There are roughly 2,600 private-equity firms in the U.S. looking for a good deal on a promising business opportunity.
But a growing number of investors are going a step further and backing an entrepreneur before an acquisition target is in sight. The model is called a search fund and it has been a tiny but vital sector of the small-business sector for almost 30 years.
Here's how it works. The would-be entrepreneur -- often with a partner -- raises between $200,000 and $400,000 to bankroll a search for a business, which could take up to two years. Generally, 10 to 15 private individuals or small firms buy in. If the searcher finds an attractive company at a fair price, the original investors hand over another round of financing to buy the business, generally for $5 million to $20 million.
If all goes as planned, the searcher builds the business and sells it, or recapitalizes for a profit in five to seven years. "If you look at the returns over time, it's a really good asset class," says Graham Weaver, founder of Alpine Investors, a San Francisco-based private-equity firm that has bought into a few search funds. "It's also a great way to be a CEO at a young age."
To date, most search funds have been launched by recent MBA graduates from Harvard and Stanford. But the strategy is spreading thanks to a few high-profile successes.
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When Kyle Polanski's former MBA classmates from the University of Washington ask what he's up to, he tells them, "I sell dog treats." Technically, Polanski, 34, is right, though it would be more accurate to say that he is CEO of Blue Dog Bakery, a Seattle-based wholesale pet-food company that he bought via a search fund in 2009.
Under Polanski's charge, the company has expanded nationwide, securing precious shelf space in Petsmart, Safeway and Wal-mart stores. "I am almost certain I was the first public school MBA to do this," he says. "And I was just lucky enough to get exposed to it from a bunch of Harvard and Stanford folks who came through Seattle looking for companies."
The path, however, is not as easy as it may sound. It requires an entrepreneur to have the skills to close deals and the operational savvy to run a company. Of the first-time search funds launched to date, some 21 percent folded without making an acquisition, and 11 percent bought companies that eventually shut down, according to a recent study by the Stanford Graduate School of Business.
Only 15 percent have made profitable exits, while roughly one-third of search-fund CEOs are still operating the target companies. "It actually makes a lot more sense for an experienced entrepreneur," Weaver says. "But if you're 10 years out of school, you're probably not willing to just relocate somewhere just because you found a great business to buy."
Still, the strategy is gaining momentum, as the word spreads to entrepreneurs like Polanski. At least 12 first-time search funds have been launched every year since 2007, including a record 20 funds in the depths of the recent financial crisis.
That group includes Matt Capell, who at 38, is a bit older than most search funders. In almost two years of searching, Matt Capell hasn't yet bought a company. But he has screened 1,800 businesses, submitted 30 bids and hopes to close a deal with one of seven companies he is in talks with. "It doesn't matter what kind of momentum you have," he says. "At the end of the day, a lot of luck has to go into this."
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How do you turn that luck in your favor? Here are some tips from search fund entrepreneurs and investors:
Find a partner. A search is a long and lonely road. Many who go that route want a partner to commiserate with when a deal falls apart or they hear about a friend getting a plump job in the corporate world. It's also beneficial to partner with someone with complementary skills.
Build a website. A simple splash page explaining your search and financial backing could give your mission greater credibility and help attract business owners looking to sell and intermediaries. "They're so cheap these days, it's almost more of a liability not to have one," Capell says.
Attract a mix of investors. Big fish will bring legitimacy and financial stability, but their time will be limited. You should also seek some lower-profile individuals with both deep pockets and the time to lend advice.
Keep moving. Scoring with a search fund requires an endless stream of conferences, coffees and cold calls to identify target companies. In short, don't wait for a sweetheart deal to land in your lap.
Get to "yes" quickly. Once you've found a target, keep in mind that hardball negotiating tactics can burn up time and precious goodwill. Because you'll probably need the seller to help you learn the ropes during the transition, transparency and fairness are in both your and the seller's interest.
Related: How Business Buyers Can Plan for a Successful Transition
