October 24, 2022
Adam Hoeksema
About a year ago I stumbled upon what seemed like a strange niche corner of the small business world - searchers.
At that point I had been the Executive Director of an SBA lender for a decade and had never heard of a “searcher” despite the fact that we had closed many, many small business acquisition loans. Through spending some time on Searchfunder, and SMB Twitter it started to click for me and I started to really dig into how this all worked.
I have a background in accounting, am the Co-Founder of ProjectionHub, and spent a decade in SBA lending and it still took me a while and multiple different websites and podcasts and Twitter of course to kind of put it all together. I figured I am not alone and that there are others just learning about search funds for the first time, so I wanted to put together what I hope will be a pretty comprehensive introduction to search funds. Below is the outline of what I plan to cover.
- How did Search Funds get started?
What is Entrepreneurship Through Acquisition?
- Self Funded Search
- Buy a Business with No Money Down
- Who makes a good searcher?
- Do you have to have your MBA?
- Finding Search Fund Investors
- Finding a Searcher to Invest In
- How Much to Raise for a Search Fund?
- How Long Should it Take to Find an Acquisition?
- Where to Find a Business to Buy?
- What types of Businesses does a Search Fund Buy? (Roll Up Acquisitions & Tech Companies)
- What is the Average Size of a Search Fund Business Acquisition?
- How to Finance a Search Fund Acquisition?
- How Much Does the Searcher Invest into the Acquisition?
- How Much Ownership does the Searcher Retain?
- What is the Typical IRR Expected from Search Fund Investors?
- How to Calculate the Expected IRR for Search Fund Investors?
- How to Forecast Cash Flow of an Acquisition?
How Long do Search Funds Operate a Business?
So much to cover, let’s dive in!
What is a Search Fund?
A search fund is an investment vehicle that allows an entrepreneur to raise funding from investors in order to acquire a company according to Wikipedia. The entrepreneur, also known as the “searcher”, will take a leadership role at the acquired company and operate the day-to-day of the business.
When I first heard about this I thought people were just making up names for what sounded like finding investors to help you acquire a company. Why all of the strange terms like search fund and searcher?
Well there are some aspects that make a search fund more than just finding a couple of investors to help you come up with the capital to acquire a company. The primary thing, from my perspective, that makes a search fund unique is that the searcher will actually find investors to put capital into the fund in order to pay for a reasonable salary for the searcher as well as search costs like due diligence and travel expenses for potential acquisitions.
Basically the search fund concept acknowledges that it takes time to find a good business to acquire and time to close the deal. There are investors that might like to acquire a business, but they don’t have the time to source the deal, complete due diligence, and close the deal, so they take their capital and invest in a search fund and a searcher that can do that work.
A search fund also solves a couple of problems for the searcher:
- It can be a full time job to find the right business to acquire and close the deal. The search fund allows the searcher to quit their day job and dedicate full time to finding a deal.
- By bringing in more investors, a searcher can acquire larger businesses than they would otherwise be able to on their own. Let’s say a searcher has $100,000 to commit to buying a business along with an SBA loan, they might be able to acquire a business for $1 million. But by bringing in more investor capital, the searcher can target much larger opportunities.
There are two distinct phases of a search fund:
- The search - During the search process the investors will put in capital to fund the searcher’s salary, travel and due diligence expenses. So let’s say 5 investors each put in $100,000 each to fund a search process for up to 2 years. Those investors are putting in that capital for a right to buy a pro rata share of the target company once identified.
- The acquisition - Once the target company is identified, let’s say the acquisition price is $10 million. To keep it simple in this example, let’s assume the search fund is paying all cash for the business and not borrowing any money, so the search fund needs to come up with $10 million in investment. Each investor would then have the opportunity to invest $2 million into the deal since that was their pro rata share of what was invested into the search fund initially. If one of the search fund investors declines to invest the $2 million into the deal, their $100,000 that was invested in the initial search fund is effectively lost, and one of the other investors would have an opportunity to invest more and hold a larger percentage of the company post acquisition.
After the acquisition the search fund investors would each own a portion of the company, but the searcher would also retain a percentage of the company. We will get into more of those details later.
How did Search Funds get started?
The search fund concept was originated by Stanford Professor H. Irving Grousback in the mid 1980s. It seems that the basic idea was that recent MBA graduates from the countries top MBA programs might have the knowledge, desire and leadership skills to be able to lead a company right out of school, but they might not have the capital to be able to buy a business yet. Search funds became an option for elite MBA students to pursue instead of starting their own company or going to work in management at a larger firm.
What is Entrepreneurship Through Acquisition?
According to True North Search:
“Entrepreneurship Through Acquisition is a well-proven model, where an aspiring entrepreneur searches for, acquires, operates and grows an established small business. The acquisition capital is provided by third party investors, while the new entrepreneur operator retains a significant equity share in the business.”
