Hi everyone!
I’ve recently read a Primer on Search Funds from the Stanford Business School and I found it very insightful.
I decided to compile some of the key learnings from every chapters and share it with the rest of the community.
If you want full access to the primer, you can find it here.
Let’s dive into it!
Part 1: The Search Fund - Personal Perspective
The first section is to help you evaluate whether the role of search fund entrepreneur is appropriate for you.
Individuals who raise search funds often share two common motivations:Â
A desire to take an entrepreneurial path to running a companyÂ
A desire to achieve significant financial upsideÂ
Skills
Successful search fund entrepreneurs tend to share a number of common personality characteristics.
The following attributes are neither prescriptive nor exhaustive, but self-assessment regarding these characteristics may determine if pursuing a search fund is a strong personal fit:
Attention to details
Perseverance
Ability to build relationships
Adaptable, modest lifestyle
Ability to lead
Experience
Do you have the qualities required to become a search fund entrepreneur? You should be self aware enough to know your strengths and weaknesses.
Compensation
The amount and structure of the equity varies widely. Typically, the entrepreneur/pair receives a 15-30% equity stake in the company, received in three equal tranches:
Tranche 1: Received upon acquisition of a company.
Tranche 2: Vests over time (~ four to five years) provided that the principal remains employed by the company.
Tranche 3: Vests when performance benchmarks (e.g., IRR hurdles) are realized. The typical IRR hurdle range starts at a 20 percent net investor IRR and ends at a 35 percent net investor IRR.
Part 2: Raising a Fund
Building an Investor Base
Investors should bring advice, counsel, and credibility as well as the financial support for the search, acquisition, and operation phases.
Beyond providing the capital to fund the search process and acquisition, the right mix of investors can serve many purposes:
Act as a sounding board for the searcher
Provide introductions and leverage with professionals such as lawyers, bankers, and accountants
Provide introductions to sellers of companies, industry contacts, and intermediaries to boost deal flowÂ
Provide personal support through the ups and downs of the search and operation of the company
Serve on the board of directors of the acquired company
Provide valuable guidance in early operations
Provide introductions to other searchers and entrepreneurs for a peer network
Finding Investors
Most successful fundraisers generally approach the following people as investors, in no particular order:
Professional search fund investors
High net worth individuals, particularly those who have invested in other search fundsÂ
Former business associates
Business owners, entrepreneurs, and executives known to the searcher
Friends and family
Individuals who regularly invest in search funds can bring many benefits: They are comfortable with the search fund model and the risks; they can provide perspective and guidance on how to run an efficient search; they may have a network of deal sources and other professional contacts; and they are often a patient source of capital.Â
Part 3: Search Fund Economics
The basic economics for entrepreneurs and investors in search funds are determined primarily by two major factors:
The structure of the investor capital, and;
The amount of the entrepreneur’s earned equity (Carried Interest)
The search fund acquisition is often structured as a participating preferred equity investment.
This means that the investors receive a return of their initial capital, often with a modest preferred return, before the searcher begins to participate in equity appreciation.Â
Investor capital can come in various forms, including, but not limited to, those addressed here:Â
Preferred equity
Preferred stock
Redeemable preferred stock
Nonredeemable participating preferred stock
Value Creation
There are three primary levers used to create equity value in any company:
Operations
Revenue growth through sales and marketing efforts or strategic initiatives (e.g., sales improvements, new products/services, geographic expansion, pricing)
Margin expansion through cost reduction or operating leverage
Add-on acquisitions to enhance scale, product/service offerings, or capabilities
Finance
Capital structure decisions
Cost of capital
Capital intensity reduction – fixed assets, working capital, and/or capital expenditures
Valuation Multiple
Buy at lower multiples, sell at higher multiples (due to professionalization of management, improvements in company operations, faster growth, larger size, running an optimal company sale process, etc.)
Part 4: Criteria for Evaluating Industries
The purpose of setting investment criteria is to create a framework for the search process and for evaluating acquisition opportunities.Â
Characteristics you are looking for
Selecting an Industry
Generally, industry selection follows a multi-stage funnel process, as depicted below:
Part 5: The Search - Sourcing Opportunities
The following chart lists potential sources of brokered deals and representative transaction sizes:
The broker community is extremely large and fragmented; there are over 10,000 members of the Association for Corporate Growth (ACG) and more than 1,800 members of the International Business Brokers Association (IBBA), industry trade associations dedicated to small business M&A.Â
Deal sourcing advice:
Maintain a robust pipeline
Involve lenders early in the process
Remain flexible with the deal structure
Part 6: Evaluate the Target Business
Every acquisition process is different; however, to generalize, a searcher will go through three levels of evaluating an acquisition opportunity before the deal closes:
First pass – When the opportunity is first presented, the searcher will typically evaluate very limited and high-level information about the company and industry to determine if the particular opportunity warrants more time and resources.
Valuation/LOI stage – In this stage, the searcher will qualify the owner as having a genuine intent to sell the company; perform a more detailed analysis of the industry; conduct sufficient analysis on the business to submit a Letter of Intent, which will include a nonbinding valuation (or valuation range) and major terms; and prepare a list of items to be explored in a comprehensive due diligence process.
Comprehensive due diligence – Generally, once a company is under LOI, the searcher will conduct a more thorough vetting of the company’s organization, products/services, operations, customers, suppliers, assets, liabilities, financial results, prospects, and legal aspects.
Due Diligence
Below is a chart showing the major areas of focus in the due diligence process:
Part 7: Transitioning Ownership & Management
The purpose of a search fund is for the search fund principal not only to acquire a company but to run the business.Â
In some instances, the search fund principal will take over as the CEO on the day the acquisition closes while the seller completely exits the business. In other cases, the search fund principal may arrange for the seller to remain in an active management position at the company.
Given the typical inexperience of search fund principals, some have found it useful to keep the seller involved for a transition period to help calm the anxiety of employees, customers, suppliers, and other relationships—as well as to allow the search fund principal to learn the business more thoroughly via an apprenticeship approach.Â
Key Advice
Avoid the 10 traps of new CEOs:
Setting unrealistic expectations
Rash decisions vs. analysis paralysis
Being a know-it-all
Living in the past
Being isolated
Stifling dissent
Savior syndrome
Misreading real power sources
Picking the wrong battles
Disrespecting your predecessor
Access to the ETA Primer
If you want to dive into the full report, you can find it here:
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