Why More Entrepreneurs are Choosing To Build Search Funds over Startups

BY ORINOLA GBADEBO-SMITH - FINANCE EDITOR @TOPTAL

Once an Obscure Asset Class

There are many ways into the colorful world of entrepreneurship, from the impact or bootstrapped venture, to the super-charged, venture-backed startup; and not far behind are usually their starry-eyed entrepreneurs armed with their unicorn dreams, pedestalled founder-gods, and dizzying ambition—“through technology we’ll change the world,” they often quip. But controlling for Silicon Valley’s powerful myth-engine and its entrepreneurs’ infectious idealism, we are left with more grounded reality. The failure rate for startups is high, the pressure on entrepreneurs immense, and financial and psychological fallout often devastating.

It is against this backdrop that alternative models for entrepreneurship have emerged. One such model is entrepreneurship through acquisition, better known as the search fund. Once an obscure, esoteric track, the search fund model has seen a recent surge in popularity by a select cohort of formally trained entrepreneurs (e.g., ex-bankers, ex-private equity investors, ex-consultants, and ex-operators), most of all those who deeply understand their motives, risk appetites, and contextual/financial encumbrances.

In this article, I will explore what the search fund model is, the reasons for its emergent prominence, and why it may represent a far superior path for the well-trained, introspective and prudent entrepreneur.

The Search Fund

A search fund an investment vehicle that affords an aspiring entrepreneur the opportunity to raise permanent capital with which to search for, acquire, and scale an existing, cash flow-positive business. The origin of the search fund dates back to 1984 and was the brainchild of prolific entrepreneur turned academic, Irving Grousbeck. Grousbeck, in between grading HBS papers and managing his newest toy (the Boston Celtics), generously pioneered the concept as a way to afford young and talented but unproven business persons a direct path to owning and managing a company and creating wealth.

The Search Fund Stages

The search fund’s lifecycle runs through four major stages: (1) fundraising, (2) search and acquisition, (3) operation and scaling, and (4) exit.

Stage One: Fundraising

At launch, the entrepreneur or pair of entrepreneurs incorporate a limited liability company and draft a private placement memorandum (PPM) with which to approach shortlisted investors. Formal capital is then raised in two staged phases: (1) the funding required to finance the search (search capital); and (2) the funding required to acquire the target once it has been identified (acquisition capital).

In a typical search fund, the search capital is used to pay the entrepreneur a modest salary of around $80,000 per year as well as cover administrative and deal-related expenses (e.g., office space, utilities, flights, legal, due diligence, and advisory costs) over two years. Once a target has been identified, given due diligence, and negotiated, the search fund entrepreneur then raises the acquisition capital to purchase the company.

Typically 10 or more investors purchase one or several ownership units of the search fund at an average price of $35,000 to $50,000 per unit, implying an average (and median) initial search capital raise of $400,000 – $450,000. In exchange, each initial investor receives: (1) the right but not the obligation to invest pro-rata in the equity required to consummate the acquisition, and (2) conversion of their search capital into the securities issued as the acquisition capital, typically on a stepped-up basis (e.g., 1.5x the actual investment).

Stage 2: Identifying & Acquiring the Target

Unlike fundraising, which can be efficient given the number of dedicated investors in the asset class, the target identification and acquisition process is often time consuming and emotionally trying. According to the 2016 Stanford CES study, the duration of the median search is roughly 19 months and, depending on the complexity of the deal, can take a further 6 months to close.

Acquisition targets are typically high-margin growth businesses whose founder or founders are looking to exit for reasons ranging from age or general exhaustion (coupled with a lack of succession options), to irreconcilable differences between founders. What is common across all scenarios, however, is that the founder(s) are willing sellers.

Acquisitions are usually executed at fair market value, i.e., at EBITDA multiples ranging from 4.0x to 8.0x, and enterprise values ranging from $5 million to $20 million. Typically, a minimum equity commitment of 10% of the target’s purchase price is required, with the differential being financeable with debt.

It is important to note though that a given search fund may or may not find an acquisition target; if a target is not successfully found, the investors make no capital contribution and the fund is dissolved.

Stages 3 and 4: Operation & Exit

After a company is acquired, the search fund entrepreneur typically assumes the helm of the company as CEO. The entrepreneur builds the company, creating value in one or more of the following ways: revenue growth, margin expansion, adroit capital structuring (i.e., use of leverage), bolt-on acquisitions, exit-multiple expansion, or product, channel, and geographic diversification.

