Entrepreneurship through Acquisition

Welcome to this week’s edition of Cape May Wealth Weekly.. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive. This series was first published in the summer of 2024, thanks to the help of search fund investor Adrian and self-funded searcher Fred.

Imagine a regular day in your corporate / banking / consulting job. 

You’re in the office, late in the evening, all by yourself, wondering if it's really worth it. Yes, you’re looking for fulfillment and purpose - but in the end, life isn’t free, and having a little seven-figure payday really would make things easier. You can stay in your job for another decade to get there, but you’re ready for a change, you’re ready to take a risk. What do you do?

Your first thought might be to start the next-cutting edge tech start-up: Find a solution to an unsolved problem, raise money from a VC fund, and have your big payday a few years down the line. Yes, that can work - but as most people know, only a few start-ups make it, and even if you get to an exit, liquidation preferences might significantly cut into your payday.

Or you could bootstrap a business. If you go for an innovative business, the risks around start-up product-market fit remain. If you start a ‘boring’ business, it might take a while to take off. And even when all goes well, it might take a decade or longer to reach a VC-sized exit.

But what if there was another way - a more reliable way - to get your seven-figure payday? 

Let’s talk about a path you might’ve not thought about yet: Entrepreneurship through Acquisition (ETA). We’ll get into all of the details what ETA is, how it works, and what you need to bring for it to be a desirable path for you - but for now, let’s focus on our key motivation, getting that “seven-figure payday”:

In 66 ETA transactions, over 70% of ETA entrepreneurs held equity worth more than $1M (!) at the point of exit. Excluding exits over $10M, the average equity value stood at $3.3M, rising as high as $7.6M when including exits above $10M. Also worth highlighting is the hit rate: Almost half (66% acquisitions * 73% with a gain) make money on their deal, anecdotally much higher than with start-ups, at least from my experience.

So to quantify these results: Assuming you manage to close a so-called “search fund”, your average personal exit proceeds were between $1.6M and $3.7M.

Of course, things are much, much more difficult in practice, and that payday is not guaranteed. While still a less-taken path in Europe, ETA has picked up significantly in popularity since I first came in contact with it in 2022, with both former colleagues and my clients considering (or taking) that path. And the opportunity might only become bigger in the next few years.

An Introduction to ETA (and Search Funds)

ETA is an alternative to starting a business (start-up or regular). Aspiring entrepreneurs, so called “searchers”, seek to acquire and then manage an established and profitable small- to mid-sized business. While initially pioneered at Stanford University in 1984, the concept of ETA has been growing in attention given the scarcity of internal successors in family-owned businesses, especially in the (German) Mittelstand.

There are typically two paths to ETA:

• Traditional Search Funds. In this model, the searcher raises capital from investors who believe in the searcher’s abilities to find and acquire a business. The searcher focuses full-time to identify and negotiate an acquisition (during which they are usually paid a modest salary by the fund), and will subsequently become a manager (CEO or similar) of the acquired business.

• Self-funded Search Fund: In this model, the searcher uses their own funds to finance a search process. However, once the target is identified, additional capital is usually required from external investors to complete the acquisition. Also, unlike a PE-type deal, once again, the searcher would become a manager of the acquired business.

Let’s assume you picked the first option. Here’s how things usually work:

The typical search fund is structured as an special purpose vehicle (SPV) managed by the searcher. The searcher decides on their strategy (i.e. region, deal size, industry, etc.) and then tries to find investors ready to invest in the searcher’s “search fund”. 

The investors provide equity capital in two tranches: First, the “Search Phase” in order to fund the searcher’s salary and acquisition-related fees. Second, the “Hold Phase” to finance the acquisition (usually in conjunction with debt and other financing options).

After a successful search and subsequent acquisition (which, on median, is 20 months long), the searcher steps into their management role. They usually remain there either until they sell the business, or until they eventually replace themselves. Depending on deal structure, the searcher typically retains equity between 15% and 25%,subject to vesting (⅓ at closing, ⅓ time-based, and ⅓ performance-based) - which, as outlined previously, can result in a substantial payday if things go right.

But what type of company is interesting for a search fund? How big are they, what industries are relevant, and what else needs to be kept in mind? 

What makes a good ETA deal?

Earlier, I spoke about ETA as an alternative to starting a tech start-up. Tech start-ups, as most of my readers know, are risky endeavors, which raise venture capital funding (often at very high valuations) to fund years of losses until the start-up can either be sold or eventually turn profitable. In order to justify the risks, VC firms need start-ups to hit it big - think nine- or ten-figure outcomes. 

All parameters that a search fund is trying to avoid.

So what makes for an ideal search fund target?

Affordable Entry Valuation. According to the Stanford 2022 Search Fund Study, the average Price/EBITDA and Price/Revenue Multiple at which search funds have acquired their target company were “only” 6.4x and 1.7x, respectively (compared to 20x or higher revenue multiples for a software start-up). The acquired companies are also typically on the smaller end, with a median purchase price of $12.6M.

