Startup Financing

Search Funds: What You Need To Know About This Investment Model

Search Funds: What You Need To Know About This Investment Model
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From billion dollar garage startups to tech unicorns, investors globally are being bombarded with companies hoping to become the next industry disruptor.

Amidst all the hype is a lesser-known niche known as search funds.

In 1984, H. Irving Grousbeck, the Director of the Center for Entrepreneurial Studies at the Stanford Graduate School of Business, pioneered a new investment model, commonly termed a “search fund.” The objective of a search fund is to provide a vehicle for young, aspiring entrepreneurs to search for, acquire, manage, and grow a company.

Search funds started slowly in the 1980s and then picked up steam in the ’90s and 2000s. Today, the median search fund spends 19 months looking for and acquiring a company, and raises $426,000 of initial search capital. The fund searches for a high-growth, high-margin business, valued at $5-20 million. Acquisition targets are typically businesses that have an older founder looking to retire, a middle-aged founder looking to turn over the reins, or a warring pair of co-founders that elects to bring in new management. 

To date, over 175 search funds have been raised. A 2013 study conducted by the Stanford Center for Entrepreneurial Studies concluded that a portfolio of first-time search funds produced an aggregate, pre-tax internal rate of return of 35% and an aggregate, pre-tax return on invested capital of 10x.

Some key considerations to help your search fund succeed:

1. Raising capital

You will need to raise capital for your fund and this will depend upon your budget regarding salary, administrative, travel and deal related expenses. It is important that you not merely source capital but also identify investors who can act as potential advisors and assist with deal evaluation, structuring and execution, in addition to potentially serving in a Board capacity post transaction.

2. Identifying a business

You will be required to network, cold call, research, and pitch to prospective businesses wishing to be acquired. This is where the entrepreneurial mind-set will need to prevail. Be prepared to learn by doing as you work your way towards finding the perfect business for your search fund. If you are starting a search fund with a partner, be sure to identify someone who has a skill set and mind-set that complements yours.

Related: The How-To: Map Your Startup's Financial Journey

3. Making an acquisition

The purpose of the search fund is to create value- for you, the company you acquire, and most importantly your investors. As such it is important to closely scrutinize the company’s financials along with the micro and macro business environment that the company operates in. Consider high growth, high margin, and high revenue per employee businesses. More formal analysis using enterprise value is also helpful. 

This stage will entail various formal processes including the structure of the transaction, performing due diligence, sourcing debt financing, securing equity commitments, negotiating the entrepreneur’s earned equity allocation with investors and planning the post transaction transition.

4. Operations and value creation

As you will be an external party walking into an established business, gaining trust and a real understanding of the business will be paramount.

Once the entrepreneur has built trust and gained comfort operating the business, value creation will become key.

Possible growth levers could be geographic market expansion, improvements in operating efficiency, investments in sales and marketing or add-on acquisitions. These means of creating value are not mutually exclusive; ideally, more than one will apply to a search fund investment.

Your investors have a direct interest in growing your company over the next several years up to the exit event. Their goal during this period is the same as yours: to increase the value of your company by expanding the business.

5. Exit

Most search funds are established with a long-term outlook, generally greater than a three-year time horizon, and often longer. The average hold period for a search fund investment is seven years, and the most successful search fund deals have been held for more than ten years.

Investors will eventually require liquidity and this will involve one of several exit strategies. Liquidity events for investors and principals can occur through a number of avenues including an outright sale, initial public offering, a debt or equity recapitalization or dividend distributions.

6. The road ahead

The path of a search fund entrepreneur is not for everybody. Searching for, acquiring and operating a lower, middle-market company requires a significant amount of physical, intellectual and emotional energy. Entrepreneurs must have the ability to successfully navigate in an environment with constant, high levels of uncertainty and challenge. 

The massive upside is the opportunity to identify real potential, lead a business towards your vision, and in the process, create tangible value. 

Related: Looking Further Ahead: Your Business May Do Better With A Non-Traditional Funding Route