A deeper look at raising a search fund
David shares his perspective on raising a traditional search fund and why he chose it over the alternatives
In the Overview of ETA published last month, I provided a summary of the popular ETA models currently used by search fund entrepreneurs. This week, I will dive deeper into raising a traditional search fund leveraging the core text of that article and my experience recently raising the fund for White Cedar.
Raising a search fund
The Traditional path is when an entrepreneur partners with a group of investor-advisors to locate, acquire, manage, and exit a business under some set of predetermined terms. The entrepreneur can pursue this path solo or with a partner and raise two distinct rounds of capital from a group of investors: Search Capital and Acquisition Capital. For this post, I will focus exclusively on raising Search Capital.
Search Capital
The first round of fundraising is for Search Capital, typically ~$450,000 for a solo entrepreneur / ~$700,000 for partners to pay for the expenses (including salary), in which the entrepreneur(s) conduct a highly structured search to acquire a private company, typically up to 24 months. However, some extend into the third year if their budget permits.
Searchers have the opportunity to earn up to 25% in common equity of the acquired business under a prespecified set of terms and conditions (30% for partnerships, 15% each). The 25% common equity is split equally into three tranches that searchers (same for partnerships) earn by hitting certain milestones during the operating phase. The standard practice is that the entrepreneur will receive ⅓ of the common equity at closing, another ⅓ after four years of operating the business, and the remaining ⅓ depending on a particular performance threshold based on internal rate of return (IRR) and multiple on invested capital (MOIC) targets.
To compensate investors for providing search capital without the certainty of participating in the equity financing of a business transaction, every dollar invested in the search capital phase receives a 50% step-up in preferred equity into the ultimate transaction. Investors also receive a right of first refusal (ROFR) to invest additional capital into the business for further optionality. It’s important to note this has a few consequences for searchers. The 50% step-up provides increased downside protection for investors and aligns incentives so they’re inclined to invest later on at the deal stage. Every incremental dollar raised for your search fund, however, will make beating the preferred return threshold more challenging. Failing to generate sufficient returns in the operating stage will favor investors over the entrepreneur, as their securities will have priority in the capital structure over those of the searcher.
Further, another consequence is that some searchers may want to seek more partners to improve optionality as a result of the investor ROFR and step-up. However, the more investors a searcher has in his or her cap table, the more likely misalignment is to occur. The result is that a searcher could be left with equity gaps if enough investors opt out of the acquisition and others with the ROFR don’t step in to fill that gap. Although finding new equity partners is less of an issue nowadays, searchers should be aligned with their investors and keep others informed in the event that they need to close a deal.
Structuring the Fund
Before kicking off the formal fundraising process, an entrepreneur must consider how they want to structure their fund, what types of investors they would ideally like to partner with, what industries they will focus on, and how they plan to differentiate themselves from other searchers going through similar fundraising processes. I will discuss some of these topics in more detail in future articles, but for now, let’s assume that the entrepreneur has done their proper due diligence before moving forward.
I found there to be three distinct activities before the fundraising process: building the private placement memorandum (PPM), networking, and formulating a strategy to receive formal commitments.
Building the PPM is at the core of structuring your fund, and there are various resources online to support you if this is your first time (as it was for me). The Stanford Search Fund Primer has a template PPM included in a .zip file that’s a great starting point for anyone looking for structure, and that structure was at the core of my PPM. In the PPM, many elements are the same, so it is crucial for potential searchers to focus on a few details: their investment structure, search strategy, background, and industries of interest. Concurrently, I worked with a few advisors, investors, and attorneys to provide feedback on the document.
Networking in the ETA community is equally important to continue while you work on your PPM. You can think of networking in two distinct categories: investors and searchers (both former and current). With investors, potential searchers should introduce themselves to get to know one another and find those that fit their objectives and personality. During this stage, keen searchers should take the time to connect with the investors on a more personal level, articulate their fundraising plans, and look out for those individuals who stand out from the crowd. The earlier, the better! With current and former searchers, use this time to learn about their journeys and ask questions about fundraising specifically. Timely questions about your fundraising in these conversations will be more helpful than ones targeted to later stages of the search. Solve the immediate unknowns through these chats and give back whenever you can to others considering search.
Formulating a strategy to receive commitments will keep you prepared throughout the intensity of the fundraising process. Every searcher raising capital must think through their optimal number of investors, the mix of different investor types, where you need more hands-on support, and communication strategy before beginning formal conversations with investors. There are trade-offs between many investors in one’s cap table and very few. More provides the searcher with a bit more flexibility in terms of the deal while fewer can make communication and alignment much more straightforward. Whatever fundraising strategy a searcher lands on, they should stick to it to display preparedness and confidence with others throughout the process. Searchers can remain flexible on some aspects of this process, but they should be careful about the signal that too much uncertainty can send to investors. We will dive into the fundraising process in future posts to clarify here.
