly recommended).

• Fund economics

Largely described above but I would highlight that, if at the end of the 2 years you don’t make an acquisition, you DO NOT owe anyone anything. This is not debt. You and your investors just go your separate ways. In some cases, perhaps if your investors think you’ve been doing a good job but have just had some bad luck, they might even give you more money to keep searching for an additional period of time.

• CEO compensation economics

Most search investors will simply say that they pay their CEOs a market rate for SMBs. But then you have to wonder which data source(s) are they using and what metrics are they using to determine ‘market.’ Is it by revenue? Industry? # of employees? Custom KPIs and if the CEO is hitting them? Most investors’ perspective is that they want to pay the CEO enough that they can fully focus on the business, but not enough such that the CEO is not still hungry to grow the business, so that the CEOs upside remains in the equity portion of their compensation and aligned with growing the business.  If forced to put a number out there I would guess $200-350K (Stanford study suggests the same) all in for investor backed CEOs, scaling up if you start growing and crushing it. If you have better data/intel, please let me know on this one. Obviously if you’re self-funded and manage to gain majority ownership, this can be different.

A final note

Remember that unlike the rigid pay scales and rules of the military (and many post-MBA jobs) just about everything I’ve written above can be negotiated. I’ve mostly tried to write to what is ‘typical.’ I bet there are at least a few exceptions to everything above as well. This has been written as a very basic primer targeted for transitioning Vets who have heard a bit about search funds but don’t really know what they are or where to start. If you’re still interested after reading this post I recommend carefully going through the first 3 resources listed below and joining the community mentioned.

This post was written by a Veteran who self-funded a search for a year post b-school. After looking at around 5,000 companies I realized I didn’t actually want to own the type of small business search funds acquire regardless of the title or *potential* to make more money more faster. I welcome feedback to improve this post. Please check out my passion project targeted at High Earners, Not Rich Yet (HENRY’s) at personalfinancegod.com

Resources

• HBR Guide to Buying a Small Business

• Stanford GSB Study and materials

• Jimsteinsharpe.com (several posts specific to Veterans)

• Searchfunder.com

  • The ~$80/mo fee looks steep, however, it is waived if you complete any interaction on the site 1x per month. That includes just hitting like on a post. You can also bank up to 12 months of interactions.

HBR Guide to Buying a Small Business: Think Big, Buy Small, Own Your Own Company (HBR Guide Series)
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