Exit opportunities post successful operation include IPO, private equity acquisition, sale to a strategic buyer, and/or management buyout. In addition to a competitive annual salary, successful searchers usually earn a meaningful share of the upside—this upside is almost always structured to vest upon the realization of specific performance hurdles. A common vesting structure vests one-third when the acquisition closes, one-third over time, and one-third upon hitting pre-defined performance targets.

The Typical Searcher Profile

Most search fund entrepreneurs are relatively young and draw from a diverse range of professional backgrounds. Specifically, searchers typically range from 24 – 54 years old with a median age of 32, and often hail from the following backgrounds: Private equity (27% of all searchers), general management (12%), management consulting (11%), investment banking (11%), sales (6%), operations (5%), and even the military (9%). Other noteworthy statistics include: 82% of searchers have MBAs, 72% of all first-time searchers are solo founders and not co-founders, and only 5% of all search entrepreneurs are women.
In totality, these statistics speak mostly to the fact that searchers come in all shapes and sizes, but above all, one’s skillset and ambition (not experience), are the key determinants for a successful search fund fundraise.

The Asset Class’ Performance

As an asset class, search funds have achieved a return on invested capital (ROI) of 8.4x and an internal rate of return (IRR) of 36.7%, with top performing funds returning well over 200x the initial capital invested. The performance of individual search funds varies widely—distribution by ROI and IRR respectively range from >10x (ROI) or 100% (IRR) for highly successful companies, to total capital losses for the least successful.
Isolating the returns for search funds that are still in operation, the aggregate multiple on initial capital invested (MOIC) stands at 1.9x, implying an IRR of 23.0%. For terminal search funds (i.e., those for which the searcher has exited the business), returns are 16.7x MOIC and 43.5% IRR.
To the search fund entrepreneurs themselves (based on an available sample of 52 searchers in 2016), the average personal cash return at exit is roughly $9 – $10 million over 5 – 7 years, which equates to $1.3 – $2 million per year of personal wealth creation.

The Darker Side to Search Funds

Expectedly, there also exists a less glamorous side to search funds. The first is as follows. Though the asset class’ cash return profile averages $9 - $10 million to the entrepreneur, the distribution is skewed by outsized successes. The reality is, most first-time searchers do okay with their first attempt, but subsequently go on to raise huge quantums, post which achieve their noteworthy successes.

The second truth is that search funds require the same non-trivial time-commitment (5 – 7 years) that venture-backed startups do, but without the explosive upside potential that characterizes the latter. In defense of search funds, however, the somewhat capped upside comes with a materially muted downside, implying a more comparable and often superior risk-adjusted reward proposition in favor of search funds.

Third, and in sharp contrast to the in-vogue big-data and AI-enabled tech startups, the sorts of companies acquired by search funds categorically lack “sex appeal.” First, they are often located in the least metropolitan cities of the most salt-of-the-earth, middle-American states—think Boise, Idaho; Helena, Montana; or Oklahoma City, Oklahoma. Second, their industries typically veer toward the old world—again, think specialty chemicals, oil-pipeline cleaning, and dark-fiber laying sorts of companies; very profitable but woefully dry. Imagine breaking to your new spouse that they’ll be moving to Boise for the next 5 – 7 years because you just closed on your dream widget factory.

The final truth to search funds is that its ecosystem lacks the depth and robustness of its startup counterpart. There isn’t the vast ocean of venture capital on tap (check out Toptal Finance Expert Alex Graham’s article, Guide to Venture Capital Portfolio Strategy); there aren’t any incubators or accelerators that offer training wheels for the virgin entrepreneur; and there aren’t many support groups for your darker days. With search funds, you are in the deep end from time zero: finding investors will be mentally taxing; cold-calling around a disorganized, fragmented landscape of small-businesses for 12 – 18 months will be painful; and dealing with middle-American, Baby Boomer founders that “don’t trust city slickers” will test even the strongest. That said, once you close on that already profitable, fast-growing business and assemble the all-star team that will help your scale to IPO, you will be in a very different mental space from your startup counterpart who continues to dance on the edge of oblivion. Life’s about trade-offs.

UNDERSTANDING THE BASICS
- How Do Search Funds Work?
The search fund lifecycle involves four stages: Fundraising, Search & Acquisition, Operating & Scaling, and Exit. Fundraising involves raising the search and acquisition capital; Search & Acquisition involves acquiring a suitable target; Operating & Scaling involves the entrepreneur(s) leading the company to Exit.
- What Is a Search Fund?
A search fund is an investment vehicle established to house a captive pool of capital raised to support one or a pair of entrepreneurs in their search for, acquisition of, and operation through to exit of a single, privately held business.

Is a Search Fund Right for You?

