Search Funds 101
As a business advisor, by now you have undoubtedly come across the concept of search funds, a unique financing model that allows entrepreneurs to raise capital and acquire small businesses. The search fund community is growing rapidly because it offers an attractive path to entrepreneurship that has less risk than bootstrapping a start-up venture. But for the sell-side professional, there is often a sense of confusion about how to screen this category of buyer for and ability to close. It can also be daunting to know how to describe a search fund buyer to a seller.
A Brief History of Search Funds
The search fund model was first developed by H. Irving Grousbeck, a professor at Stanford Graduate School of Business, in the 1980s. The model was designed to give young entrepreneurs the opportunity to learn about the process of acquiring and managing a small business, while also providing them with the capital and resources needed to do so.
Since its inception, the search fund community has grown significantly, with a number of successful search fund alumni going on to become successful entrepreneurs and investors in their own right. Today, ETA (Entrepreneurship Through Acquisition) courses can be found in dozens of top business schools, with new schools being added each year.
Types of Search Funds
There are three main types of search funds: traditionally funded, self-funded, and accelerators. Here is a brief overview of each:
- Traditionally funded search funds These search funds are funded by external investors, who provide funding for salary and expenses during up to a 24-month search period. These investors have the option to invest in a business the searcher finds but can also opt out if it does not meet their criteria. In that event, the searcher can fill the equity gap with other investors (typically experienced Search Fund investors). These search funds typically look for companies with $1.5 – $5 million EBITDA and will only use non-SBA debt for financing.
- Self-funded search funds This term refers to the fact that this type of searcher does not have a fund paying for salary and expenses during their search. It does not mean that all of the equity for the deal will be from the searcher, however (this is a common misconception from the name). Self-funded searchers often do raise equity capital from experienced investors. Self-funded searchers often look for companies with $500k – $1.5 million EBITDA and almost always use SBA loans for debt capital.
- Accelerators Accelerator search funds are typically run by experienced entrepreneurs or business leaders and are designed to provide mentorship and support to young entrepreneurs who are looking to acquire a small business. These search funds often have a structured program that includes training, networking, and other resources to help entrepreneurs succeed. As the name implies, this model is intended to speed up the path toward finding and closing on a deal.
The question of how to work with search funds as a business broker is an interesting one. They represent a growing percentage of active buyers, and despite appearing to be an “unfunded sponsor,” they often have excellent debt and equity sources behind them via Bank lenders (SBA and conventional debt) and experienced equity investors.
Search funds typically raise some or all of the equity for an acquisition from experienced serial small business investors, who are individuals or firms that have a track record of investing in small businesses. These may be high-net worth individuals, exited former searchers, family offices and funds who are active in the search fund community.
To raise equity from these investors, search fund entrepreneurs typically create a detailed business plan that outlines their underwriting of the business and their plans to grow the business with detailed projections. These plans are very thorough and well researched. In addition to providing capital, these investors can also bring valuable expertise and connections to the table. A lead investor is chosen based on who has the most experience in that particular industry, and this investor will be the Board chair. Other investors will take some of the other board seats and will meet with the entrepreneur regularly providing oversight and guidance during the operating period.
Screening Search Fund Buyers
A search fund buyer will plan to step in to run the company they acquire day-to-day. Therefore, they tend to be good fit when the business does not require significant technical experience, and the seller would prefer not to sell to a PE fund but rather to someone who will carry their legacy forward in a more holistic manner.
Deciding whether a particular “searcher” has the wherewithal to get through diligence, and the debt and equity raise is also a very important decision. l qualified searcher will be able to produce letters of support from experienced search fund Lenders and investors. They should also be able to provide a resume with references and should be able to describe what their timeline will be for getting debt approvals in place and what the diligence roadmap will look like. This set of information, a quick internet search of the equity partners and a call with the lender can be a relatively efficient way of screening which searchers are a good bet. A personal financial statement is less telling since the searcher will be relying on capital from investors rather than their own liquidity.
With a succinct information request, and a few minutes of verification, a broker can more effectively tap into a new and growing category of buyers. Armed with a better understanding of how they raise capital, and what kinds of business characteristics they fit well with, a business brokerage can work with them more efficiently and productively.
1. Steps to qualify a searcher: Request a resume, list of references, lender letter of support & investor letter or support
2. Interview the searcher for cultural and skill set fit. Confirm with lenders, investors, and references.
3. Ask for their diligence roadmap and expected timeframe for milestones.
Knowledge is Power
Armed with a better understanding of how they raise capital, and what kinds of business characteristics the fit well with, a business advisor can work with them more efficiently and productively. For those who are especially curious and want a deeper dive on search fund community, there are multiple well attended annual ETA conferences usually held at some of the business schools that offer the program. With a succinct information request, and a few minutes of verification, an advisor can more effectively tap into a new and growing category of buyers for the right deals and know better who not to invest time in.
Co-Director – Search Fund Lending
Heather Endresen is a Director of Search Fund Lending at Live Oak Bank. She is a 30-year industry veteran, residing in Orange County, CA, and is a frequent panelist at industry conferences focused on acquisitions of small companies as well as a guest speaker at business schools with Entrepreneurship Through Acquisition programs. Heather provides debt for small company acquisitions nationwide and is an expert in the use of both SBA and conventional bank credit vehicles.
Prior to joining Live Oak, Heather had launched and served as managing director of several successful SBA lending business units over the past 20 years including Citibank, Union Bank and most recently Banc of California. Over the last 12 years, she developed a passion and a strategic focus serving the needs of upper small business and lower middle market acquirers using SBA and conventional loans for SBA eligible projects requiring more than $5 million in debt.
She is an industry leader in this niche and can assist sellers, buyers and acquisition advisors in structuring financing that addresses the needs of all parties.