A Guide to Search Funds In ETA
If you’re an aspiring entrepreneur with a keen eye for business opportunities, but lack sufficient capital, a search fund could be your answer.
Entrepreneurship through acquisition (ETA) is a compelling pathway to realize your business ownership goals and own an established business. Search funds provide the financial vehicle to make that dream a reality.
In this blog post, we’ll provide an overview of search funds, contrast traditional and self-funded approaches, how to start one, and shed light on the appeal, challenges, and trends surrounding this exciting option.
What is a Search Fund?
At its core, a search fund is an investment vehicle through which entrepreneurs raise funds to locate, acquire, manage, and grow a company. Traditional search funds are backed by investors who finance the search and acquisition process whereas in a self funded search fund the entrepreneur uses their own resources to finance the search for a target company.
The search fund concept originated in 1984 at Stanford Graduate School of Business. Since its inception, many groups of fresh MBA graduates and experienced managers have successfully established search funds and acquired companies via this innovative acquisition model.
The Appeal of Search Funds for Entrepreneurs
For many entrepreneurs, search funds present a less risky and more immediate path to CEO-ship than starting a business from scratch. They provide an opportunity to lead and grow an established business, avoid the pitfalls of a start up and bring in new ideas and strategies.
There are many success stories of this acquisition method. One of the most notable is Asurion, a technology protection company. It was acquired by a search fund in the mid-1990s when it had about 40 employees and $4 million in revenue. Through strategic growth and acquisitions, Asurion has grown into a multi-billion-dollar company with thousands of employees worldwide.
Stanford Graduate School of Business, a pioneer in the study of search funds, regularly publishes reports on the performance of these funding vehicles. Their 2018 report noted that the aggregate pre-tax internal rate of return (IRR) for search funds was approximately 33.7%, and the aggregate pre-tax return on invested capital (ROIC) was 6.9x.
Traditional vs. Self-Funded Search Funds
One of the defining characteristics of search funds is the method used to finance the acquisition. There are two primary approaches: traditional and self-funded.
Traditional Search Funds
In this model, a “searcher” or entrepreneur raises capital from investors to fund the search process itself. Once a suitable business is identified and acquired, the investor group provides the necessary capital for the purchase.
Traditional search funds generally focus on businesses valued between $5 million and $50 million, seeking investments of $2 million to $10 million in equity capital. They prioritize industries with a spread-out market, aiming for companies that have stable market standings, a consistent history of solid cash flows, and promising long-term prospects for enhancement and expansion.
Pros of Traditional Search Funds
- Access to Capital: Entrepreneurs have the ability to raise a significant amount of capital from investors, allowing them to target a broader range of companies for acquisition.
- Risk Diversification: The financial risk is shared among investors, reducing your personal financial exposure as an entrepreneur.
- Expertise and Networking: Investors in traditional search funds often bring valuable industry experience, mentorship, and a wide network of contacts.
- Credibility: Having a pool of reputable investors can increase the credibility of the search fund, potentially facilitating negotiations and deals during the acquisition process.
Cons of Traditional Search Funds
- Reduced Control & Autonomy: Entrepreneurs must work closely with investors and may have less autonomy in decision-making processes, especially in choosing and managing acquisitions.
- Profit Sharing: Financial returns are shared with investors, reducing your potential personal gain from the success of the acquired company.
- Expectations: There is a higher level of expectation and pressure from investors for successful outcomes, which can be stressful to deal with.
- Complex Capital Structure: Managing investor relations and adhering to the terms of investment agreements can add complexity to the fund’s capital structure and operations
Self-Funded Search Funds
Pros of Self-Funded Search Funds
- Full Control & Autonomy: Depending on the extent to which you self-funded, you as the entrepreneur have the majority or complete decision-making authority without the need to consult external investors. This allows for more flexibility in choosing which businesses to pursue and how to run them post-acquisition.
- Higher Potential Returns: Since there are no external investors to share profits with, you stand to gain a higher share of the financial returns if the acquired company is successful.
- Simplified Capital Structure: Without external investors, the capital structure is simpler, which can make the acquisition process and subsequent company management more straightforward.
- Personal Satisfaction: There’s a deep sense of personal achievement and growth when successfully running a business that has been acquired and improved using your own resources.
Cons of Self-Funded Search Funds
- Higher Personal Financial Risk: Using personal funds increases the financial risk for you as an entrepreneur. If the venture fails, it can lead to significant personal financial loss and possibly negatively impact your credit scores.
