REFRAMING THE SEARCH MODEL
I wrote this essay a few weeks ago on twitter, I thought it was relevant for the forum, interested to hear your thoughts:
Search funds are LBO acquisitions, done by recently graduated MBA’s. Investors give them funds to pay their “Search” a[redacted]months process to acquire and run a small, healthy business. I attended my first search fund conference in 2016 at IESE in Barcelona. I was a startup entrepreneur curious about the system.
I came away feeling like the search model was interesting, but the structure and incentives didn’t make sense. I understood that recent MBA graduates were foregoing larger salaries, and they had debt. I understood the historical returns search funds generated (so who am I to question it?), but I left with a few doubts:
1. Why searchers gave up so much potential equity to receive a 24-month salary? The searcher would still be taking on financial risk (personal guarantee), and operational risks post-close. 2. After speaking to a few failed searchers, I felt the investors and searchers were fixated on finding the perfect deal. Both searchers and investors killed deals because it didn’t tick every box.
After starting two companies, I think the ETA model is the most de-risked starting point for an entrepreneur. However, I feel the independent sponsor model offers the best alignment for investors and entrepreneurs. The investors get a fully vetted company, with a motivated operator. The entrepreneur is compensated for their risk with a majority equity share.
In LMM acquisitions all deals have warts. I believe the search fund should be reframed as the first step in creating a larger holding, or fund. Focusing on the perfect deal keeps the entrepreneurs out of the arena. Once you are an owner, finding attractive acquisitions is far easier.
The only thing that makes a self-funded deal work is the fact that it's small. If you keep the equity check significantly below $3mm, you stand a good chance of raising your equity from the doctor/lawyer/dentist crowd--ie. those with enough money to want to invest in alternates, but not enough so that the 10% of their portfolio that should be in alternates meets the minimum for a PE firm to take on as an LP.
If you end up with a $3mm EBITDA company under LOI as a self-funded searcher and need an equity check north of $5mm, you'll probably end up having to get capital from significantly more sophisticated investors who will insist on terms that are either the same or at least very similar to the standard PE/Traditional Search model.
Having said that, I totally agree that ETA is the most de-risked way to start out as an entrepreneur. I also appreciate that there are as many ways to search as their are searchers and I think that every method has it's pros and cons. It's just a concept that covers everything from an e-commerce roll up to a fundless sponsor or a search venture firm. Why more don't do it, I'm not sure.
Thanks for the post!
I just get surprised when I hear about searchers over bidding, or how many don't close. I think if the goal is to get a deal done, the investors should encourage flexibility. Once they own something, it's way easier to build a portfolio or fund.
With that said, I think if the financing can be solved, the independent sponsor model is a much more economical way for a searcher to get more equity on the back-end. The other consideration is if someone is coming out of an MBA with few savings, it would be very difficult to fund a self-funded independent sponsor model without taking some search capital. Those who can fund the search themselves are in a much better position in this respect.