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Search Funds: The New Path to Entrepreneurship

Heather Endresen Live Oak Bank | March 27, 2018

No generation has had the impact on small business creation that the baby boomers have had over the past 50 years. And now, many of these baby boomers are looking to retire.

During 2017, 36 percent of all small business owners—those with $100,000 to $10 million in sales—said they plan to transition the ownership of their company in the next five years. That number is up from 27 percent anticipating a change in 2010.

With the increasing number of small businesses up for sale over the next five years — and with current taxes, financial performance, and attractive multiples favoring strong investment returns — the conditions for acquisitions are opportune.

Traditional corporate and financial acquirers are eager to take over these businesses. But another method for finding and financing a business is also seeing unprecedented growth: the search fund.

This new generation of young entrepreneurial talent is emerging from elite business schools across the country. In an interesting shift, many of these young MBA graduates are opting to be CEOs on Main Street instead of Wall Street, by acquiring small businesses.

“The growth [of the search fund] has been phenomenal,” says Karen Spencer, COO of searchfunder.com, a networking site for searchers and investors. The number of search funds has increased a whopping 428 percent over the last five years, increasing at a rate of about 40 percent per year, according to searchfunder.com.

The growth is being fueled by awareness of the model and its success. “More programs about entrepreneurship through acquisition are forming at the business schools, and I think that the awareness of the model because of that is greater. Also, various universities are having conferences about the model,” says Spencer. “There’s also the global expansion—now that there have been successful search funds in other markets, people are looking to do that.”

Mark Yuan, co-founder and CTO of searchfunder.com, adds, “There is also market pressure. We are in a time of record high asset prices. There is a ton of dry powder—un-deployed capital sitting on the sidelines committed to general partners at various asset management firms—that have too few deals to chase. Only smaller deals—less than $20 million—remain attractive and uncompetitive; however, these deals do not usually make sense for the cost structures of traditional private equity firms. Search funds are able to access these companies because searcher salaries are low compared to private equity and outcomes do not have to be in the hundreds of millions to make the deal a success.”

A Variety of Models

There are three types of search funds—traditional, self-funded, and fundless sponsors. With traditional funds, searchers raise capital from a group of investors to look for a company with certain agreed upon attributes. The investors have the right of first refusal on any deals the searcher may find, according to searchfunder.com.

“Traditional search funds are backed by about 200 investors in the country who have been doing this for 30 years—serial search fund investors. Those are backed by that cadre of investors and have certain stipulations,” explains David Slenzak, of Broadtree Partners, a search fund accelerator.

Self-funded searchers finance their own search efforts. Once they find a deal they look for outside capital. The terms are negotiated on a deal-by-deal basis, according to searchfunder.com. Self-funded searchers often choose to use SBA loans to finance the acquisition because of the favorable and flexible terms offered.

Fundless sponsors raise search capital on a deal-by-deal basis often from a single source or a group of investors. “Fundless sponsors are more seasoned. They know how to structure deals, and people will back them based on their prior track record,” says Slenzak.

Back to School

As this segment booms, more ETA programs are being created at business schools around the world. One such program was founded by Royce Yudkoff, professor of management practice at Harvard Business School (HBS), along with Richard Ruback, professor of corporate finance at HBS, a decade ago. Yudkoff says that his students often see the search fund path as less risky. “At first, when you think about entrepreneurship, it seems like—wow, that’s a really risky thing. But what these students are doing—and this is a world of difference from startups—is they’re buying from a retiring founder of some business that has been around for many years. It’s demonstrated that it’s enduringly profitable. You buy it at an attractive price, there’s overlap with the founder as they train you, and then you’re taking it over and running it. The risk in the minds of these students is very, very measured.”

Yudkoff attributes the growing interest in the program to increased awareness, as well as larger forces in the economy—including the number of small companies coming up for sale along with the fact that careers in large companies seem less secure or predictable than they were 20 years ago.

Onward and Upward

Many in the industry agree that this is a trend that will continue to boom.

“I believe the timing is right. We have more schools building awareness about it, and I think that the model gets easier as more baby boomers retire out of their businesses,” says Spencer.

Yudkoff agrees that it will continue, though he says what’s driving it now is probably different from what’s driven it to here. Moving forward, “I think the biggest force is that business school students are seeing their predecessors doing this in large numbers, and it’s working out for them on average.”

There is also money out there to support the growth. “I think this model is just showing up on the radar of a lot of big money sources, and I think over the next two to five years, we’ll see a lot of money trying to get into this space,” says Slenzak. “As private equity returns diminish, they’re going to look to try to get higher returns in this micro-cap space, and they’ll look to this model to try to capture that.”

Axial is the deal network for the middle market.

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