- Limited Capital Resources: Self-funding often means limited capital compared to traditional search funds, which can restrict the size and type of companies that can be acquired.
- Limited Expertise and Support: Without a group of investors, you may lack access to broad industry expertise, mentorship, and networks that traditional search fund investors often provide.
- Stress: Managing the entire process alone can be more stressful, as you bear the full weight of decision-making and accountability.
Search Fund Accelerators
In recent years, search fund accelerators have emerged as a valuable resource for aspiring entrepreneurs. A search fund accelerator is a specialized program designed to support and streamline the process for entrepreneurs, particularly newcomers, in establishing and operating a search fund. It offers a blend of educational resources, networking opportunities, and operational support, significantly reducing the learning curve for acquiring and managing a business.
While accelerators can increase the likelihood of success by connecting searchers with experienced advisors and potential investors, they may also involve costs, fees, and sometimes a share in equity, which could affect the independence of the entrepreneur. This model is especially beneficial for first-time searchers and those seeking a more structured pathway to entrepreneurship through acquisition.
The Appeal of Search Funds for Entrepreneurs
Lower Barrier to Entry
Guidance and Support
Entrepreneurship with Reduced Risk
How to Start a Search Fund
Step 1: Define Your Objectives
Step 2: Choose Advisors
Selecting the right advisors is a key part of establishing a search fund. Experienced individuals such as previous search fund principals, business school professors, key investors, and industry leaders can play a pivotal role.
They not only enhance the credibility of the fund, especially for young MBA principals, but also provide guidance throughout the process of searching, acquiring, and managing target companies. Advisors offer a wealth of benefits including a sounding board for ideas, industry contacts for generating deals, and access to networks for fundraising and expertise.
Step 3: Raise Initial Capital
If you’re pursuing a traditional search fund, you’ll need to secure initial capital to finance your search process. This typically involves pitching your search fund concept to potential investors. You’ll need to craft an attractive investment proposition.
Investors are drawn to search funds for several reasons. A standout feature is the potential for high returns. The investment structure of a search fund is also appealing due to its staged nature. Initial investments do not obligate contributors to further capital in the acquisition phase, allowing them to become more familiar with the fund’s principals and the investment opportunity with significantly more detailed information.
A traditional search fund usually involves 8-20 investors, with initial investors often receiving preferential rights in the acquisition phase. These investors buy units in the fund and receive a pro-rata right of first refusal for additional investment in the acquisition, as well as a ‘stepped-up’ interest in the acquired company.
Step 4: Deal Sourcing & Screening
Once you have your initial funding in place, start your search for a suitable business to acquire. This involves extensive market research and financial due diligence. Begin your search by identifying potential acquisition targets. Evaluate businesses based on your criteria, their financials, and compatibility with your objectives.
When selecting a target company for acquisition, ideal candidates tend to be in industries that are fragmented, showing no clear market leaders, and have both historical and projected market growth. The industry should also be stable. The target companies themselves should be of a size that fits within a predetermined revenue range, with potential for growth.
Look for companies that have sustainable and differentiated products, stable cash flows, and a strong middle management team. These features not only enhance the likelihood of a successful acquisition but can also support the company’s ability to thrive post-acquisition.
Step 5: Due Diligence
Once a suitable target company for acquisition is identified, the closing process involves a series of important steps. This includes negotiating an offer and issuing a letter of intent, followed by the issuance of a term sheet. The process then moves to conducting thorough due diligence to assess the company’s viability.
Thoroughly research and assess the financial, operational, and legal aspects of the target business. Identify any potential risks or issues that need to be addressed. This is a good time to bring in the expertise of a highly experienced ETA accountant like Midwest CPA who can assess quality of earnings and do a complete due diligence, forecasting and viability analysis.
Step 6: Negotiation and Purchase Agreement
Step 7: Transition and Growth
In conclusion, search funds represent a compelling avenue for aspiring entrepreneurs who aim to achieve business ownership through acquisition. Whether you’re interested in traditional or self-funded search funds, the allure of lower barriers to entry, mentorship, and a proven business model make them a viable option.
Many entrepreneurs targeting acquisitions under $5 million tend to rely on a self funded search fund approach. With limited resources, it’s critical that you have a very clear strategy and understanding of what’s to come.
As ETA specialists, our team at Midwest CPA are very familiar with how search funds work and their potential to transform your entrepreneurial dreams into reality. Let us help you get this right, from day one.
Contact us for a free consultation, and let’s start shaping your path to business ownership.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.