Not everyone wants to start a business from scratch, not everyone has the mindset necessary to take a business from 0 to 1, so entrepreneurship through acquisition (ETA) is another approach to business ownership.
Why Start a Search Fund?
There are countless examples of business owners buying an existing business utilizing an SBA loan, seller financing and other creative financing options where the searcher can retain a majority of the ownership of the business, so why would you want to use the search fund option? From my perspective there are few reasons why starting a search fund makes sense:
- Acquire Larger Businesses - The largest SBA 7a loan is only $5 million. This is why typically search funds target businesses valued at between $5 million and $50 million. If you were going to buy a business for less than $5 million, an SBA loan is hard to beat.
- Devote Full Time Attention to the Search - There are plenty of very small mom and pop businesses for sale for less than $5 million, but if you are looking for a larger deal that fits your experience, interest and budget as a searcher, you are probably going to need to devote full time attention to the search. Since the search fund investors pitch in to cover your costs during the search process, you can actually do this full time.
- Experience of the Search Fund Investors - Finally, it can be incredibly valuable to lean on the experience (and finances) of your search fund investors. Leading a business valued at between $5 and $50 million is no small task, it will be helpful to have partners in the business that have skin in the game.
Self Funded Search Fund
So far I have been describing what is typically called the traditional search fund model where investors put in capital to fund the salary and search expenses of the searcher, but you could still operate a search fund structure where you have a group of investors that help you acquire the company once you get to that point.
What is a Self Funded Search?
A self funded search is when a searcher will fund the search period from their own savings or outside income rather than raising funding from search fund investors.
The reason you might want to self fund your search is because you would end up with a higher percentage of ownership in the company post acquisition if your investors don’t have to take the risk to put in money early to fund the search process.
Buy a Business with No Money Down
There is a surprising amount of search volume on Google for search phrases like “how to buy a business with no money” which frankly sounds like a pretty bad idea in most cases. If you truly have no savings, you probably need a job, not to buy a business. But if what you are looking for is a way to acquire a business with little to no personal cash investment, then a search fund is an option. If you are the right operator, you might be able to convince a group of investors to join your search fund and provide you with all of the financial backing you need to buy a business.
What is a Searcher?
A searcher is an aspiring business owner that is looking for a business to acquire, operate, and grow with the financial backing of search fund investors.
Who makes a good searcher?
Traditionally, searchers have been MBA graduates from elite universities. A searcher needs to be able to raise capital from search fund investors and have the skill set to operate and grow a business. I think one of the reasons that many successful searchers have been MBA grads from elite universities is because they have access to the university network of alumni that are willing to invest in a search fund for a searcher from their alma mater. In fact, some universities help organize opportunities for students or recent graduates to network with search fund investors. The Harvard Search Fund Fellowship is a unique example.
Do you have to have your MBA to be a searcher?
No. There is no rule that you need to have your MBA in order to start a search fund. If you can convince investors that you have the skills to acquire, operate and grow a business, then you can launch a search fund.
How to Start a Search Fund?
It sounds like a pretty good gig right? Quit your job, start looking for a business to acquire, grow the business and sell it. Why wouldn’t more people do this? It might be a little tougher than it sounds. Next I am going to dive into the key aspects of starting a search fund, acquiring a target business and ultimately exiting the business to provide a return on investment to your investors.
Finding Search Fund Investors
The first step is really to find a group of search fund investors to invest the initial capital to fund your search process. Since a search fund is a pretty unique investment vehicle and process it makes sense to try to find investors that have backed other searchers in the past. Through a quick Google search I was able to find a few promising investors with a specialty in search fund investing.
Search Fund Investors
- WSC & Company - A firm with over 125+ searchers backed and a portfolio of over $1 billion in enterprise value.
- Trilogy - This is a firm that specializes in search fund investing and has a portfolio of over 50+ investments.
- Pacific Lake Partners - This firm specializes in investing in and supporting searchers. Their portfolio also has over 50 companies.
Search Fund Accelerators
- True North Search - This is an accelerator that I assume must partner with searchers, but also provides services to searchers to help accelerate their process. You can learn more about their investment focus here.
- Search Fund Accelerator - SFA is a cohort based search fund accelerator that has worked with 8 cohorts and helped acquire 37 companies to date.
You can also network with other searchers as well as potential search fund investors on the SearchFunder platform.
Finding a Searcher to Invest In
This article is primarily focused on the searcher, but if you are interested in investing in a search fund to back entrepreneurial and operational leaders, you can find aspiring searchers on the SearchFunder platform as well. I would also recommend getting engaged in the community on Twitter, listening to podcasts like Acquiring Minds and Acquisitions Anonymous to start to get connected in the community.
How Much to Raise for a Search Fund?
The average search fund will raise between $400,000 and $500,000 from 10 or more investors. This should give you 24 months of runway to identify and acquire a target business.
How Much Does the Searcher Get Paid During the Search Process?
