Exploring Search Funds: A Fast-Track to Become a CEO
Outlining search funds and what makes them an interesting path for aspiring CEOs
I saw Jon Matzner retweet a post from Tim Ludwig who is the founder of Majority Search, an investment firm based in San Diego and New York. They are a small business PE firm with a unique approach that leverages the search fund model to build their portfolio. Intrigued by this relatively new concept of a "search fund," I was interested to dive deeper. As I think about operating my own business versus growing from working alongside seasoned execs, I find this path intriguing and one that aligns with my long-term goals. Through this post, I’ll share insights from my research and provide an overview on search funds.
Let's start at the beginning. Developed in 1984, a traditional search fund, also known as entrepreneurship through acquisition (ETA), involves the "searcher" raising funds from investors to find and acquire a privately held business within a two-year commitment. This path offers a fast-track opportunity to become a CEO with an ownership stake. Typically, searchers raise enough funds to cover a $125,000 salary for two years and various expenses for travel and operating systems. During the two-year span, the searcher conducts a rigorous process to identify an attractive and resilient business, considering specific criteria such as:
Profitability of $2M and above
Industry growing at the rate of GDP or higher
Recurring or reoccurring revenue
Strong margins (typically 50% gross margins or higher)
Some growth in the business
Competent and honest seller
Once the searcher identifies a suitable business, additional funds are raised to finalize the sale. The closing procedure follows a standard deal process, which includes:
Signed LOI - Provides exclusivity to transact for due diligence.
First 30 days - Due diligence period for the buyer to request data from the seller to validate assumptions. This period is focused on intensive market and company diligence to examine the health of the business. Any data to help understand the business, quality of revenue, customers, employees, and more. The buyer typically has a thesis on why it’s a good business and certain things that need to be true prior to closing.
Next 30 days - Both parties start papering the deal and finalize a Definitive Agreement (Asset, Stock Purchase, Employee Agreement, etc.).
Last 30 days - Definitive Agreement is signed and the transition to new ownership begins. The searcher becomes the CEO, rehires everyone under new paper, and begins operating the business.
At the closing, the searcher receives an equity award typically divided into three tranches: 8 and a third percent at closing, 8 and a third percent vested over time, and 8 and a third percent rewarded based on performance hurdles. As the CEO begins operating the company, the base salary in the first year is usually around a couple hundred thousand dollars, with potential for bonuses and subsequent salary growth based on their compensation structure, business size, board makeup, and the CEO's performance.
There’s also an option of self-funded search, which is similar to the traditional search fund but relies on the searcher's own resources to acquire and operate the business. In this case, debt products are often used for financing, but require a personal guarantee, putting everything at stake. As personal guarantees are signed and debt amounts typically exceed 80% of the purchase price, the searcher usually ends up with a higher ownership stake in the company. There are risks involved, and examples exist where this scenario could be challenging.
It’s not too long ago since its conception. The majority of search fund raises have taken place in the past several years and the returns are rather surprising. Since 1984, there’s been 400 search fund raises, with 50% of them occurring in recent years. According to Stanford's 2020 Search Fund Study, 88 search funds were launched in 2018 and 2019, resulting in approximately $1.4 billion of equity capital invested from 1984 to 2019. Out of these 400-plus search funds, the Stanford Study reports that 75% of the businesses acquired by searchers yielded a positive return for investors, with 69% of them generating a return on investment that was at least double. The study also highlights an impressive pretax return on invested capital of 5.5x and a pretax internal rate of return of 32.5%. However, an estimated one-third of searches close without making an acquisition, according to the Haas School of Business.
I have also come across various firms that leverage the search fund model to build their portfolios. Among them, Majority Search, NextGenGP, and Alpine Investors have uniquely positioned themselves in the market to accomplish this.
Majority Search stands out by designing their fund to invest substantial time, resources, and trust in the searcher's journey. They provide essential skills, comprehensive databases, operating systems, and a network of connections to empower searchers. What differentiates them is their capacity to fully finance the entire acquisition process without relying on outside capital, eliminating the need for cumbersome bank approvals or personal guarantees.
NextGenGP offers an Entrepreneur-in-Residence (EIR) program. Through this program, entrepreneurs gain the expertise required to effectively manage and guide a company, ensuring the continuity of its legacy while driving its expansion and progress into the future. The EIR program is dedicated to cultivating successful business leaders who can seamlessly transition into key positions and contribute to the ongoing growth and prosperity of the organization.
Alpine Investors, on the other hand, focuses on their CEO-in-training program. They provide their members with the opportunity and support to excel, Alpine aims to develop outstanding CEOs. They believe that early training, rather than traditional recruitment, can produce highly successful leaders.
The search fund route offers an appealing opportunity to assume a CEO position at a stable company, as opposed to the more unpredictable startup route. However, it's important to note that the search fund path may not be suitable for everyone and depends on individual goals. Jan Simon, a former Goldman Sachs executive and instructor of the popular Search Funds course at Haas, highlights the preference of certain entrepreneurs: "Rather than starting a company from scratch, many individuals prefer to join in the middle—from 100 to 1,000. We seek entrepreneurs who excel at taking an existing business and driving its growth."
I had the fortunate opportunity to speak with Tim Ludwig at Majority Search a couple weeks ago. It’s people like him who make the world go round. I appreciate his willingness to take one of my first curiosity chats. He helped me think through what it would look like to work at a firm like Majority Search, the pros and cons of raising my own search fund, and parallel paths to both opportunities. I could tell Tim is a remarkable person. He’s building something special at Majority Search. I look forward to following their journey and helping in any way I can.