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.
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.
However, one year later, Maverick is worth $150. If investors were to liquidate the business now, debtholders would still receive their $50, while $100 would go to equity holders. Having preferred equity in the capital structure would enable that investor a guaranteed preferred return over the life of their investment before common equity holders receive anything. This instrument is highly valuable for those investors because it provides downside protection by minimizing agency costs of the common equity holders (primarily the searcher). Put another way, in a liquidation event, a searcher with common equity in a traditional search funded deal would not receive any compensation until the preferred return is fully paid off for the duration of the investment.
This piece is critical and one that I find to scare off prospective searchers considering the traditional model. The downside protection of the preferred equity can make it much more difficult for searchers to realize a robust economic outcome for themselves under mediocre and poor results compared to the self-funded model. While a fair concern, we must remember the added value investors should provide searchers, not just their capital. My opinion is that the high bar required for searchers to receive their common equity is more than justified, given the risk that these investors are taking by allocating time and capital towards your career. They must be compensated for the risk they are taking in us.
We’ve just talked through how you and your investors will acquire a business and the high bar put on the searcher to perform to capture their common equity. The way to do this is through creating equity value. Well, how do we do that?
The Stanford Search Fund Primer nicely describes the three ways a searcher can do so: through finance, operations, and multiple expansion. In essence, value creation comes down to growing revenues, lowering costs, lowering the cost of capital, increasing financial leverage, increasing operating leverage, and selling the business at a higher EBITDA or revenue multiple than what you bought it for. There are many trade-offs to some of these value creation tactics that I will omit in this discussion, but my approach going into the operating phase will be focused on improving the fundamentals of the business and not financial engineering. Banking on multiple expansion is not advised for searchers looking to create shareholder equity. It may or may not happen, but you should focus on doing what’s best for the business and then let the right multiple find you.
Here’s the list from Stanford’s Search Fund Primer on value creation:
Revenue growth through sales and marketing efforts or strategic initiatives (i.e., sales improvements, new products/services, geographic expansion, pricing)
Margin expansion through cost reduction or operating leverage
Add-on acquisitions to enhance scale, product/service offerings, or capabilities
Capital structure decisions
Cost of capital
Capital intensity reduction – fixed assets, working capital, and capital expenditures
Buy at lower multiples, sell at higher multiples (due to management professionalisation, improvements in company operations, faster growth, larger size, running an optimal company sale process, etc.)
As we’ve discussed in previous articles, typical solo search fund entrepreneurs can earn up to 25 percent of the common equity (partnerships up to 30 percent) in the acquired company. However, they do not get all their common equity at once but instead in three equal tranches in the following order:
First 1/3 of the total for acquiring the business
Second 1/3 of the total for operating the business over some period (i.e., typically 4-5 years)
Final 1/3 of the total for achieving specific performance benchmarks within the acquired company (i.e., IRR or MOIC hurdles)
According to the Stanford Search Fund Primer, the third tranche is typically anchored to an internal rate of return (IRR) metric and commonly starts at 20 percent IRR and max out at 30 to 40 percent IRR, net of the searcher’s common equity. IRR targets can be challenging for searchers to attain as time increases since compounding a business’s size at over 20 percent for five years is no small feat. Since more prolonged periods often pull down the IRR despite strong performance, searchers who operate over five years may be subject to being evaluated by some other return metric, such as the multiple on invested capital (MOIC). These are highly specific by the deal but are illustrative of what you should expect.
Let’s consider searcher compensation throughout the journey, not just the attractive and dreamy exit point, where we are all hoping to 10x our investors’ capital. Because let’s face it, many prospective searchers have lucrative opportunities as alternatives, one of the most common being consulting.
Back in 2016, the popular HBR Guide to Buying a Small Business writers Richard S. Ruback and Royce Yudkoff wrote a piece that compared the compensation over time of small business owners with management consultants. I recommend you read the article in full for their analysis, but I will utilize some of their assumptions to highlight a few main points.
Before we do that, let’s establish a couple of elements around compensation. First is the method – the main ways people earn an income are through a salary, bonus, and equity compensation. Second is the timing – some income is liquid, meaning that it’s available almost immediately (such as your salary) while others are more illiquid (such as equity ownership in a business). Both are crucial when evaluating the quality of any career opportunity.
As a search CEO, one can expect three forms of compensation: salary, bonus, and common equity. Focusing on the first piece, the searcher sacrifices yearly earning power relative to other career paths with higher base salaries such as management consulting and investment banking. This trend is because the small business CEO needs to pay down debt and utilize profits to invest in new projects at the firm. Bringing in the two salary comparisons below (which are a bit dated from market terms), the ETA path salary serves a similar purpose to the individual as a low yield bond, with predictable cash flow to expect each year that will increase at the rate of inflation or slightly more. Alternatives for MBAs can expect a similar bond-like structure to their salary compensation but with a higher yield than the small business owner. Notice below in the diagram from Ruback and Yudkoff the starting salary between the two career paths and the divergence as years on the job increase.
Luckily for the small business owner, that’s not the complete picture. We need to factor in other types of compensation. Employees receive volatile annual bonuses for consulting/banking/tech roles and can depend upon several factors, primarily personal and company performance. While search fund CEOs will earn annual bonuses driven by similar characteristics, although maybe not as much, it is not the most important feature of their compensation.
The other piece frequently overlooked is equity compensation or carried interest. As discussed above, search fund CEOs can earn a meaningful portion of common equity in the acquired company, highlighting that much of their compensation will not occur until much later down the road. Deferred compensation in the form of equity is riskier and more illiquid than other paths, but the payoff structure is much different when considering the full picture. Instead of compensation resembling a bond with certain payoffs in the future, the potential for outsized returns many years down the line creates a structure similar to a long call option, as shown below. By paying for the opportunity costs in the short term, search fund CEOs can earn much more upside in the long term in positive outcomes. They still earn respectable salaries with mediocre and adverse outcomes, but compensation appears more like the first chart above.
Numbers aside, there’s an essential lesson in these payoff structures for aspiring entrepreneurs. We tend to focus on our short-term compensation opportunities – annual salary and bonus – but fail to sacrifice immediate income for better opportunities down the road. This concept of deferred gratification applies to many aspects of life but is particularly important for entrepreneurs to understand. One choice is not right or wrong, but generational wealth opportunities for yourself and your family will not occur without a long-term mindset and some willingness to take calculated risks. As an entrepreneur, you must be aware of that.
In conclusion, we discussed the economics and incentive structures that drive search funds and how value is created to make the model work. We also reviewed some of the features on how searchers are compensated without getting too into the weeds of specific numbers. When we associate a number with a particular opportunity, we anchor ourselves on a particular number, which can be good or bad. Given the uncertainty of where a search fund can take you professionally, I find it more important to understand the payoff structures and then get to work.
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