It all started when…
In 1984, H. Irving Grousbeck, the Director of the Center for Entrepreneurial Studies at the Stanford Graduate School of Business, pioneered a new investment model, commonly termed a “Search Fund.” The objective of a search fund is to provide a vehicle for young, aspiring entrepreneurs to search for, acquire, manage, and grow a company. “It’s the most direct route to owning a company that you yourself manage,” Grousbeck said.
The search fund process is divided into four stages:
Stage One: Raise Search Capital
In the first stage entrepreneurs raise anywhere from $350,000 to $750,000 in total capital by selling 10-15 “units” in the fund. The capital is to be used to fund the entrepreneur’s search. Specific uses of capital include a salary, administrative, travel and deal related expenses. The total number of investors in a typical search fund ranges from 10-20, made up of a combination of angel and institutional investors. Most search fund entrepreneurs solicit investors who can also serve as advisors and assist with deal evaluation, structuring and execution, in addition to potentially serving in a Board capacity post transaction.
Stage Two: Identifying and Making an Acquisition
In the second stage entrepreneurs embark on a search to identify and acquire their company. There are a number of factors that dictate the length of the search including economic environment, industry characteristics, a business owner’s willingness to sell as well as the strategy employed by the searcher. Historically, those searchers that develop a systematic approach towards generating deal flow and analyzing opportunities tend to be more successful. The total process ranges from 3 to 74 months, with the median being 19 months. Once a target has been identified, the entrepreneur is responsible for negotiating the structure of the transaction, performing due diligence, sourcing debt financing, securing equity commitments, negotiating the entrepreneur’s earned equity allocation with investors and planning the post transaction transition. If the initial search capital is exhausted before an acquisition is completed, the entrepreneur may choose to either close the fund or to solicit additional funding in order to extend the search period.
Stage Three: Operation and Value Creation
In the first 12 months after a transaction has been closed, entrepreneurs, guided closely by the Board of Directors, focus on immersing themselves in the business. During this time an emphasis is placed on evaluating the management team and better understanding the operational and financial details of the business. The goal is to identify the building blocks required to construct a solid foundation for future success. Once the entrepreneur has built trust and gained comfort operating, the team will test potential value creating levers with the goal of identifying where to focus the company’s resources in order to drive growth. Once these levers have been identified, the team will drive value creation. Possible levers could be geographic market expansion, improvements in operating efficiency, investments in sales and marketing or add-on acquisitions. These means of creating value are not mutually exclusive; ideally, more than one will apply to a search fund investment.
Stage Four: Exit
Most search funds are established with a long-term outlook, generally greater than a three-year time horizon, and often longer. The average hold period for a search fund investment is seven years, and the most successful search fund deals have been held for more than ten years. Despite the longer term hold period, investors and principals share a desire to gain liquidity at some point. Throughout the course of the investment, principals will evaluate exit alternatives in order to gain liquidity and realize returns. Liquidity events for investors and principals can occur through a number of avenues including an outright sale, initial public offering, a debt or equity recapitalization or dividend distributions.
The path of a search fund entrepreneur is not for everybody. Searching for, acquiring and operating a lower, middle-market company requires a significant amount of physical, intellectual and emotional energy. Entrepreneurs must have the ability to successfully navigate in an environment with constant, high levels of uncertainty and challenge. Key characteristics that most entrepreneurs possess include strong work ethic, sales and interpersonal skills, a competitive nature and the ability to execute. Success in the search stage will only offer the entrepreneur the right to prove themselves again as an operator. There is no guarantee that the operating outcome will prove to be financially rewarding. However, entrepreneurs will gain valuable professional experience throughout the search and operating stages, and have the potential to realize significant financial upside.
To date, over 258 search funds have been raised. A 2016 study conducted by the Stanford Center for Entrepreneurial Studies concluded that a portfolio of first time search funds produced an aggregate, pre-tax internal rate of return of 37% and an aggregate, pre-tax return on invested capital of 8.4x.