A search fund is essentially a mini SPAC (special purpose acquisition company).

A fresh MBA grad (or anyone else with a rudimentary grasp of business) raises about $400-600k ($500k is typical) from investors to fund a shell company. The MBA grad is called the “searcher”. The shell company is called the “search fund”.

The Search

After raising money, the searcher then begins searching for a business to buy. The searcher can spend up to 2 years searching for the right business. During that time, the search fund pays them a salary of about $100-150k per year.

The searcher is typically looking for a business they can buy for somewhere between $5 million and $30 million. The median acquisition price for search funds is around $15 million. Don’t worry — the searcher isn’t expected to have this money up front. When they raised their search fund, they didn’t only raise $500k. They also got letters from their investors saying that each investor planned to invest up to a certain amount of additional money once the searcher found a business to buy.

Most searchers look for businesses that meet certain criteria:

• Industry growth
• High return on tangible capital (ROTC)
• Recurring revenue
• Low customer/revenue concentration
• Low cyclicality (i.e. recession-resistant)
• Low seasonality
• High barriers to entry
• TAM of at least $150 million
• Low regulatory/tech/environmental risk

The most frequent acquisition targets are in technology and business services. However, metalworking can also be a good industry, and data businesses are fantastic but rare.

The Acquisition

Once the searcher finds a business they want to buy, they send the details to their investors to see if the investors like it. If enough investors like it (“enough” means the investors who like it have pledged enough capital to cover the acquisition costs), then the searcher will submit an LOI (Letter of Intent) to the business owner to begin the sale process. However, if not enough investors like the deal, then the searcher will move on to look for another business.

After the LOI is submitted, due diligence begins. Depending on the size and type of the company being acquired, different types of due diligence may be used. However, one type of diligence that is always required is a “Quality of Earnings” (QoE) analysis. A QoE analysis is basically an “audit-light”. An accounting firm will come in to look for hidden financial risks in the company being acquired. The QoE analysis should do things like:

• Make sure no personal business expenses of the business owner have been attributed to the business.
• Look for revenue concentration. E.g. are there any customers who account for more than 30% of revenue? Are there any groups of customers who all know each other who account for more than 30% of revenue?
• How much revenue (and how much profit) is coming from one-off jobs versus recurring subscriptions or long-term contracts?

Simultaneously with the QoE analysis, the search fund’s legal counsel will begin legal due diligence. This includes things like:

• Reviewing long-term customer contracts to ensure they are actually enforceable, and
• Ensuring that the company is operating with all required licenses, permits, and surety bonding.

If due diligence turns up any unsurmountable issues or risks, then the search fund will break the LOI and move on to continue searching for another business. Typically, a search fund should expect to enter and break 3 LOIs before finally acquiring a business (or just winding down after 2 years if no suitable acquisition target is found).

After the searchfund finds the business it is going to acquire, it receives an infusion of additional capital from investors to actually fund the acquisition which will merge the acquisition target with the search fund. The acquisition will typically be funded by some amount of equity from investors together with a bit of seller financing plus an SBA loan.

The operation

After the acquisition, the searcher becomes the CEO and operator of the business that was acquired. The searcher’s goal now is to hold and grow the business for the next several years. On average, a searcher will operate and grow the business for about 7 years. However, it’s not uncommon for hold times to exceed 10 years.

In exchange for operating the business, the searcher will receive not only a salary but also equity compensation. Here’s how equity compensation might be structured:

• 5% equity vested immediately upon conclusion of the acquisition
• 10% equity vested over the first 4 years of hold time.
• 10% equity vested based on IRR performance hurdles agreed upon with the investors. A typical IRR hurdle might start at 20%, with full vesting at an IRR 35%.

The exit

Eventually, the searcher will find a buyer for the company and sell it. The buyer will typically be either a private equity fund or a larger competitor.

Example:

Suppose Bob the searcher buys a business for $10 million and grows the business to $50 million over 10 years, earning 22% equity in the process. Once Bob sells, he will have earned 0.22 x $50 million = $11 million. The investors will have made (0.78 x $50M) – ($10M) = $29 million in total gain (a 14.6% annualized return over 10 years).

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