Search funds are a business acquisition model. The concept was originated in 1984 at Harvard Business School. It later grew amongst MBA programs and in particular, the Stanford Graduate School of Business.
I ran into this concept while I was attending the University of St. Thomas OPUS College of Business MBA program in the mid-2000s. It’s an effective way for young business leaders to find small to medium-sized businesses to acquire, grow, and ultimately sell to achieve a return to their equity investors. A good operator will drive outsize returns in a small to medium-size business. There is no question in my mind that this is the case after financing numerous deals and going through our own ownership transition at Flagship Bank Minnesota.
The returns to investors according to the 2020 Search Fund Study by Stanford GSB are pretty outstanding on the whole:
“From 1984 through 2019, at least $1.4 billion of equity capital was invested in traditional search funds and their acquired companies, up $475 million from the last study, generating, in total, approximately $6.9 billion of equity value for investors and an estimated $1.8 billion for entrepreneurs so far. The aggregate pre-tax internal rate of return for investors was 32.6% through the end of 2019, down from 33.7% in the 2018 study, and the return on invested capital was 5.5x, down from 6.9x in 2018, reflecting slightly lower returns, shorter hold periods, and a record number of new acquisitions. Of note, IRRs excluding the top 5 returning funds continue to increase, perhaps indicating that on average better companies are being acquired and developed.”
The traditional search fund relies a lot on your ability to recruit investors that believe in you and your business acquisition strategy. This can both be daunting and challenging. It can also be unnecessary if you have the capital to do a self-funded fund and start the adventure into business ownership without investors upfront.
A self-funded search fund is a great way to acquire a small to medium sized business for a number of reasons. Two in particular are that it allows the principal to retain more ownership and more flexibility in the types and compositions of the businesses they acquire. It also often requires the principal to take on more debt than a traditional search fund. This is where today’s timing is beneficial to principals pursuing this pathway.
2021 is a Great Year to pursue a Small Business Administration Loan
The recent Consolidated Appropriations Act, 2021 passed by President Trump on December 27, 2020 provides some opportunities for small business acquisition loans for those that qualify. In particular, if your plans are to rely on an SBA 7a loan and/or an SBA 504 loan. The terms include:
- Waived 7a guaranty fees (2.00%-3.75% of the SBA guaranty amount)
- Increased guaranty amounts (up to 90%) allowing for more flexibility and financing options from your bank.
- Loans that qualify and close between February 1, 2021 and September 30, 2021, the government will make principal and interest payments for up to six months, payment support capped at $9,000 per month.
The new law provides significant temporary working capital support for a small to a medium-sized business acquisition. By having payment support from the government for the first six months of operations, your business will have significant support to allow you to focus on its operations and sales growth.
What might a financing structure look like?
We would like to see minimum ratios for the following for an SBA loan:
- 75% senior SBA guaranteed bank loan
- 15% seller note (five years or longer term)
- 10% shareholder equity from the principal(s) and investor
Traditionally, the debt service coverage ratio would be acceptable in this scenario if the price paid is between 3-4X EBITDA.
All owners with ownership greater than 20% will be required to guarantee the SBA loan.
Other options consider a conventional business loan partnered with shareholder capital or mezzanine debt. You can usually expect that the bank loan to be a lower loan to enterprise value in these scenarios to mitigate risk. Commonly you may see bank acquisition debt between 50-65% of enterprise value before other collateral, subordinated debt, covenants, and enhancements are included.
More businesses will be for sale as Boomers Retire
According to the Exit Planning Institute, nearly 4.5 million businesses with an aggregate of $10 trillion in valuation will be on the sale block in the coming decade. This provides a plethora of opportunities for the millennial and generation x to acquire and grow businesses.
There are more millennials on the planet than any other generation. They are hungry and according to the Fast Company, the “Millennial personality seems to be pre-set to ‘leadership’ mode. They’re not sitting around waiting for it to happen.”
We have seen it firsthand at Flagship Bank. Mollie Windmiller has been doing awesome things connecting people at LAB Talks, Dr. Rees and his wife Rosalie growing their business Maverick Chiropractor, Natalie Standridge growing her Spanish Immersion childcare business Casa de Corazón®, Brenda Nolby at her gymnastics business Jam Hops, and many others who have purchased, started, or grown their businesses. We've even done acquisitions at Flagship Bank and have spoken on it at events around Navigating Small Business Mergers & Acquisitions.
At Flagship Bank, we are proud to be partnering with Minnesota small businesses and Minnesota business acquisitions. Relationship banking can be key as you search for that acquisition and even more so as you get close to closing. A bank will need detailed information to underwrite the cash flow of the business. Having those conversations about the business loan as the deal starts to come together will not only save you time but also money.