A search fund is an investment vehicle formed by individuals who deploy privately raised capital to search for, acquire, and actively lead privately held companies for the medium term. Sequoia Legal will tell you more about search fund below.
Search Fund Explained
In 1984, H. Irving Grousbeck, a professor at the Stanford Graduate School of Business, founded the first search fund while helping two students raise capital to purchase their first business. Shortly thereafter, the idea gained popularity among motivated entrepreneurs who aspired to run their own businesses but lacked the capability to start them. The number of search funds eventually grew from 20 in 1996 to over 400 search funds in operation by 2020.
Search funds are exceptionally appealing to newly minted MBAs looking to fast-track their path to the C-Suite. Many entrepreneurs making up today's search fund partners are looking to gain leadership experience growing and building a new company. The potential for lucrative financial returns is also a significant draw. According to a 2020 Stanford Study, search funds' aggregate pre-tax internal rate of return was an average of 32.6 percent, with an aggregate pre-tax investment multiple of 5.5x for invested capital.
Overview of a Search Fund
One or more entrepreneurs make up the leadership of a search fund, commonly referred to as the search fund partners. These partners use the fund to pool private investors' capital to conduct a fund search for a company's potential acquisition. Generally, the target companies are smaller, medium-sized businesses valued between $5 million and $30 million. Popular industries for investment are easy to understand and unimpeded by rapid technological change, such as software, education, healthcare, and financial services.
Upon the successful acquisition of a target company, the partners assume the company's management role. As managers, they attempt to improve their profitability to increase the company's overall value. After maximizing value, the partners exit the business through a sale or alternative liquidity event at a higher price than purchased initially.
How Do Search Funds work?
The search fund process is relatively straightforward, search fund entrepreneurs:
- Raise initial capital for a search;
- Search for an acquisition;
- Acquire a target company;
- Manage and grow the company;
- Finally exit when the time is right.
To launch a search fund, the partners must first raise enough capital to cover the overhead costs of a search. The entrepreneurs then conduct seller outreach to identify potential target businesses owned by a party interested in a sale. Once the partners identify a potential investment, they conduct due diligence into the company's financial history and operations. Following a positive due diligence outcome, the search fund partners negotiate a purchase with the sellers while raising acquisition capital to fund the purchase. After a successful acquisition, the entrepreneurs become the business's new owners. Their ultimate goal as owners is to increase the company's value and eventually exit the investment at a profit.
Search Fund Cycle & Structure
The search fund life cycle is the beating heart of the search fund business model. Four stages comprise the life cycle: stage one, raising the initial capital to fund the search; stage two, searching for and acquiring a company; stage three, operating and managing the acquired company; and stage four, exiting the investment.
Stage 1 - Initial Capital Raise
Raising enough capital for search fund investors to get a search fund off the ground can take anywhere between two to six months. The partners spend this time raising capital in two phases: the search phase and the acquisition phase.
Search Capital Phase
Search capital covers the salary and wages of the partners, administrative costs, and other related expenses incurred while searching for target companies, this typically ranges from $250,000 to $750,000. Frequently, an investor's initial investment of search capital comes with a pro-rata right-of-first-refusal to invest in an acquisition. Essentially, this gives the search capital investors a right but not an obligation to invest additional capital in an acquisition.
Acquisition Capital Phase
Entrepreneurs raise acquisition capital once due diligence on a target company begins, as discussed further below. The average purchasing cost falls between $5 million and $30 million. The partners first request additional capital from their original investors. If they cannot cover the entire cost, they look for new equity investors, lenders, and even the target company's seller for additional financing.
Stage 2 - Search and Acquisition
During this phase, the partners focus their search efforts on companies with a viable business model, a history of positive cash flows, growth potential, and a sustainable market share. Searching for a target company is the most time and energy-intensive portion of the search fund process. While most funds acquire their first business within twenty-three months of their search, one in three funds fails to find a suitable investment. The search is an art rather than a science because it requires relentless drive, discipline, and a creative approach to finding sellers. Much of this phase involves cold calling, networking, and dealing with rejection. An entrepreneur may contact 1,000 businesses and undergo due diligence only one or two.
After identifying a potential target company, the entrepreneur conducts a three-step acquisition process. First, the fund makes a hasty evaluation of the company and industry to determine whether a further inquiry into the company is warranted. Second, the searchers qualify the owner's intent to sell, identify issues for further investigation, and submit a Letter of Intent with a non-binding valuation, major terms, and a list of items to explore for more comprehensive due diligence.