Now endowed with this information, let’s turn to the question of whether entrepreneurship through acquisition is right for you. To expediently answer this, I offer a framework—a set of questions to help you efficiently root out your motives, skills, personality, and risk profile.

“The two most important days in your life are the day you are born and the day you find out why.”
–Mark Twain

Question One: Who am I, and what are my motivations?

The “Who am I, and what are my motivations?” question is by far the most important of your entrepreneurial life, and the one worth obsessing over. Too many aspiring entrepreneurs overweight on the “what” of their journey, as opposed to the “why”—“what company shall I start?” or “what sectors should I explore?” or “what product should I go to market with?” But without the “why” to your “what,” I can promise that you will be left rudderless and adrift at your first brush with adversity. So, motivations…

Over the years, several schools have emerged and distilled the entrepreneur’s motivations into three major typologies. The first is Rich vs. King, coined by Noam Wasserstein of Harvard University and the author of The Founder’s Dilemmas. The second is Missionary vs. Mercenary, coined by John Doerr, the legendary Kleiner Perkins Caufield & Byers venture capitalist (explored in the following article). And third is Opportunity vs. Necessity, introduced by the World Bank’s Open Knowledge Repository.

Rich vs. King: “Rich” is defined as a psychology driven more by the opportunity for financial gain than by the need for control; “King” is defined as a psychology driven more by the need for control than by the prospect of financial gain. As is often reiterated by the Kauffman Foundation, Rich and King represent the two most common drivers of why entrepreneurs embark upon their journeys, with many of the other motivation types (sub-drivers) falling under these headers. Drivers such as wealth creation, financial security, power, status, and self-actualization fall under Rich; while drivers such as control, a leadership calling, autonomy, independence, lifestyle, flexibility, legacy, and impact (i.e., a tighter loop between decisions and organizational impact) fall under King.

Missionary vs Mercenary: This is the next most prominent motivation typology, and arguably the more powerful. “Missionary” is defined as a psychology driven by a cause or mission greater than the self; while “Mercenary” is defined as a psychology driven mostly by the self or by the prospect of personal gain. As with Rich and King, many other sub-drivers fall under the Missionary and Mercenary banners. The drive to impact society, to make a difference in a small or large community, or the desire to right an injustice are sub-driver examples that fall under Missionary. While financial gain, the need for a greater challenge, achievement, wealth, or power, and status complexes are examples of drivers that fall under Mercenary.

Opportunity vs. Necessity: This is the third and most psychologically fundamental of the three typologies. This category brings us closest to the entrepreneur’s subconsciousness and innermost workings—their dreams, their aspirations, their fears, their struggles. The “Opportunity” entrepreneur is one driven by hope, i.e., the prospect of something greater, e.g., greater return, greater status, greater impact. The “Necessity” entrepreneur is one driven by context, fear, and oftentime desperation, often launching as a solution to a real-time survival struggle.

So, are you Rich vs. King, Missionary vs. Mercenary, chasing Opportunity, or acting out of Necessity? Do you understand your sub-drivers—is this about wealth, power, self-actualization, leadership, or just passion about nurturing products that no one has seen before? If you are King and not Rich, Missionary and not Mercenary, or excited at the Opportunity to take the helm of business, shape its vision, and be the architect of its expansion, then you should resist the siren song of the Valley and explore a search fund.

Please note, though, that, whatever your answers may be, you should embrace them unapologetically. And even after you’ve come to satisfactory answers, keep probing, keep digging, and keep asking “Why?” Great resources in this regard are: the 5 Whys, the Root Cause technique, and True North.

Question Two: What is my risk profile?

The second question you must ask yourself is, “What is my contextual risk profile?” (i.e., your personal risk profile juxtaposed against your life-context and life-stage). Asked differently, are you comfortable with open-ended risk in pursuit of long-tail outcomes (venture-backed startups), or are you more conservative? Does your marital status, familial or dependent status (wife, children, aging parents), or financial status (loans, mortgages, healthcare bills, and other encumbrances) affect, even slightly, your personal/situational risk profile?

If your risk appetite is indeed more conservative, or your situational context calls for serious financial obligations in the short to medium term, it may be more prudent to swing for a base-hit (a search fund) with somewhat capped upside but materially muted downside. A reasonably sure $5 - $10 million outcome in 5 - 7 years before attempting your home-run probably isn’t the worst outcome or decision.

If, on the other hand, you are truly comfortable with open-ended risk, are independently wealthy or otherwise have a cleverly designed safety net, you probably should consider the bigger swing in the form of a venture-backed startup—motivations dependent, of course.

