Search Funds: What they are and how they work

Written by

Meow Technologies, Inc.

Published on

Sunday, June 16, 2024

Search Funds: What they are and how they work

A search fund is an investment vehicle used by aspiring entrepreneurs to acquire and actively manage an existing small business. The entrepreneur leading the search fund, known as the search fund entrepreneur or searcher, raises a pool of capital from private investors to finance the search, acquisition, and initial operation of a target company. After finding and purchasing a business, usually valued between $5 million and $30 million, the search fund entrepreneur steps in to lead the company as CEO.

Search funds offer motivated individuals with limited capital and operational experience an alternative path to business ownership and leadership. Since the concept was pioneered at Stanford Business School in 1984, search funds have become an increasingly popular vehicle for entrepreneurship, with over 500 funds launched to date.

History & Origins

The search fund model was conceived in 1984 by H. Irving Grousbeck, a professor at the Stanford Graduate School of Business. Grousbeck helped two Stanford MBA students raise money from investors to acquire a small business which they would then manage and grow before eventually selling. This new concept quickly spread among entrepreneurial students and alumni seeking hands-on leadership experience.

By formalizing the search process and bringing onboard experienced investors to advise them, business school graduates could shortcut the traditional career path and become owners and operators of a successful firm in their 20s or 30s. The model was especially appealing to those interested in buying stable, profitable companies rather than risky startups.

Over the next decades, the search fund approach continued to gain popularity as a path to the C-suite. Alumni from top MBA programs like Stanford, Harvard, and others launched funds, often with backing from their school's alumni networks. There are now over 400 active search funds in operation globally, with the concept taking hold in Europe, Asia, and Latin America.

How Search Funds Work

A search fund goes through four key phases:

1. Capital Raise

The first step is for the search fund entrepreneur to raise capital for the search itself and eventual acquisition. This initial funding, usually $250,000 to $750,000, covers the entrepreneur's living costs along with expenses like travel, legal fees, and advisory costs. Investors in the search phase also get the option to participate in funding the future acquisition.

2. Search & Acquisition

Next, the entrepreneur conducts an extensive search for a suitable target company to purchase. This involves researching potential targets, reaching out to business owners, evaluating opportunities, and ultimately negotiating a purchase. With extensive due diligence and input from their investors, the entrepreneur selects an established business that meets their criteria. On average the search takes almost 2 years.

3. Operation & Growth

After finalizing the acquisition, the search fund entrepreneur steps in as CEO and implements strategies to improve operations, expand revenues, and increase the company's overall value. They run the acquired business with oversight from the company's new board of directors.

4. Exit

The end goal is to profitably sell the business after 3-7 years of ownership and growth. Typical exit strategies include sales to private equity firms or strategic buyers. Top-performing search funds can generate returns of over 5X for their investors.

Typical Targets

Search funds tend to target profitable small businesses with revenues between $5 million and $30 million per year. Industries like manufacturing, distribution, healthcare, education, and business services are common targets.

Ideal targets are profitable companies in stable, defensive industries that don't require specialized technical expertise to run. Common reasons owners sell to search funds include pending retirement and lack of succession options internally. Search fund acquisitions often benefit sellers who want their business legacy preserved.

Structure & Participants

There are three main parties in a search fund:

Search Fund Partners - The entrepreneurs leading the search, including any co-founders or partners. They contribute their time and effort in exchange for a significant equity stake in the acquired company, often 20-40%.

Investors - Angels, VCs, family offices, and others who provide the capital to finance the search fund’s activities. They take a limited partner position.

Sellers - Owners of potential target companies who are looking to exit their successful small business through a sale process. They get liquidity and a fair purchase price.

In addition to the core search team and financing partners, search funds rely on networks of mentors and advisors who guide the process. These are often alumni of top business schools who share lessons, make introductions, and provide critical feedback.

Returns & Performance

Search funds have delivered impressive returns historically when successful:

- Average pre-tax IRR of 32.6% over the life of the investment

- Median return multiple of 2.4X on invested capital

- Top quartile of funds return 5-10X capital

These outsized returns come from the high growth and value creation achieved under the search fund entrepreneurs’ leadership. However, the model does come with risks, as 1 in 3 search funds fails to ever locate and acquire a target company after raising initial capital. Extensive due diligence, gradual capital deployment, and guidance from experienced advisors help mitigate downside risk.

Search Funds vs. VC, Private Equity

Search funds differentiate themselves from venture capital and private equity firms in a few key ways. These include:

Investment Stage - Whereas VC and PE firms typically invest in early-stage startups or buy out mature companies, search funds focus on established small businesses.

Deal Size - Search fund acquisitions range from $5M to $30M, while VC and private equity deals are often far larger.

Operational Role - Search fund entrepreneurs take an active managerial role after acquiring a company, unlike traditional private equity owners.

Target Profile - Search funds look for profitable, stable companies compared to the high-growth potential stars sought by venture investors.

These differences make search funds a complementary component of a diversified private capital portfolio. Some private equity firms even operate their own search funds to source new deals.

Popularity & Growth

The search fund approach continues to rise in popularity globally. North America is currently home to the majority of search fund activity, but the model has taken off in Europe, Asia, and Latin America in recent years. Some growth drivers behind search funds include:

- Strong historical returns attracting more capital

- Increased mentorship and networking opportunities

- New search fund-specific investor groups and events

- Growing ecosystems and communities of searchers sharing knowledge

International search funds are still a relatively new phenomenon, but their numbers increase each year. Observers expect the rapid growth to continue as more regions develop their own robust search fund ecosystems.

Conclusion & Summary

Search funds have emerged as an appealing path to business ownership and leadership for aspiring entrepreneurs across the globe. By targeting profitable small companies and bringing hands-on operational experience, financial backing, and mentorship, searchers can generate strong returns for themselves and their investors.

While search funds carry risks like any private equity strategy, their unique structure offers downside protection and invaluable learning opportunities. With the model still gaining momentum worldwide, search funds remain an exciting area within the entrepreneurial landscape for years to come.

Meow Technologies is a financial technology company, not a bank or FDIC-insured depository institution. Likewise, Meow Technologies is not an investment adviser and none of the information presented herein should be relied upon as financial advice or a recommendation to make any financial decision nor should it be considered to be tax or legal advice. The information is the opinion of Meow Technologies for educational purposes and may not be suitable for all companies. Products, like the one described herein, are offered through Meow Technologies and are not advisory services which are only offered through Meow Advisory, LLC.** The FDICs deposit insurance coverage only protects against the failure of an FDIC-insured bank.**

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