Search Funds: A Guide to Raising Capital

Key Takeaways:

• There are two stages where searchers raise capital in a search fund model: search stage and acquisition.
• Traditionally, searchers raise capital up front from investors to help fund the search stage. Some searchers may choose to do a self-funded search or conduct a non-traditional approach to funding.
• Once the searcher identifies a target company, they raise capital for the acquisition stage using equity investors or other methods such as debt financing, seller financing or equity rollovers.

In the world of entrepreneurship, search funds have emerged as a way for individuals to acquire and operate existing companies, offering a compelling path to company ownership and wealth creation. For aspiring entrepreneurs, understanding how capital is raised in a search fund is a key consideration to participate in this growing market.

Securities compliance is critical, and searchers should consult with an attorney to confirm they do not run afoul of federal and state securities laws.

The Search

Traditional Search Model

In a traditional search fund model, entrepreneurs (searchers) raise capital from interested investors at the outset of the search process. To raise capital, searchers should prepare a private placement memorandum (PPM) that provides investors with the following information: the searcher’s experience and background, the intended target industry, the industry-focused search strategy and the illustrative economics of the search. Providing a PPM will give the searcher the best foundation to secure an initial pool of capital.

Searchers should cast a broad net to secure investors. Investors can be anyone from high-net-worth individuals, friends and family, venture capital firms, private equity investors or other institutional investors. Many searchers view their investors as value-added partners, contributing capital, advice and guidance throughout the search fund process. Once a searcher secures commitments from their preferred investors, they can form an LLC or similar pass-through entity and use the capital raised from these investors to fund the search process.

During the search, the initial pool of capital raised will be used for expenses such as the searcher’s salary, the searcher’s travel expenses, technology and miscellaneous service providers like lawyers and accountants. After a searcher has identified a target company, they will raise more capital to fund the acquisition.

Alternative Search Models

Some searchers may opt to do a self-funded search, where they fund the search either through personal funds (or personal debt financing), electing to raise capital only when they identify their target company. Self-funding requires more personal financial risk but allows the searcher more control over the search and acquisition process. If a searcher intends to acquire multiple companies, they may use a holding company model, where they set up a parent company to manage subsidiary companies.

Independent sponsors represent another non-traditional approach to raising capital in the search fund space. An independent sponsor is an individual or group who identifies potential acquisition targets and raises capital on a deal-by-deal basis from investors to fund the purchases. Independent sponsors often hire external executives to lead the acquired companies instead of personally running them.  

The Acquisition

Regardless of which approach a searcher takes, once a suitable target company is identified and the search process is complete, searchers must raise capital for the acquisition stage. This funding often comes from equity financing from the same investors who supported the initial search process. If the investors received equity for their initial investment in the search fund entity, they can roll this equity into the transaction. They also have the right of first refusal to “follow-on” with a pro-rata investment of the equity required for the acquisition. In addition, new investors may be sought if more equity is needed than can be raised from the initial investors.

If searchers cannot or do not wish to obtain all necessary capital for the acquisition from equity investors, additional sources are available. Searchers may use debt financing to fund the acquisition process, which involves obtaining loans from banks or alternative lenders. Debt financing can come in the form of term loans, lines of credit, asset-based financing, government-backed loans or hybrid debt and equity arrangements. Another popular option is seller financing, where the seller of the company provides capital for the purchase. Seller financing terms can include deferred payments, earn-outs or installment payments based on future company performance. Equity rollovers may form part of the funding, where the seller or other key players retain equity in the company post-acquisition in lieu of a cash payment at closing.

Attorneys who regularly advise search funds or their investors can play a critical role in helping structure capital raises, navigate regulatory requirements and position themselves for a successful acquisition. If you are considering launching a search fund, investing in one or exploring alternative capital-raising models, consult Fredrikson early in the process to ensure your strategy is sound, compliant and aligned with your objectives.