Ways to Participate in ETA: Search Fund

This is newsletter is the third in a multi-part “ETA Fundamentals” series that covers the following questions:

1. What is Entrepreneurship Through Acquisition?

2. What are the key activities in ETA?

3. What are the the different ways to participate in ETA?

Ways to Participate in ETA

Let’s say you’re sold on the idea of buying a company rather than building one from scratch. I was leaning this way in late 2022, but I realized I had deeper choices to make around how I buy a company. There were different “models” or methods, for buying a company, and I considered the following:

1. Self funded search

2. Search fund

3. Independent Sponsor

This newsletter double-clicks into search funds.

SELF FUNDED SEARCH

Search funds are a niche way of acquiring a business, at least relative to the thousands (or tens of thousands) of self funded searchers. In 2022, 57 search funds were raised, and the total number of active searchers in 2023 is probably 200 - 300 people. In some ways this is an explosion - the data below from Stanford shows the recent rise in search funds - but overall the numbers are quite small relative to the market of people searching to buy a business.

Activities - what you’ll do if you choose the search fund model

Search: the search phase is funded by search investors. The searcher raises a “search fund” that pays for two years of searching. The search fund pays for 1) salary for the searcher and 2) costs associated with searching (travel to visit companies, software, interns, etc). Unlike self funded search, the money raised also covers broken deal costs. The long runway and funding allows search fund searchers to conduct a higher degree of proprietary outreach to business owners. That said, search fund searchers also look at businesses for sale via business brokers. Having lots of “lines in the water” is an important part of doing a search fund, and searchers are often conducting high-volume outreach in disparate industries. The search is focused on companies that can potentially meet the aggressive growth targets set by search investors. Think: healthcare services and software. Searchers are targeting companies with a Total Enterprise Value (TEV) of roughly $10mm - $30mm, although some search fun acquisitions have been over $100m in TEV.

Acquire: Because search investors don’t use the SBA 7(a) debt favored by self funded searchers, there’s a wider possibility of options for debt and equity financing. Search fund searchers typically use debt for acquisitions, but at a much lower percentage than the 80-90% used in SBA 7(a) acquisitions. Some acquisitions (typically software) can be funded with all equity and no debt. The searcher rarely contributes equity to the deal; typically 100% of the equity is provided by the search investors. When the searcher finds a deal, the investors who funded the search fund have right of first refusal in proportion to the percent of the search fund they purchased. (E.g., if an investor funded 10% of the search fund, she has the right of first refusal to buy up to 10% of the company.) If there’s additional equity needed, the search can go to outside equity sources - good companies have no problem getting funded.

Operate: The search fund operator is required to operate the company. For most people doing a search fund (myself included), the chance to operate a growing company as a CEO is the primary draw for doing a search fund.

Resources: what you’ll need to participate

Because a search fund provides the resources to search, the crux of doing a search fund is the ability to raise funds from search fund investors. Typically search fund searcher fit a narrow profile: white, male and recent graduates of either Harvard Business School or Stanford’s Graduate School of Business. In recent years diversity has improved: more women and minorities are searching, you’ll see the occasional searcher without an MBA, and there are mid-career searchers. However, it feels to me that ~70% of searchers fit the typical mold.

As with self funded search, the “soft” resources required are grit and determination. Search fund searchers are competing with self funded searchers, Private Equity funds and strategic buyers. The ability to create connection with a potential seller is key - search fund searchers often win in competitive deals because the seller views the searcher as the best future owner for the company.

Upside: what you can potentially earn

Because search fund searchers are looking for companies in high growth industries, the upside potential for the searcher can be quite high. Searchers have bought companies and later sold for hundreds of millions of dollars, and the largest search outcome was a company purchased in 1995 doing $6mm in revenue that’s now estimated to do $21.5 billion in revenue.

The ownership terms for the search are similar in all search deals: the searcher can earn up to 25% of common equity in the company. The common equity is only valuable in the event that the searcher increases the value of the company, and it vests in three tranches: 33% at the close of the acquisition, 33% time-based over four years, and 33% performance-based for hitting IRR hurdles.

You must balance the best-case scenario against average outcomes. 33% of search fund searchers don’t acquire a company after two years of searching, and some fail to achieve signifiant returns for investors. That said, according to the Stanford study linked to above, the average equity for an exited search fund CEO is $7.57mm.

Hot takes (aka, inflammatory things you might hear people on Twitter saying about doing self funded search)

• Positive: I’m a CEO of a large company with excellent growth prospects, and I’m in control of how long I stay

• Negative: You’re just another employee (with a larger equity stake) sweating to make a 35% IRR happen for investors

Please let me know if there are aspects of search funds you’d like me to double-click into in future newsletters.

ETA Course

If you’re interested in going deeper on Entrepreneurship Through Acquisition, I’ll be teaching a course in November. The goal of the course is to deeply understand the different methods of participating in ETA and choose the one that’s best for you. It’s a live, cohort-based class where you’ll have a peer group to learn with and learn from.

You can learn more about the course and sign up for updates here.

If you have questions about the course, you can set up time to discuss with me here.