Predictable Business Models. Since acquisitions are typically funded with debt, searchers try to find companies that have stable, predictable and almost boring cash flows. Accordingly, search fund acquisitions have been historically focused on defensive industries, such as software, tech-enabled services or healthcare. 

Established, but not too big. Buying a small business always bears the risk of essentially “buying a job”, especially if there is no management layer in place between the CEO and employees. More professionalized companies with structures and processes might be too large and thus ask too high of an asking price for a search fund. For ETA, the truth is usually somewhere in the middle: Companies with one or two levels of hierarchy with lots of room for optimization, and a clear opportunity for the searcher(s) to become part of company management - often driven by succession issues, i.e. a lack of internal employees willing or capable to take the reins.

Now you know more about how a search fund works, and what type of companies they acquire. Maybe you’re not quite ready to become a searcher yourself, but could see yourself investing in a driven individual looking to raise a search fund. What returns can you expect? 

Search funds, the next high-performing asset class?

So far, we explained how search funds work and what kind of companies they look to to acquire. We also showed what searchers can make if things go well. Let’s dive into another crucial topic: Search fund investor returns. Stanford University and IESE Business School provide excellent data on the matter: 

US and international search funds generated a MOIC (excl. the top 3 exits) of 3,1x and 1,9x and IRRs of 29,3% and 25,1%, respectively. Including top 3 assets, MOIC increases to 5,2x in North America and 2,4x internationally. (My friend and search fund investor Adrian Bezler notes that search funds have not been around internationally as long as they have been in the US, so IRRs might be more representative than MOIC to compare regions.)

And some cases can be MUCH bigger. Take the case of Jim Ells and Kevin Taweel.

Back in 1995, the Stanford grads acquired roadside assistance company Road Rescue for $8M. The business grew steadily, expanding into Europe, Australia and Latin America. In 2007, the company (now called Asurion) was acquired by three PE firms for $4.1BN (!). Those firms since then executed multiple billion-dollar dividend recaps, and one firm recently rolled its stake into a continuation vehicle - so the story of Asurion certainly has not come to an end yet.

With or without outliers such as Asurion, one thing becomes clear: Search fund returns can compete with its private equity peers. Yet you might ask: If search funds have done so well, why aren’t more investors betting on them (yet)? I see three reasons:

First, search funds aren’t as accessible as private equity. Private equity funds look to build a diversified portfolio of companies through successive funds. A search fund, however, is a small operation raising funds once to acquire a single business, and accordingly, requires a more sophisticated selection process than PE. I recently spoke to a German family office that is very active in search fund investing, which had invested in 30+ search fund transactions over the last few years - more akin to the portfolio of a VC fund rather than a PE fund in both sourcing and portfolio management.

Second, they bear a different risk profile. Out of 526 North American search funds, 142 ended without an acquisition, and 39 generated a negative return to investors upon exit (excl. those still operating). There is also likely a significant ‘hidden figure’ (Dunkelziffer) of individuals who tried to raise a search fund and failed, or conducted a self-funded search and didn’t find an appropriate target company. In discussions with searchers and search fund investors, it has also become clear that actually closing a transaction is becoming more difficult: While many investors are interested in the initial deal (which receives a ‘kicker’ for taking the blind pool risk), the number of investors willing and able to finance the six- to seven-figure equity ticket at time of acquisition has shrunk amid more challenging market conditions for PE. All valid reasons to take the easier path of a (regular) small-cap private equity fund.

Third and last, search funds are still a tiny asset class. According to Stanford University, the total volume raised by searchers since 1986 has been $2.3BN - less than what some PE funds raise as individual funds. 

Anecdotally, the asset class is only now slowly moving into the mainstream: When I first spoke to an M&A advisor about search funds back in 2022, the advisor told me that he spoke about the search fund topic with aspiring searchers maybe once a month, but that he had never seen a searcher actually close a transaction. Today, times have progressed: Many of my clients consider ETA as their next professional endeavor (often driven by their experiences in venture capital), more than one friend or colleague has considered raising a search fund, and there’s also a growing number of (institutional) investors looking to invest in search funds.

Despite these ‘challenges’, I see a clear path for ETA to succeed. Search fund or not, I personally see small-cap private equity as a structurally advantaged part of the market given the many inefficiencies (and resulting multiple arbitrage opportunities) that small companies tend to have. But more importantly, search fund investors and entrepreneurs might benefit significantly from the ‘Silver Tsunami’ fueling a large number in succession-related acquisitions. I’ve seen more than one case of entrepreneurs with perfectly fine businesses needing to shut down or essentially hand over their business for free amid a lack of successors - and such cases will likely persist in the next few years, especially in “unsexy” industries or geographies outside large metro areas.

ETA and search funds will likely be a trend that will continue to rise in popularity over the next few years - and I definitely see the appeal.

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