Fundraising
Now that you’ve completed your PPM and received feedback from key partners around you, you are ready to kick off the fundraising process with investors formally. The process for me involved sending an email with my PPM to investors that I had already met in an introductory call and a round of meetings with each group to determine whether they would invest. I raised 20 units intending to land on around 10 to 12 investors, but in hindsight, I should have just raised 10 units to easily communicate the unit size to investors. While the number of units does not matter since you are just dividing your total fund amount by a different number, it appeared to me that most investors were used to working with around 10 units.
Given that my fundraising process occurred in the Covid era, we held all of the meetings through Zoom or Microsoft Teams, including a few of them over the phone. Each call took about 45 minutes on average and generally began with an overview of my background (if I was meeting someone new) and my desire to pursue the career path. Then we dived into specifics on White Cedar. I received lots of questions about my search strategy and industries of interest, which seemed to challenge my thinking and see how well I responded in the face of pressure and criticism. Subsequent conversations with investors provided updates on other commitments, shifts in my strategy or thinking from the previous discussion, and further questioning of my background. Depending on many factors regarding your search, strategy, location, and general timing, the fundraising process can take anywhere from one to six months.
There were some interesting dynamics at play during the fundraising process that I had heard about in previous conversations but did not consider as much as I should have when going into it. Receiving your first few commitments can be pretty tricky since many investors prefer to see a searcher persevere and build an investor group that aligns with their own interests. The classic chicken or the egg paradox perfectly applies here. Once I received the first few commitments, others came in quite quickly, but those weeks leading up to it definitely test your nerves. Confidence and persistence are paramount to success in fundraising, and I will discuss my lessons in greater detail in a future post.
Another factor to keep in mind is the relationship between you and your potential investors. It is tempting to want to accept capital from whoever is eager to commit to you, but the decision is much more serious than that. Think hard about who you as the entrepreneur want to partner with for the long term. Ask how they add value and how that relates to what you are looking for from your investors. I wanted to work with people that I could see myself partnering with in perpetuity, so having that as a filter became very beneficial going into the later stages of commitments. Even if every conversation with an investor goes well, pay close attention to how you feel after speaking with them. Fit is everything.
Managing conversations is an important part of the process and will become increasingly vital as you move into the later stages of fundraising. Ensure that investors are all aware of your situation and you are transparent with them about your thinking. There’s no point in trying to hide information from your investors because that will only lead to frustrating at least one party. Driving alignment is just as important while you are the CEO, so start now and be communicative, clear, and transparent.
Once you are fully subscribed with verbal commitments, the entrepreneur must firm up these commitments by completing the final paperwork in partnership with their attorney. Back to the theme of managing conversations, the searcher will confirm the cap table commitments from each investor, work with an attorney to draft the various agreements needed, and then distribute those first to the lead investors, followed by the rest of the group. This process was entirely new to me, but my investors and attorney helped guide me through each step. The final stage is to consolidate all of the signature packets and prepare to launch your search.
Choosing the traditional model
I commonly hear from prospective searchers their doubts about pursuing the traditional path because of their desire to control more of a firm and report to no one. Those are fair assessments but I believe they are a bit short-sighted. Lacking executive management and deal experience, I wanted to partner up with people that would provide guidance and resources in building a great organization. Also, I appreciated the different skills that traditional searchers must develop during the fundraising, sourcing, transacting, and operating stages, some of which are muted in other models. For me, a traditional search fund provided the proper balance of incentives, support, challenge, and opportunities that cannot be found elsewhere. Yes, the terms and control may not be as attractive to the searcher as a self-funded model, and the infrastructure is nonexistent unlike an incubator, but choosing traditional enabled me to craft my own narrative while partnering with some exceptional people. We competitive types tend to want to do everything ourselves without asking for help. But for me, the value of a strong investor group outweighed the costs associated with seeking outside capital.
This is a personal choice for every prospective searcher and is not something to be taken lightly. Mine to pursue the traditional path, however, was relatively straightforward. It was largely anchored on my former athletic background and overall preference for team environments and coaching. One piece of advice that I will give you is that when considering the ETA model that works best for you, do not discount the value of having good people around you.
Thank you for reading, and please subscribe to stay in the loop on future Maverick posts if you've enjoyed this article. If there are elements of my experience that you would like to hear more about, reach out to me directly.