Economics of search funds

What are the financial implications behind choosing the career path?

Before making any important financial decision in life, whether it be buying a new home or deciding on a new job opportunity, it is intelligent to consider the consequences of such a decision thoroughly. We like to think we are constantly making sound, rational choices, but we often rush into big decisions because of strong emotional pulls in our life. Maybe someone close to us pushes us to do it, or we are fed up with a particular circumstance. Regardless, it helps to put some theory and numbers to those big decisions.

Today, I will walk through three determining elements that describe the economics behind search funds and the embedded incentives. In addition to my perspectives, this post leans heavily on the Stanford Search Fund Primer and a Harvard Business Review article on small business owner compensation to articulate some of the concepts. While the discussion focuses on the traditional search fund model, which is somewhat standardized in terms of economics, much of the post will apply to other ETA models and entrepreneurship more broadly. Let’s dive in.

Typical search fund structure

We’ve already discussed the two stages of financing required for those pursuing the traditional model: Search Capital and Acquisition Capital. Here, we will focus primarily on post-acquisition economics, demonstrating where wealth opportunities can be created or destroyed.

Acquisition Capital

Assuming that a searcher has found and is ready to close on an acquisition opportunity, the searcher will raise additional investor capital in the form of debt and equity.

Debt financing will have a fixed term and coupon rate in which the loan is scheduled to be paid back to lenders. Debt financing in search fund acquisitions typically comes in two forms – we will label them as traditional and seller related. For traditional debt financing, the business may take on senior term debt, mezzanine (high-yield debt), and a revolving line of credit. Think of these loans similarly to how you would like a mortgage, but instead, the loan is applied to a business producing cash flow each year. The other type is seller financing, which may come in the form of a seller note. These contracts between the buyer and the seller specify a schedule in which the acquirer will pay the seller out over some time in the future with interest. Depending on the seller’s willingness, searchers may be able to leverage earnouts, which are contractual payments contingent upon some specified financial or business milestone after the transaction is closed.

For simplicity, equity financing for the acquisition will typically come in the form of preferred equity. Over time, the searcher will have the opportunity to earn common equity in the firm but under certain conditions (more on this later). There are often other forms of equity (including rollover equity from the seller) in the transaction. Still, for now, we’ll focus on the preferred piece owned by the searcher’s investors since it’s the most critical piece to understand. For simplicity, preferred equity means that the investor gets capital ownership plus additional compensation and liquidation rights to common equity holders but is still junior to debtholders. While there are various structures in search fund acquisitions and types of preferred equity, an excellent way to understand how these instruments work is to think about the firm as a whole.

Let’s take a hypothetical example. We will call the firm, Maverick. Maverick was purchased last year for $100 with 50% debt ($50) and 50% equity ($50). Today, however, the firm is only worth $25. Since debtholders are senior to all equity holders, they will take all the $25 value left in Maverick (up until a value of $50). None would go to the equity investors if they were to liquidate the business.