The average compensation for a searcher during the search process was $116,508 per year according to the 2022 Stanford Search Fund Study.
How Long Should it Take a Search Fund to Find an Acquisition?
The median number of months it takes for a search fund to acquire a business is 19.3 months according to a study by Stanford University.
Where to Find a Business to Buy with a Search Fund?
Have you ever noticed that the best homes will get sold before they even get listed on the market? In the same way, the best businesses for sale will likely get acquired long before they ever get listed publicly on BizBuySell. Of course you can search for businesses for sale on business broker and listing websites like BizBuySell, but I am willing to bet that most search fund acquisitions happen through connections with your network and your investors network. It will be important for you to network with business brokers, bankers and other searchers in order to get more opportunities put in front of you. The more that others know what you are looking for, the more likely they are to think of you when they here about an opportunity.
What types of Businesses does a Search Fund Buy?
Your search fund criteria will be unique to your specific situation and your investors, but here are some general guidelines for the types of businesses a search fund would buy:
- Purchase Price - $5 million to $30 million
- Annual Revenue - $2 million to $30 million
- EBITDA - $1 million to $5 million
Source - Searchfunder.org
Some other key ingredients of a good target business:
- Defensible moat around the business
- Stable revenue and cash flows
- Opportunity for growth in the long term
What is the Average Size of a Search Fund Business Acquisition?
The median size of a search fund business acquisition was $16.5 million according to the 2022 Stanford Search Fund Study.
How to Finance a Search Fund Acquisition?
Typically a search fund will finance an acquisition with a mix of equity invested by the initial search fund investors and debt which could include some portion of seller financing. There are many different ways to structure an SBA loan and seller note alongside search fund equity.
How Much Does the Searcher Invest into the Acquisition?
Traditionally, the searcher would not invest capital into the acquisition. They are investing their time in the search and acquisition process and then investing time to operate the business. Of course I am sure that a searcher could negotiate custom terms where the searcher will invest capital into the fund in exchange for additional equity.
How Much Ownership does the Searcher Retain?
Traditionally a searcher will retain 25% of the acquired business. The Acquired Minds podcast outlines how this works, but essentially the searcher will receive equity as follows:
- 8.33% equity vested at close, in exchange for finding and closing the deal
- 8.33% vested over time, typically 4 years
- 8.33% for hitting certain performance hurdles or upon an exit
What is the Typical IRR Expected from Search Fund Investors?
The aggregate internal rate of return for search funds has been 32.6% based on a study of 401 search funds.
How to Calculate the Expected IRR for Search Fund Investors?
Calculating the internal rate of return (IRR) for a search fund is relatively straightforward. You simply need to know the total investment and the forecasted cash flows of the business in order to forecast an expected IRR. I put together this free IRR calculator that will allow you to quickly calculate your search fund’s IRR.
Example IRR Calculation
As an example, let’s assume that the search fund investors invested $5 million in equity to acquire a business with the following cash flows:
Year 1 Cash Flow = $750,000
Year 2 Cash Flow = $1,000,000
Year 3 Cash Flow = $1,250,000
Year 4 Cash Flow = $1,500,000
Year 5 Cash Flow = $2,000,000
In order to calculate the IRR, we also need to assume a future growth rate in the cash flows and a discount rate. I used 7% and 15% respectively as you can see below:
Based on these assumptions our forecasted IRR is 53%.
How to Forecast Cash Flow of an Acquisition?
Now if you don’t have a cash flow forecast already in place, you can use our Acquisition Financial Projection Template to create a pro forma with forecasted cash flow. The model will allow you to enter your historical financials and then implement projected increases or decreases for your revenue and expenses. It will also allow you to enter in unique financing details of the acquisition including investment, SBA loans, and seller notes in order to project future cash flows. The acquisition template is industry agnostic making it perfect for searchers to utilize to create pro formas for multiple potential deals.
How Long do Search Funds Operate a Business?
A search fund can be broken down into 4 stages with the following average timelines according to the 2022 Stanford study:
- Initial Capital Raise to Fund the Search - 6 months
- Search for and Close an Acquisition - 12 to 24 months
- Operate and Grow the Business - 4 to 7 years
- Exit / Sell the Business - 6 months
The assumption going into a search fund is that eventually you will sell the business in order to provide liquidity and investor returns to your initial investors.
When to Sell the Business?
Again, selling the business is typically the long term plan for a search fund. That provides a liquidity event for the searcher as well as the initial investors, but when should you sell the business? The answer is probably when you can maximize your returns for your investors which is another way to say who knows exactly when that will be. But to give you some idea, according to the 2022 Stanford study that we keep referencing, out of 131 exited companies the average time to exit was between 5 and 7 years.
Ok that is it! I hope you found this helpful as a comprehensive introduction to search funds. As you begin your search process and need to model potential acquisitions, keep ProjectionHub in mind, we would be more than happy to help! Best of luck!
