Search Funds: A Promising Exit Strategy for Mid-Sized Business Owners by PerplexityAI

Search funds represent an increasingly viable exit path for mid-sized business owners planning their succession strategy. By understanding this acquisition model and positioning your company appropriately, you can potentially expand your pool of prospective buyers and maximize valuation. This article explores the search fund landscape and provides practical guidance on preparing your business to be an attractive target.

What is a Search Fund?

A search fund is an investment vehicle through which entrepreneurs (typically recent MBA graduates) raise capital from investors to acquire, operate, and grow an established business. Originally conceived at Harvard Business School in 1984 and popularized by Stanford Graduate School of Business, search funds have grown from a niche concept to a recognized acquisition model with hundreds of active funds worldwide.

The search fund model operates in two distinct phases:

1. Initial Search Phase: The entrepreneur ("searcher") raises approximately $400,000-$500,000 from investors to fund their search for a suitable acquisition target, covering salaries and expenses during the typical 19-month search period.

2. Acquisition Phase: Once a target company is identified, the searcher raises additional capital from the same investor pool to complete the purchase. After acquisition, the searcher assumes an active leadership role, typically as CEO or President.

Unlike traditional private equity firms that may acquire multiple companies simultaneously or flip businesses quickly, search fund entrepreneurs typically seek a single company where they can create value through hands-on leadership over a 5-7 year period before exit.

Financial Profile of Target Companies

Search funds seek companies within specific financial parameters:

• Purchase Price Range: Traditionally $5-30 million, with a median purchase price of $14.4 million (as of 2023)

• EBITDA Range: $1-5 million, with a median of $1.9 million

• Revenue Range: $2-30 million, with a median of $7.3 million

• Purchase Multiples: Median Purchase Price/EBITDA of 6.3x and Purchase Price/Revenue of 1.8x

Self-funded search funds (where the entrepreneur funds the search phase personally) may target smaller businesses, typically valued below $5 million.

Example Target Company Profile

A prototypical search fund target might be:

• Revenue: $8 million

• EBITDA: $2 million

• Valuation: $12 million (6x EBITDA)

• Employees: 40 (median size from Stanford study)

• Annual growth rate: 11-15% (aligned with typical targets)

Deal Structure and Financing

Search fund acquisitions typically employ a combination of funding sources:

• Senior Debt: 50-70% of the purchase price, with debt-to-EBITDA ratios commonly between 2x and 3x

• Seller Financing: Often 10-20% of the purchase price through seller notes

• Equity: Remaining 20-30% from search fund investors

Sample Deal Structure

For a company with $2 million EBITDA valued at $12 million:

• Senior Debt: $6 million (3x EBITDA)

• Seller Note: $2 million (16.7% of purchase price)

• Equity: $4 million (from search fund investors)

This structure allows search funds to achieve their target returns while providing sellers with both immediate liquidity and potential upside through seller financing.

What Makes Your Business Attractive to Search Funds?

Search funds look for specific characteristics that signal both stability and growth potential:

1. Stable, Predictable Cash Flows

Search funds target businesses with:

• Consistent historical financial performance

• Predictable revenue streams

• Strong profit margins (typically 20%+ EBITDA margins)

• Limited seasonality or cyclicality

These characteristics support debt servicing and provide a stable foundation for growth strategies.

2. Recurring Revenue Models

Businesses with subscription-based services, long-term contracts, or high customer retention rates are particularly attractive. A consistent pattern of repeat business from existing customers significantly reduces acquisition risk.

3. Sustainable Competitive Advantages

Search funds seek companies with:

• Established market position

• Specialized expertise or capabilities

• Proprietary products or services

• High switching costs for customers

• Barriers to entry for competitors

4. Growth Potential

While stability is important, search funds also need opportunities to create value through:

• Geographic expansion

• New product/service development

• Operational improvements

• Technology implementation

• Add-on acquisitions

5. Limited Owner Dependency

Companies where success is tied to systems and teams rather than a single owner's relationships or expertise are more valuable. A strong management team that can operate with minimal owner involvement is highly desirable.

Positioning Your Company as an Ideal Search Fund Target

If you're considering a search fund exit, these strategic improvements can maximize your attractiveness and valuation:

1. Strengthen Financial Reporting

Implement best-in-class financial practices:

• Maintain clean, audit-ready financial statements

• Implement robust accounting systems

• Track key performance indicators (KPIs)

• Separate personal and business expenses

• Consider a financial audit or review by a reputable firm

2. Reduce Owner Dependency

Work systematically to make yourself dispensable:

• Develop a strong management team

• Transfer client relationships to multiple team members

• Document specialized knowledge and processes

• Establish formal decision-making protocols

• Gradually reduce your day-to-day operational involvement

3. Document Business Operations

Create comprehensive documentation:

• Detailed standard operating procedures (SOPs) for all core functions

• Employee training programs and manuals

• Customer acquisition and service delivery processes

• Vendor relationships and agreements

• Organizational charts with clear roles and responsibilities

4. Highlight Growth Opportunities

Develop and document realistic growth strategies:

• Market analysis showing untapped opportunities

• Competitive landscape assessment

• Product/service expansion plans

• Geographic growth potential

• Pricing optimization opportunities

• Potential operational efficiencies

5. Build a Diverse, Stable Customer Base

Reduce concentration risk:

• Ensure no single customer represents more than 10-15% of revenue

• Diversify across industries or market segments

• Implement customer retention programs

• Establish multi-year contracts where possible

• Document customer satisfaction metrics

The Search Fund Acquisition Process

Understanding the typical acquisition process helps prepare for a smooth transition:

1. Initial Contact and Screening

The searcher will:

• Sign an NDA before detailed discussions

• Request high-level financial information

• Discuss your business model and operations

• Evaluate fit against their acquisition criteria

2. Preliminary Due Diligence and Offer

If interested, the process advances to:

• More detailed financial review

• Operational assessment

• Customer and market analysis

• Letter of Intent (LOI) with proposed terms

3. Comprehensive Due Diligence

Following LOI acceptance:

• In-depth financial examination

• Legal review of contracts and liabilities

• Customer interviews

• Employee assessment

• Operational evaluation

• This phase typically lasts 30-90 days

4. Transaction Closing

The final stage includes:

• Negotiation of definitive agreements

• Securing financing from investors and lenders

• Finalizing transition plans

• Legal transfer of ownership

5. Post-Acquisition Transition

Most search fund acquisitions include:

• 3-6 month transition period with the previous owner

• Potential ongoing consulting role

• Possible board seat for the seller

• Regular updates on business performance if seller financing is involved

Financial Returns and Exit Timelines

Search funds aim for specific financial outcomes:

• Target ROI: 4.5x on invested capital (based on historical performance)

• Target IRR: 30-35% (the actual aggregate IRR across all search funds has been 35.1%)

• Typical Hold Period: 4-7 years before exit

For search fund investors, exit options typically include:

• Sale to strategic or financial buyer

• Recapitalization

• Management buyout

• In rare cases, initial public offering

Conclusion

Search funds represent a unique exit opportunity for mid-sized business owners looking to transition their companies to motivated, capable new leadership. With their focus on stable companies with growth potential, search funds can offer attractive valuations and ensure your business legacy continues under thoughtful management.

By understanding search fund criteria and implementing the recommended improvements, you can enhance both your company's operational performance and its attractiveness to potential acquirers. Even if you ultimately choose a different exit path, these improvements will likely increase your company's value and appeal to any buyer.

Whether your exit timeline is immediate or several years away, now is the time to begin strategically positioning your business as an ideal search fund acquisition target.