Finally, the searchers conduct a thorough vetting of the company's financials, structure, and operations. It is not uncommon for the entire deal process to take four to twelve months. Upon completing the due diligence process, the searchers reevaluate the nonbinding valuation based on their findings and submit a final offer.
Stage 3 - Operation and Value Creation
Once the offer is accepted, the partners establish a board of directors and assume control of the newly acquired company. After understanding the business's operations, the fund executes a strategy to create value. These strategies might include correcting operational inefficiencies, facility expansions, add-on acquisitions, or technological improvements. Typically, the entrepreneurs operate the company for three to seven years before exiting the investment.
Stage 4 - Exit
Once the entrepreneurs implement their value-creating strategies and an opportunity to exit the business materializes, they enter into the exit stage of the life cycle. This stage could involve a direct sale of the company, a public offering, or an alternative liquidity event.
Search Fund Structure
A search fund's structure involves a fund agreement outlining governance, earnings distribution, and financing terms. However, structuring can become somewhat complex given the jurisdiction of the investors and partners and any tax planning considerations. When structuring a search fund, partners should seek legal counsel to ensure they are in compliance with state and federal regulations. Search funds are generally structured as either a limited liability company or a limited partnership. A limited liability company, or LLC, is a business structure for private companies that combines the aspects of a partnership and a corporation. LLC's benefit from the flexibility and flow-through taxation of partnerships and maintain the limited liability of a corporation. Limited partnerships, or an LP, are a type of partnership with at least one general partner and at least one limited partner. Partners in an LP are only liable for the amount they invest.
Why Are Search Funds Successful?
Most successful search funds thrive because of their nimble size, which allows them to work closely with sellers and hyper-focus on acquisition details. Search funds distinguish themselves from other private equity funds by targeting different business fundamentals, like stable cash flows and sustainable growth, compared to other funds, like venture capital firms. This distinction makes them attractive to investors looking to diversify their private equity holdings.
The major difference between search funds and venture capital is their target businesses. Venture capital firms seek high-growth opportunities in startups and firms in the early growth stage. In contrast, search funds traditionally target established companies with a proven track record and high-profit margins.
Pros and Cons of Search Funds
The search fund model offers downside risk protection because investment failures are usually identified at the early stages of acquisition during the due diligence process.
67% of entrepreneurs who find and buy a business successfully scale and exit that investment. Venture capital's success rate is less than 10%.
Search funds demand a high investment of a manager's time and energy.
Capital is not enough. Investors' feedback and guidance on target companies are necessary given the relatively limited experience of the younger search fund entrepreneurs.
What Are the risks?
While search funds' returns and success rates are alluring, they are not without risk. Despite their full-time efforts, one in three search funds fails to acquire a company within twenty-four months of launch. Potential investors and entrepreneurs face risks related to finding a suitable company to acquire, completing a transaction, and managing and growing the company to provide an attractive return. Additionally, legalities involving tax planning, securities, governance, and term agreements pose risks that could cripple a search fund.
Some search fund disadvantages may deter potential investors and entrepreneurs from pursuing a fund in the first place. For example, individuals interested in gaining exposure to cutting-edge industries like technology should steer clear because most entrepreneurs lack the leadership expertise to run a technology company successfully. Search funds are not suitable for investing in startups because their success depends mainly on small to medium-sized companies with proven track records. Additionally, investing in distressed companies or startups is more aligned with other areas of the private equity space.
Do I Need a Lawyer to Start Up a Search Fund?
Yes. Search fund entrepreneurs should consider the various legal issues associated with raising capital, financial structuring, acquisitions, tax considerations, and operations. Retaining legal counsel at the beginning stages of a search fund would help ensure adequate consideration to relevant legal issues, saving partners the headache of unexpected legal matters and fees later.
Sequoia Legal Can Assist You in YourSearch Fund Acquisition
Our varied experience with entrepreneurs, private equity firms, startups, and corporate M&A deals allows us to handle many of the unique legal challenges you might face. At each step of the way, our attorneys work closely with you, becoming an essential part of your team. Sequoia Legal can provide you with various services through the search fund life cycle stages such as:
- Business Formation
- Baseline Acquisition Structure
- Regulatory Compliance
- Tax and Transaction Structure Analysis
- Negotiating and Drafting Documents
- Due Diligence
Contact Us for a free consultation!