Search funds: A unique path to becoming an owner and CEO

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I count owning and growing my own business as one of the great thrills and accomplishments of my life. I also had a great time working as an employee at ExxonMobil and Cimarex Production many years ago, but having one’s hand on the helm of the ship is a different experience entirely. I was not the founder of BIC Alliance, but as an owner, I have helped start new divisions of the company and seen it grown eightfold under my joint tenure with Earl Heard.

Often a business colleague will tell me they, too, wish they could be an owner of a business, but they simply don’t have the money to make an acquisition and because of temperament and life circumstances, they don’t desire to start a company from scratch. One path forward is the search fund.

While the search fund was originally popular among newer MBA graduates, it has more recently captured the interest of mid-level managers. It is a path for wouldbe entrepreneurs to search for, acquire, manage and grow a company. The search fund was first created in 1984 by H. Irving Grousbeck. As an investment vehicle, the search fund process consists of up to four stages: fundraising, search and acquisition, operation and eventual sale.

In the first stage, fundraising, the entrepreneur raises initial capital referred to as “search capital.” Most often, there is a single search entrepreneur, but it isn’t uncommon for there to be two partners in a search. There is an inherent advantage in two heads being better than one, both in the search for and management of the acquired entity, but the dual role makes the search more costly. Investors in a funded search expect compensation as part of the fund. Search capital is used to pay the entrepreneur a modest salary and cover deal-related expenses over a roughly two- or three-year period while he searches for a company to buy. Salary and payroll taxes generally represent more than half of the expense of the search.

Per a recent study by Stanford University, the median amount of initial search capital in a fund is around $450,000, with a typical salary of $85,000-$100,000 during the search. Search fund entrepreneurs will usually need to tap into a large network to raise a search fund, including business associates, business owners and executives, private equity groups, former employers, family and other contacts. Typically, there will be eight to 15 investors who help the entrepreneur cobble together the search capital — less if the investors are institutional. It is important an entrepreneur not merely source capital but also identify investors who can act as potential advisors and assist with deal evaluation, in addition to potentially serving in a board capacity for the acquired business.

There are many ways to skin a cat, but the search entrepreneur can earn up to 25 percent of the equity (15 percent each for partners in a dual search), which typically vests one-third at closing, one-third over four years afterward and the final third upon attaining a negotiated internal rate of return target of 25-35 percent upon exit. These terms are finalized when the business is purchased and may be reduced depending upon the size of equity raise required to consummate the deal.

After an acquisition target is identified, the search fund entrepreneur, with assistance and input from the search investors, raises the acquisition capital to purchase the company. Searching for the acquisition, raising the second tranche of capital to acquire the business, running the business and a successful exit are subjects that each might consume its own textbook. The purpose of this article is merely to advise there is a vehicle that provides a way to pay expenses while seeking a company for acquisition, and that also provides an ownership position to the entrepreneur who may himself have little personal capital for investment.

For more information, call (281) 538-9996.

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