Search Funds: The Life Cycle

Key Takeaway:

• There are five main stages in the search fund model: forming a search fund, searching for a target company, acquiring a target company, operating a target company to create value and exiting the investment.

The search fund model has skyrocketed in popularity in recent years. Not only does the search fund model give talented entrepreneurs a fast track to the C-Suite by owning, managing and growing a company, the model also gives investors a reliable rate of return. The Stanford 2024 Search Fund Study (the Study) found that 69% of entrepreneurs who find and acquire a target company scale the business and exit the investment for a profit in five to seven years. Comparing the 69% search fund success rate to venture capital’s 10% success rate, it is no wonder that this model has become a favorite among entrepreneurs and investors alike.

The search fund model proceeds in five main stages: forming a search fund, searching for a target company, acquiring a target company, operating a target company to create value and exiting the investment.

Step One: Forming a Search Fund

In the traditional search fund model, a mid-career professional or a partnership, termed the “searcher,” starts by speaking with investors who can offer capital and guidance. These searchers often have big ambitions but limited funds. The self-funded searcher, who feels confident in their personal resources and ability to navigate the market, may skip this step. (Note that the Study did not evaluate self-funded searches; success rate of such may not be as previously stated.) Searchers aim to select a group of investors for the initial search fund, raising a total of approximately $500,000 to cover the searcher’s salary, travel expenses and administrative costs. The investors serve as the searcher’s partners over the next five to seven years.

Searchers and investors should come to agreement on search strategy and investment philosophy. One way to ensure agreement is to prepare a Private Placement Memorandum (PPM). A PPM is a document, often prepared with the help of a legal professional, that outlines the details of the search fund including its search strategy, acquisition criteria and target industries.

Prior to searching, a searcher must select a structure for the search fund. Most search funds are structured as pass-through entities. Searchers should consult with an attorney at this stage to select the structure that provides the search fund with the most tax benefits and the highest rate of return.

Step Two: Searching for a Target Company

Stage two is about locating the target company that the searcher seeks to acquire and operate. The odds are in the searcher’s favor during this stage, but the searcher must remain patient. According to the Stanford 2024 Search Fund Study, 63% of searchers acquire a company, with an average search term lasting 19 months.

Searchers network extensively within their chosen industry. This helps the searcher build a network of professionals in their target industry and become more competent and credible in discussions about the target industry. Successful searchers generally target companies in large, fragmented industries with low operating risks and steady cash flow.

Step Three: Acquiring a Target Company

Once a target company is identified, the searcher begins the process of conducting due diligence and preparing a letter of intent (LOI) which includes a non-binding offer to acquire the target company.

At the acquisition stage it is critical that a searcher seeks the help of an attorney. Attorneys can help minimize liabilities when acquiring a target company. Buyer‑side protections at closing can include indemnities, escrows or holdbacks, representation and warranty insurance (RWI) when applicable, and post‑closing purchase price adjustments (e.g., working capital true‑ups).

Should the searcher decide to continue the acquisition, each investor is given the pro-rata right of first refusal on the equity required to fund the acquisition. The median purchase price for a target company according to the Study was $14.4 million. A financial valuation of the target typically precedes the calculation of the purchase price. Investors consider the size of the target company, the quality of the target’s business model and the target’s growth profile when calculating the fair market value.

Step Four: Operating a Target Company to Create Value

After the searcher develops a baseline understanding of the target company, the search fund creates a Board of Directors. Investors typically make up majority of the Board of Directors; occasionally industry professionals or individuals who previously navigated a search fund take up seats as well. The Board sets a strategy to create value in the newly acquired company, and then the searcher spends the operating years implementing the Board’s strategy to create value within the target company.

Step Five: Exiting the Investment

Once the company has increased significantly in value and the searcher is ready to move on to new opportunities the search fund begins the process of exiting its investment. Searchers and investors exit the investment by direct sale, public offering or an alternative liquidity event. Those events may include repaying an investor debt, selling investor equity to other investors or the company issuing dividends.

Navigating the search fund model for the first time can be difficult. Fredrikson attorneys are well-versed in the search fund model and ready to guide entrepreneurs and investors through every stage of the process. Stay tuned for more insights.