Understanding Search Funds

The path to entrepreneurship isn’t the same for everyone. For some, entrepreneurship means starting a business from scratch. For others, buying an existing business (aka entrepreneurship through acquisition, or ETA) is the path forward. And while buying an existing business can be more attractive for a variety of reasons, it still takes time to find the right business to buy. But how do you support yourself while you are searching? How do you cover the costs of site visits, due diligence and advisory services? Some will choose to self-fund their business search. Another option, which has been around for some time, and is recently gaining in popularity is what is known as a “search fund.” 

At its core, a search fund is a type of investment vehicle formed to support aspiring entrepreneurs while they search for, acquire and eventually run an existing business. Search funds have become particularly popular thanks to exposure through MBA programs, providing a path for recent graduates who are ready to apply their formal business education and take the helm of an existing company. Investors in search funds benefit by receiving a share of the profits that the acquired business generates, in addition to a return on their investment.

There are attributes and intricacies unique to search funds, including their lifecycle, purpose, and strategic advantages. 

Search Funds: A Path To Entrepreneurial Success

Participating in search funds offers a distinctive path to entrepreneurship, involving raising capital to search for, acquire and run a business. This model provides access to valuable networks, mentorship, and the operational know-how of search fund investors, increasing the chances of success in business acquisition and management.

Definition and Origin

Although search funds may not be the most common method of raising capital to buy a business, they actually date back as far as 1984 and are credited to entrepreneur, Stanford University professor and Boston Celtics co-owner Irving Grousbeck. Grousbeck's theory was that a consortium of investors could buy a healthy business, grow it for several years, and then sell it for a healthy return. 

Overview of the a Search Fund’s Lifecycle

Search funds generally have a lifecycle that consists of four stages: fundraising, search and acquisition, operation and scaling, and exit.

• Fundraising involves creating the investment vehicle, drafting a legal document for prospective investors (a private placement memorandum, or PPM for short), and then raising capital. Investors are often sought who are willing to provide advisory/mentorship services as well as capital.
• Search and acquisition is the time-consuming, challenging process in which entrepreneurs identify and buy a business for sale. Some search funds will allocate up to two years for the search process.
• Operation and scaling follows the acquisition. At this stage, the entrepreneur takes over as CEO. 
• The exit stage concludes the life cycle for investors. Several exit options can be considered including an initial public offering (IPO), acquisition by private equity, sale to a strategic buyer, or a management buyout.

Getting Started With Search Funds

Initiating your search fund journey demands strategic planning. Here’s what you need to get started.

Creating an Investment Thesis/PPM

Initiating the search fund journey involves crafting a comprehensive investment thesis and a private placement memorandum (PPM). These documents delineate the entrepreneur's strategy, target industries, and the value proposition for potential investors.

The investment thesis should encompass a clear business strategy, target market analysis, and a compelling value proposition for potential investors, providing a roadmap for the search fund's objectives. Equally important is the PPM, a comprehensive guide that provides potential investors with transparency, risk assessment, and a detailed overview of the search fund's financial structure and terms. 

These documents not only serve as informative tools but also foster trust and confidence, empowering investors to make well-informed decisions. At this stage, investors typically provide enough capital to fund the search process, such as cost of living and out-of-pocket expenses for the aspiring entrepreneur.

Identifying Acquisition Targets

During this stage, entrepreneurs meticulously research and analyze potential companies which align with their investment thesis. The goal is to identify fitting acquisition targets based on financial health, market positioning, and growth potential for successful scaling within the search fund model.

Pitching the Target to Search Fund Investors and Acquisition

Once a target company has been identified, entrepreneurs re-approach search fund investors for acquisition funding. At this point the acquisition process begins, including detailed due diligence, negotiation and deal structuring (which traditionally includes an equity role for the search fund investors). Post-acquisition, the entrepreneur traditionally takes the role of CEO of the acquired company and implementation of the growth strategy begins.

Navigating Challenges in the Search Fund Journey

Although search funds can be an excellent way to acquire and operate a business, there are potential challenges along the way that have to be considered, including typical business challenges as well as those that are unique to this method of getting into a business venture.

Unpredictability in Deal Sourcing

Deal sourcing can be an unpredictable challenge. Identifying suitable acquisition targets that align with your investment thesis can be a complex and time-consuming process. Market dynamics, competition, and economic factors may influence the availability of viable businesses, requiring a flexible and adaptive approach.

Operational Demands Post-Acquisition

Securing a deal is just the start. Transitioning to operational duties requires strategic leadership and effective management — both of which are only as good as the people you bring on board for the project. Newfound owners have to navigate the intricacies of running a business, implementing growth strategies, and addressing any issues that either weren’t known during acquisition or that come up post-sale.

Investor Expectations and Pressure

Although search fund investors play a pivotal role in providing essential financial support, entrepreneurs must skillfully navigate the associated expectations and pressures that come with such partnerships. 

Effectively communicating and aligning their vision with investor interests becomes a crucial aspect of maintaining a strong, productive relationship. Striking a balance between the pursuit of returns and strategic decision-making demands finesse, ensuring a productive collaboration and the continued support of investors throughout the search fund journey is essential for long-term success.

Economic Downturns and External Factors

External factors, such as economic downturns or unforeseen market challenges, can impact the performance of acquired businesses. Entrepreneurs in search funds must remain resilient, adapting their strategies to navigate through challenging economic conditions.

Exit Strategy Complexity

Crafting a successful exit strategy for a search fund involves evaluating multiple options, each with its unique considerations. Entrepreneurs need to weigh the complexities associated with Initial Public Offerings (IPOs), private equity acquisitions, and management buyouts (MBOs).

• IPOs (Initial Public Offerings): Entrepreneurs exploring IPOs must navigate regulatory compliance, substantial expenses, and scrutiny from would-be investors. Assessing the suitability of their business for the public market is crucial for a successful IPO.
• Private Equity Acquisitions: Selling a controlling stake to a private equity firm can yield significant financial gains. However, entrepreneurs should anticipate potential changes in management and operations that the acquiring entity might bring on.
• Management Buyouts (MBOs): In an MBO, the existing management team — including the entrepreneur — acquires the business from the investors. This option offers continuity, but also requires adept negotiation for funding and fair valuation. Entrepreneurs must engage in effective discussions with current owners and potential financing partners for a smooth transition of ownership. Thoughtful consideration of these options ensures alignment with both entrepreneurs' and investors' financial goals.

Final Thoughts

Ultimately, search funds stand out as efficient and successful entrepreneurial options, challenging conventional startup risks and addressing the complexities of self-funding an existing business search and acquisition. When it comes time to explore acquisition targets, visit DealStream, the #1 deal sourcing platform for dealmakers and entrepreneurs.