Question Three: What is my skillset?

The third question in our decision matrix is, “What does my background and skillset look like and what do they suggest is the right course for me?” Are you formally and classically business trained—either academically with a bachelor’s or master’s degree in business administration, or professionally as an ex-banker, strategy consultant, P.E. investor, or operating professional (sales, marketing, operations)?

Do you either naturally, or due to training, see, identify, measure, and seek to mitigate risk? Or do you simply see unbridled upside with little room for other concerns? Do you know how to conduct financial analyses, build budgets, diversify portfolios (products, geographies, assets), model, research, segment, and size markets, craft strategy, value businesses, or conduct due diligence? If your answer is “Yes” to any one of these questions, you are one of the few who are qualified and well suited to raising a search fund.

If, on the other hand, you aren’t classically trained but do have a passion for building products or companies, then there will be no better teacher than the school of hard knocks—i.e., a startup.

Question Four: What is my personality best suited to?

The fourth and final step in the process of understanding what is right for you is to understand, “What personality type am I?” Are you easy-going, flexible, and fluid? Or do you need order, structure, and discipline to excel? Do you thrive in unstructured, dynamic, and borderline chaotic environments, or is multitasking not your greatest strength? Do you have a sufficiently high hustle-quotient to navigate multivariate environments with limited resources, or would you perform better in a well-capitalized enterprise, with room to think, breathe, and thoughtfully execute?

If you are on the more structured side, I would strongly recommend a search fund. Search funds require you to raise once, and thereafter focus on executing. In contrast, the founders of venture-backed startups are constantly walking a tightrope—constantly raising and reraising, developing and launching their product, creating and educating new customers, getting right their pricing and distribution models, and more, all the while building teams and cultures from scratch, managing debilitating cash burn and VC expectations. Hard work!

A Surer Path

Ultimately, millions of marketing dollars are devoted annually to keeping the venture financed startup mythology alive. But, similar to the high school student with the option to stay in school or drop out in pursuit of his rockstar dream (i.e., shooting to be the next Valley unicorn), I am of the opinion that most of you should take the path you likely took if you are reading this article. Go to college! Raise a search fund—it is the safer, more secure path to leadership, autonomy, wealth creation, and impact, and one that likely fits neatly with the skillset you’ve spent years acquiring.

More interestingly, the search fund industry has continued to evolve. I’ve had conversations with newer funds whose investors have allowed entrepreneurs to acquire up to two to three portfolio businesses over their 5 – 7 year lifespan. If one acquisition has the potential to yield $9 – $10 million on average, I’ll leave it to you to work out what 2 – 3 successful exits in a small portfolio can yield, with the same muted downside risk.

Executive Summary:

What Is a Search Fund?
A search fund is an investment vehicle established to house a captive pool of capital raised to support one or a pair of entrepreneurs in their search for, acquisition of, and operation through to exit of a single, privately held business.
Once an esoteric asset class, search funds have seen a substantial rise in popularity in recent years with the number of first-time search funds rising from 62 (in 2001) to 258, as of a 2016 Stanford GSB Centre for Entrepreneurial Studies (CES) study.
International search funds are also having their day in the sun with 45 first-time funds raised, up from zero as recently as 2007.

How Does the Search Fund Process Work?
Search funds have a four-stage lifecycle: (1) fundraising, (2) search and acquisition, (3) operation and scaling, and (4) exit.
Fundraising is split into two sub-stages: (1) raising search capital (i.e., capital used to search for a suitable acquisition target), and (2) raising acquisition capital (i.e., capital used to purchase the business once it has been identified).
The Search and Acquisition stage involves the deployment of both the search capital and acquisition capital to the ends of acquiring an already profitable, high-margin business.
The Operating and Scaling stage involves the entrepreneur(s) assuming the helm of her acquired company, building a team around it and scaling it toward an exit.
The Exit involves the liquidation event for the search fund's initial investors, often in the form of a private equity sale or acquisition, an IPO, or a management buyout.

How Have Search Funds Performed?
The aggregate pre-tax internal rate of return (IRR) to the search fund asset class is 36.7%, implying a pre-tax return on investment (ROI) of 8.4x.
The cash return to the search entrepreneurs upon exit averaged $9 - $10 million, after five to seven years of operation.

How Risky Are Search Funds Relative to Traditional Startups?
Entrepreneurs who raise search capital have a 75% chance of finding and buying a business and a 67% chance of successfully scaling and exiting it, equating to a 50%+ chance of success for a young, first-time CEO.
This probability is in sharp contrast to the less than 10% success rate that characterizes venture-backed startups.