Everything You Need to Know About Search Funds and How They Work

Are you an aspiring entrepreneur, a CEO-in-the-making, or an investor looking to diversify your investment portfolio? You might want to consider starting or investing in a search fund. Let’s look at a search fund, how it works, and whether it’s the right model for your entrepreneurial or investment strategies.

Back to Basics: What Is a Search Fund

The term ‘search fund’ was first coined in 1984 at the Harvard Business School and was later popularized by Stanford University professor Irving Grousbeck. A search fund falls under entrepreneurship through acquisition (ETA) and is an investment vehicle. Its most popular purpose is to allow budding entrepreneurs to search for, acquire, and run an existing small- to medium-sized business with support from a team of investors. It is especially popular with fresh MBA graduates looking for leadership development opportunities by running or managing a business but can’t start their own business from scratch.

How a Search Fund Works

A search fund model follows a lifecycle where the ‘searchers,’ the individuals forming the fund, first raise capital. They must then find and acquire a business, manage and run it to increase its value, and finally exit it. Let’s take a look at what each stage of this lifecycle entails:

Stage 1: Raising Capital

This stage of a search fund’s life cycle takes place in two rounds and can take between 2 and 6 months. The first round raises initial capital to cover costs related to the search process, and the second round raises funds for the final acquisition of a company. Requirements for initial capital range from $250,000 to $750,000, while acquisition capital could fall between $5 million and $30 million.

‘Searchers’ set up their investment vehicle by crafting a detailed proposal, also known as an Offering Memorandum or Private Placement Memorandum (PPM). This memorandum is a business plan provided to potential investors who could also serve as mentors and advisors. It highlights the search methodology, industries of interest, expected timelines and budgets, acquisition criteria, financial projections of investment returns, and potential exit strategies. It also gives investors a background on the principals or individuals involved in the search fund and their specific roles and responsibilities.

The second round of capital raising begins once the searchers have a target company and have started their due diligence. At this stage, the original investors are not obligated to provide additional funds, and searchers may have to find alternative ways to meet their funding requirements. Some options include new equity investors, a business acquisition loan, or seller equity rollouts and earnouts.

Stage 2: Searching and Acquiring

The search and acquisition stage of this lifecycle is the most challenging and can take up to two years. Searchers first conduct research to identify a company they would like to acquire. They then conduct thorough due diligence on the company and validate the seller’s intent before approaching the seller with a Letter of Intent. Finally, they vet the company’s financial valuation and operations before making their final offer to the seller.

Factors such as the economic environment, regulatory issues, the chosen industry, and a seller’s willingness to sell could impact the search fund’s success at this stage. A 2020 Stanford study on search funds states that by focusing their search and following a strict set of acquisition guidelines, searchers can mitigate risks and improve their chances of successfully closing an acquisition. The same study found that searchers typically target healthy companies with a strong market position and favorable growth opportunities. These companies come from B2B services, technology, and healthcare industries that are easily understood and undeterred by rapid technological changes.

Stage 3: Operating and Creating Value

Once a successful acquisition has been completed, the searchers transition into management positions within the business and set up a board of directors, often including representation from their investors. In their newly minted management roles, the searchers get to work familiarizing themselves with the inner workings of their company before putting in place strategies to improve financial operations and create value. These strategies could include technological improvements, optimizing operations, add-on acquisitions, or organic expansions. The operation and value creation stage could take at least 4 to 7 years, sometimes more.

Stage 4: Exiting

The final stage, exiting the business, occurs when the acquired company sees a significant growth in profitability and value. Reaching this stage can take several years and requires those involved to have a long-term outlook. The searchers and investors then explore various exit strategies such as direct sales, issuing dividends, taking the company public, or repaying investor debt.

The Right Journey For You?

Starting or investing in a search fund is a very personal decision. However, reflecting on your abilities and goals can help you decide whether this is the right journey.

As an Entrepreneur…

You must have a strong desire to run your company and lead it towards significant financial growth and success. Characteristics such as attention to detail, discipline, perseverance, and adaptability will determine your success. With strong leadership and networking skills, a desire to learn, and the ability to handle setbacks and rejection, starting a search fund can set you up for considerable financial and career-related success.

As an Investor…

Search funds can offer a great way to diversify your investment portfolio. Although they are considered significantly high-risk, successful search funds have been known to generate returns of more than 30%. Since search fund investors are also sought out for their mentorship and advisory capabilities, this investment vehicle offers an opportunity for you to leverage your experience and knowledge and play a more active role in determining the success of your investment.

The final word

Although search funds are considered high-risk and time-consuming, they offer an innovative solution in today’s rapidly developing entrepreneurship landscape. They provide a unique opportunity for aspiring entrepreneurs to launch their careers as business leaders with support from investors looking to share their expertise. With the right skill set, reliable advisors, and a healthy serving of perseverance, search funds can significantly transform a young professional’s career and financial standing.

Want to know more about successfully navigating the search fund life cycle? In addition to HR, benefits, recruiting, and payroll through its PeopleOps, Escalon’s Essential Business Services include FinOps (CFO services, taxes, bookkeeping, and accounting) and Risk (business insurance). Talk to an expert today.

This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal, or accounting advice in this article. If you would like to engage with Escalon, please get in touch with us here.