Search Funds: Financial Structuring

Key Takeaways:

• Financial structuring is an important consideration before searchers begin hunting for a target company and after they have found a company they wish to acquire.
• During the search stage, searchers can form a general pass-through structure if their search is funded by investors or an alternative financing structure if their search is self-financed.
• During the acquisition stage, searchers can use a mix of equity, debt or hybrid financing models to structure their deals. 

Searchers should consider how to financially structure their search fund during both the search and acquisition stage to meet their business goals. The search stage is when the searcher researches and networks to try to find a company to acquire, whereas the acquisition stage is when the searcher attempts to acquire their desired target company. Different financial considerations come into play at each stage, making thoughtful financial structuring at each stage crucial.

Before embarking on their search fund journey, searchers should prepare documentation that details the structure, governance, preferred share rights, distributions, future financing and allocation terms of the fund they plan to create. Tax planning considerations are also crucial at this stage. Because the details and structure of the acquisition are unknown at the time of fund formation, this documentation should balance flexibility for the searcher with certainty for investors. By engaging in thoughtful planning, searchers will not have to revisit key legal points with investors when the fund is ready to enter its acquisition stage.

If the search stage is funded by investors, searchers can form a general pass-through structure such as an LP, LLC or S-Corporation to raise capital (note that S corporations have nuances that necessitate a close review of your ownership before electing this entity type). Because these entities do not pay tax at the entity level, profits can “pass through” to investors and be taxed at the investor level. During the search stage, the searcher will typically receive a market rate salary that comes from this capital. Key terms with investors often include preferred return and participation waterfall for investors, searcher equity grants subject to vesting tied to milestones (e.g., acquisition, time‑based, performance‑based) and post‑acquisition incentive plans.

If the search is self-financed, searchers have more flexibility in how they financially structure the search process and may choose to contain expenses by taking a reduced salary or limiting the number of companies researched. They can retain a large amount of equity using this approach, which results in greater control and financial reward. However, constrained resources in a self-funded search may also result in limits on deal size or complexity and increased personal financial risk.

During the acquisition stage, searchers should consider how they want to structure their deals using equity, debt or hybrid financing models. Equity is the cornerstone of financing search fund acquisitions. Typically, investors receive preferred equity in exchange for their capital, which allows searchers to decrease their personal financial risk and engage in larger, more complex deals.

Searchers may turn to debt financing if they wish to acquire a business without significantly diluting equity. Some options for debt financing include Small Business Administration (SBA) loans, seller financing or traditional bank loans. Searchers may adopt innovative financing models such as revenue-sharing agreements, earnouts or mezzanine financing to help finance their acquisitions.

Structuring deals depends largely on balancing debt and equity in a way that maximizes financial returns, provides flexibility to navigate unforeseen difficulties and aligns the interests of all parties. Searchers should have a clear understanding of their financial goals, risk tolerance and their target acquisition company in order to implement the right structure that will put them on the path to success.

For more information, contact Erik Splett.