Prioritizing good economic characteristics
Identifying growing industries and businesses with common characteristics will prepare you for success as a search fund entrepreneur.
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” – Warren Buffett.
This Warren Buffett quote sets the stage for a typical school of thought in the ETA community on the impact that industries, businesses, and entrepreneurs have in creating value. The underlying idea is that industries and business models are more predictive of success than management teams, especially first-time search CEOs.
I’ve seen this referred to in various ETA resources, and the concept of the race track (industry), horse (business), jockey (entrepreneur), and trainer (investors) has helped further this idea of how entrepreneurs can think about setting themselves up for success. I will use a slightly different analogy with Formula One (F1) racing instead of horse racing, which I hope will be more intuitive.
While there are competing views on which elements are most important in the broad context of entrepreneurship (many argue the driver is most important), the industry and business are foundational for a budding entrepreneur in ETA.
Finding a race track (industry) with excellent conditions
Think of each race track as its own industry. There are some race tracks that everyone wants to be on, and there are others that drivers do everything in their power to avoid. It is no different with industries. As F1 teams do not want to drive on tracks with poor weather, bumpy roads, and no barriers to protect drivers and their cars, search fund entrepreneurs should not seek industries with deteriorating fundamentals.
We will think of industries through the lens of both financial and operational dynamics. Identifying industries appropriate in a search fund context that meet these criteria will be challenging, so it is essential to acknowledge that no industry will meet all of them. Below is a list of common economic characteristics in industries appropriate for search fund acquisitions.
These elements are common in ETA and are meant to minimize the risk of operating a business as a new CEO. First-time CEOs and their investors can then focus on building the best racecar (business) as possible with the wind at their backs rather than trying to do so in an unfavorable environment. That being said, searchers and investors have varying views on industry criteria – it is highly subjective to their risk profile, experience, and general opinions.
Optimizing your racecar (business)
Racecars represent the businesses in a given industry. As an entrepreneur, you as the driver have the opportunity to buy an existing racecar that is structurally sound and will perform to help you win the race. Because searchers are buying an existing racecar and not building a new one from scratch, there are several characteristics one might look out for to make sure one is not buying a lemon.
Like industries, we will consider both the financial and operational dynamics important when evaluating an individual business. Again, these are meant to minimize the risk and uncertainty of operating a business as a new entrepreneur, but more importantly, to ensure that the business itself is healthy, competitive, and has clear growth opportunities. Below is a similar list of common economic characteristics appropriate for evaluating business models in a search fund context.
Every search fund entrepreneur will have individual revenue, cash flow, and valuation requirements, and these vary widely depending on the model they pursue. I’d say the most typical search fund criteria range from $5 million to $30 million in revenue and $1 million to $5 million in EBITDA. For self-funded searches, these ranges are typically lower, and for partnered or sponsored searches, they can go much higher.
Simply put, these businesses must be competitive. There must also be a solid foundation within the business so the searcher is set up for success, meaning that there must be solid middle management and the opportunity to improve practices within the firm.
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