While venture funds might see more publicity and fanfare, search funds are yet another channel that can be used to raise capital.
A search fund is comprised of several stages:
- The first round of capital raising in order to fund the search for a target
- Once funds are reached, the goal is to search for a target
- Then there’s the need for acquisition capital raising
- Then, of course, comes the acquisition
- Following the acquisition comes the continuous management of the acquired target (by the founders of the search fund)
- Then, finally, there is the exit or the sale of the target by the search fund
One of the most unique components of a search fund is its two-stage capital raising process:
During the first (search) stage, it’s typical to raise anywhere between $250,000 and $750,00. This initial capital raised is used to pay certain expenses, including due diligence and founders’ salaries. Stage one is when a small group of investors back an operating manager’s search for a target company to acquire. Investors can invest a pro-rata share in the target company, if they choose.
During the second stage of capital raising (once the target is identified) the goal is to acquire the funds necessary for acquisition. If the initial investors do not provide the full amount needed, it’s not uncommon for the founders to turn toward new equity investors, lenders, or the seller of the target company for the additional capital.
Following the acquisition, the search fund founders will operate the target company for an average of three to seven years. During this time, they’ll engage in an operating period where strategies are implemented, expenses are decreased, and sales are increased.
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Then, once this period concludes, the founders will sell or exit the target company.
Search funds typically target companies in the $5 million to $30 million price range, and require $2 million to $10 million in equity capital. Target companies are often times undermanaged at the time of their acquisition.
Who conducts search funds?
Often times, search funds are started by people with limited operational experience or with no direct experience in the target industry, but with substantial entrepreneurial spirit. They’re likely not interested in building a company starting at square one, but are interested in working as an operator and being compensated with equity.
Typically, a founder of a search fund will take equity stake in the target company in the form of stock options.
Understanding Search Funds investors
Investors who contribute toward the initial search capital will receive a pro-rata right-of-first-refusal to invest in additional funds, as well as the right to convert their initial capital into equity at an increased value (often times 150% of the initial amount).
Having right-of-first refusal allows investors the freedom to walk away if they don’t share in the vision of the fund, while the 150% conversion rate aims to compensate these investors for contributing during what is likely to be the riskiest stage of the investment.
Search fund investors often play the role of active advisers to the business, and founders might leverage their expertise and contacts during the acquisition diligence, as well as post-acquisition.
Certain considerations to factor in with search funds
For many search fund founders, acquiring a targeted company may be the first solo venture, which is why it’s vital that they seek legal counsel. Even prior to acquisition, during the search stage, legal counsel can assist founders in investigating and reviewing potential target investments, drafting letters of intent (as well as non-disclosure agreements) and providing much needed support with all the legal nuances associated with due diligence.
During the acquisition phase, negotiations take place on a number of fronts. Managing the relationships with sellers, investors, financing sources and more is a difficult balancing act, but one that must be performed perfectly in order to succeed. Legal and financial advisers can help founders as they implemented multifaceted strategies that address the unique needs of all stakeholders involved.
