Many people have never heard of a “search fund” before, though everyone interested in an entrepreneurial career should be familiar with the term, and the business model it describes.
Because of business school applicants’ growing interest in entrepreneurship, we would like to dedicate a small series of articles to explaining the search fund model. We will make extensive reference to materials developed by Stanford GSB’s Center for Entrepreneurial Studies, especially the Search Fund Primer, which is widely considered to be the premier source of information on the topic. It is an outstanding and comprehensive resource, and we encourage anyone interested in learning deeply about Search Funds to read the Primer in its entirety.
For those who are new to the concept, read on!
What are Search Funds?
The search fund model is often described as “entrepreneurship by acquisition.”
Simply put, instead of becoming an entrepreneur by starting your own company, the Search Model allows people to become an entrepreneur by purchasing an existing company, then managing and growing it.
- Irving Grousbeck, Stanford GSB Professor, Entrepreneur, and Co-Owner of the Boston Celtics, pioneered the Search Fund model in 1984 in order to help give aspiring entrepreneurs the opportunity to search for, acquire, manage, and grow a company.
According to Grousbeck, the Search Fund model is “the most direct route to owning a company that you yourself manage.”
Stanford’s Search Fund Primer displays a flowchart of the Search Fund model to help those new to the idea understand it more clearly, as shown below:
Stage 1 / Initial Capital
Search funds usually raise two rounds of capital.
The initial round of capital in “Stage 1” is oftentimes approximately USD $450,000, raised from 10+ investors who contribute $35,000 – $50,000 each.
The initial round of capital covers salary for the entrepreneur, or “searcher,” along with administrative costs, legal fees, due diligence fees, travel costs etc. This pool of capital provides an entrepreneur with the money they need to search full time for a company that they can purchase from the owner, which they assess has strong commercial potential for growth.
According to the Search Fund Primer: “In exchange for the initial search capital, each investor receives (1) the right, but not obligation, to invest pro-rata in the equity required to complete the acquisition and (2) conversion of the search capital, typically on a stepped-up basis (e.g., 150 percent of the actual investment), into the securities issued as the acquisition capital.”
Stage 2A / Search for Acquisition
After a searcher has raised this initial round of capital, they devote themselves full-time to researching, contacting, and meeting with business owners. They use a variety of strategies to research companies and business owners which they believe are targets for acquisition. The search phase can vary in length between 1 – 30 months, or however long the entrepreneur is able to make their initial pool of capital last.
Searchers spend some time creating a pipeline of companies, and set ambitious targets on a weekly or monthly basis for outreach. They may research companies in sectors where they have experience and interest, or may choose to research companies in any sector and filter by annual revenue, or any other metric they choose.
Over the course of the search phase, entrepreneurs will meet with as many company owners as possible, attempt to value the business, persuade the business owner to share the company’s financial documents with them, and eventually persuade the company owner to sell their business at a fair price.
Stage 2B / Acquisition Capital & Closing
Once a searcher has been able to successfully persuade a company owner to sell their business at a fair price, they go about raising enough capital to buy the target company. Initial investors from stage one are offered the opportunity to invest on favorable terms, and other investors may join the deal at this stage.
The entrepreneur then closes the deal with the existing company owner by transferring capital, providing liquidity for the company owner, and taking over ownership and management of the target company.
According to the Search Fund Primer:
“The acquisition is expected to be at fair market value. The purchase prices of search fund acquired companies have ranged from less than $1 million to $71 million, with a median of $8.5 million, with 54 percent in the $4-$12 million range. Ideally, the acquired company would provide adequate cash flow and not be highly leveraged, so that the short-term survival of the company does not rely on immediate, significant improvement in company performance by the search funders.”
Stage 3 / Operation and Value Creation
Searchers assume operation of the target company at this stage, and use all of their managerial knowledge and skills to create as much value as possible within the company. Entrepreneurs may choose to reorganize the company, hire additional staff, expand sales and marketing efforts, etc.
Stage 3 may last between 4 – 7 years, where the search fund entrepreneur methodically builds and grows the value of the business. It usually takes at least 5 – 10 years for a traditional entrepreneur to build and sell a company, and that length of time is comparable for a search fund entrepreneur.
After the search fund entrepreneur believes they have built enough value in the company to sell or merge it and give a reasonable return to their investors, they will proceed from Stage 3 to Stage 4.
Stage 4 / Exit
The eventual goal of a search fund is to create enough value within the company that the searcher can exit the company, providing the best return possible to their investors and for their own time, energy, and efforts.
If you are interested in learning more about the Search Fund Model, and seeing if it may be a good fit for your own professional ambitions, stay tuned for upcoming posts in our series on Search Funds.