A search fund is an investment vehicle formed by one or two individuals who deploy privately raised capital to search for, acquire, and actively manage privately held companies for the medium term. For aspiring MBA entrepreneurs and business owners, understanding the search fund model can unlock new pathways to business ownership and growth.
Whether you're considering launching your own search fund or evaluating investment opportunities, having knowledgeable Denver business lawyers on your side is crucial for navigating the complex legal landscape of these transactions.
Quick Takeaways
- Search funds bridge the gap between traditional private equity and independent business ownership, targeting small businesses valued between $5 and $30 million.
- Key risks include failing to find a suitable acquisition (affects 1 in 3 search funds), operational challenges post-acquisition, and complex legal and regulatory requirements.
- Four-stage lifecycle: raising initial capital, searching and acquiring a company, operating and creating value, then exiting the investment.
- Legal counsel is essential throughout the process to ensure regulatory compliance, proper structuring, and successful transactions.
What Is a Search Fund Model?
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.
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.
Search fund principals raise capital to target small to medium-sized businesses in the lower middle-market. Recent acquisitions reflect an intense focus on high-quality assets, with a median purchase price of $14.4 million and a median EBITDA multiple of 7.0x. Target companies typically have a median EBITDA of $2.2 million and demonstrate a high median EBITDA margin of 27%.
How Does a Search Fund 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. After positive due diligence, the search fund partners negotiate the purchase and raise acquisition capital to complete it. Once acquired, the entrepreneurs take ownership, aiming to grow the company’s value and exit at a profit.
What Are the Risks of Search Funds?
While search funds' returns and success rates are alluring, they are not without risk. The primary challenges relate to the search process, transactional hurdles, and ongoing compliance challenges:
- Acquisition failure risk: About one in three search funds never close a deal within two years, resulting in a total loss of the search investment and time spent.
- Valuation and deal risk: Overpaying or negotiating poor terms can quickly erode returns and cause operational strain from the start.
- Operational management risk: Many search funders lack hands-on experience running small or mid-sized companies, particularly outside their areas of expertise.
- Market and economic risk: Economic shifts or industry disruptions can hurt performance even under strong management.
- Regulatory and legal risk: Complex legal issues involving securities regulations under the Securities and Exchange Commission guidelines, tax planning requirements outlined in the IRS business structure regulations, governance structures, and compliance with state business laws can create significant liabilities if not properly addressed.
- Exit timing risk: The ability to successfully sell or exit the investment depends on market conditions, buyer interest, and timing — factors often beyond fund managers' control.
- Capital adequacy risk: Insufficient acquisition capital or working capital post-purchase can limit growth initiatives and create financial strain on the acquired business.
Addressing these legal risks early by retaining legal counsel can help the search fund entrepreneur ensure adequate consideration of relevant legal issues, saving the partners from the headache of unexpected legal matters and fees later in the process.
Search Fund Cycle
The search fund lifecycle consists of four distinct stages, each with unique challenges and requirements. Understanding this model offers insight into what differentiates search funds from traditional private equity and venture capital approaches.
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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:
- 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 the 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, partners focus on finding a target company with strong cash flow, growth potential, and a sustainable market position. It’s the most demanding part of the search fund process, requiring persistence, discipline, and creativity. Much of the work involves outreach, networking, and overcoming frequent rejection. The acquisition process involves three steps:
- Preliminary evaluation: A quick assessment of the company and its industry to decide whether a deeper inquiry is justified.
- Letter of intent and initial review: Confirming the owner’s intent to sell, identifying key issues, and submitting a non-binding Letter of Intent with valuation and main terms for further due diligence.
- Comprehensive due diligence: An in-depth review of the company’s financials, structure, and operations. This stage often involves reviewing commercial leases and intellectual property rights, and other contractual obligations.
The entire process of the deal typically lasts four to twelve months. After due diligence, the searchers reassess the initial valuation and submit a final offer. This step is critical, as the search fund model provides downside protection by identifying potential failures early in the acquisition process.
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.
Structure options include:
- Limited Liability Company (LLC): Combines the flexibility and pass-through taxation of a partnership with the limited liability of a corporation, making it a popular choice for private investment vehicles.
- Limited Partnership (LP): Involves at least one general partner and one limited partner. General partners manage the fund, while limited partners’ liability is capped at their investment amount.
For comprehensive guidance on establishing the appropriate legal foundation, Sequoia Legal can assist with business formation, operating agreement drafting, and fund structuring. Our attorneys help search fund entrepreneurs navigate state and federal requirements while aligning governance and tax considerations with long-term investment goals.
Search Funds vs. Traditional Private Equity
The search fund model offers a unique approach that distinguishes it from other private equity funds*. The fundamental differences lie in size, management, and target businesses, making them attractive to investors looking to diversify their private equity holdings.
The distinction between the two lies primarily in the target businesses: venture capital firms seek high-growth opportunities in startups. At the same time, search funds tend to target established companies with high-profit margins.
How Successful Are Search Funds? Pros and Cons Explained.
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.
Understanding the full picture of this investment vehicle requires weighing its unique advantages against its operational demands and inherent challenges.
Legal Guidance for a Search Fund Startup
Whether you're an aspiring entrepreneur or an experienced search fund investor, retaining legal counsel from the beginning is a sound strategy to ensure compliance and mitigate risk.
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 purchase agreements, fund documents, and operating agreements
- Due diligence.
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