This is my first conversation on this podcast with more than one person. I’m meeting with the team from Searchfunder.com, an online community dedicated to search funds and the various parties involved. A search fund is the smallest form of micro private equity I’ve found thusfar and is typically one entrepreneur seeking out a company to buy and run as the CEO. The team consists of the two co-founders, Luke Tatone and Mark Yuan, and their COO Karen Spencer, all of whom are graduates of MIT. Luke is the first speaker, followed by Mark and finally Karen.
During our conversation, we discuss what a search fund is, how they’re structured, who participates in search funds, and how they’ve evolved over time. If you are interested in running/buying/or even starting your own company one day, this conversation is for you.
I met the team after signing up on Searchfunder only to discover all three of them lived here in Portland, OR. Mark initially reached out and invited me to coffee where we chatted about all things search funds and I quickly met the rest of the team. This conversation is the result of one of my most recent, and favorite, small world stories. I hope you get as much value out of this conversation as I did.
Let’s start by going over what a search fund is, how they’re generally structured, what the goal is, and then who generally participates in the search funds and the different parties involved.
Luke Tatone: There’s a lot of different ways of defining a search fund. At Searchfunder, we take the broadest possible definition so fundamentally for us it’s an entrepreneur that’s seeking to buy their way into owning a company, generally with other people’s capital very early in their career, although not always.
Most of the search funds that we bump into and participate on our site are either this traditional variety that’s popularized in the Stanford study where you have usually a freshly minted MBA raise a few hundred thousand dollars at the front end of their search, and then they go and hunt for a business for a couple of years. They then have an obligation to give those investors the right of first refusal on any deals they come back with.
The older model, which really is as old as businesses themselves, is the idea of just buying a business without a sophisticated search fund model, and you see that gaining popular popularity primarily with the thought leadership of the folks at Harvard Business School right now. Royce Yudkoff, Rick Ruback, Jim Sharpe, they really promote the idea of self funding your search which means you just use your own capital for the period of time where you’re hunting for a company and then once you have a deal then you go raise capital at that time, without any big commitments.
And then thirdly there’s been a rise of accelerators where, rather than having a distributed pool of investors, you have effectively one investor that raises capital but funnels it all to you through them. They will help structure your search in a more predictable way.
We try to distinguish between search funds and independent sponsors, insofar as the market we’re trying to cover. If you’re looking to make serial acquisitions, but don’t intend to run the company yourself, you’re probably best described as an independent sponsor and distinct from a search fund. But if you do intend to operate the company, that in many ways maybe the defining characteristic in terms of what a search and search fund means to us.
I’ve been really fascinated by search funds because it seems like the smallest possible form of micro private equity. What kinds of people typically take searches or become searchers? Is it split in thirds of prior bankers and private equity associates, former CEOs and CFOs, and then founders? How does the distribution work out?
Mark Yuan: Generally, I would say that the core demographic of searchers tend to be MBAs from the top 10 ranked business schools, both in the U.S. and internationally. So in places like Harvard, Stanford, Wharton, but also international prestigious schools like ESA, IE business school, London Business School, and the reason for that is because in those schools, as part of the MBA programs, they have one or more classes dedicated to teaching their students how to run a search fund and how to become a CEO.
If you’re young, like a 28 a 29 year old MBA, and you have the aspiration of being a CEO, there’s two short ways to get to that. One is of course to do a startup and start your own company. But success rates are very very low and it’s not the most reliable way to, and you can call yourself a CEO, but the idea is that you want to be actually running a real company with employees and revenue. It takes a lot to get there. Search has another path. So rather than taking that huge risk of trying to get something brand new off the ground, most search deals fall into this category, you find an aging business owner who needs to basically pass on his company and doesn’t have kids that want to stay in the business. So we’re talking about medium sized companies that tend to be family run businesses. You’re thinking of small manufacturing companies, accounting firms, insurance companies, what have you.
The idea is you come in there and you buy it out, so the type of people who end up in this CEO role are very representative of the entrance requirements of these business schools, which typically tend to admit former consultants, former bankers, and private equity guys. I would say that historically it’s usually been the people who’ve worked in finance that are going to search funds because they have more confidence. They have participated in these acquisition type deals before, not as the principal but as an associate or something like that. So they’re more confident in their ability to take down a business.
But we’re seeing a shift from finance backed folks to more operationally backed folks. And that’s basically being driven by the investors because ultimately the goal is to run the company and to build value. So the operation where you’re running a company for 10 years is much more important than the search itself.
Would you say that, of the different experiences that you could have had before running a search fund, would you say that the operator/CEO/founder type of skill set would be more valuable than that of a private equity associate?
Mark Yuan: At least the investors view it as more valuable, and the ability to lead employees in these small companies. It’s funny now you mentioned that, the one demographic that is very large and very well represented is former military officers who have left the military and have gone to a top tier MBA. It’s because they’re used to leading “employees” from all walks of life. So, rather than a consultant or banker who may have mostly dealt with a workforce that was very white collar throughout their careers, these types of businesses tend to be smaller and you might have hourly employees. So military searchers are very eagerly sought out by investors in the search space.
Karen Spencer: I interview a lot of searchers who turn into operators and we try to catch them about that six month span. And one thing that they universally talk about is the ability to be able to engage with people of all walks of life and in all situations. Typically if you’re going to a prestigious school, you’ve been on a track in a certain way and you’ve worked in a certain type of environment. And now you’re working in something that’s completely different with people with completely different concerns. So they’ve had to take crash courses on their emotional and social intelligence skills.
How many searchers over time have you seen, studied, interviewed, or just had on the site?
Karen Spencer: We have been able to tally over 900 search funds having been formed since the beginning in 1984 and we’ve seen exponential growth in search fund formations in the last five years.
Could you speak more the growth you’ve seen over the last five years? Before we started recording, we got to see some of your data from this past year and prior, and it just looks like a tremendous growth. How has that looked over the last five years?
Karen Spencer: I think you summarized it pretty well. I think if it was profitability numbers for a company I think a lot of people on their board would be doing a jig of some sort. It’s just a very steep slope upward and I think that trajectory is going to continue. There may be bumps here and there but it’s going to continue.
So how many search funds were formed last year versus five years ago and ten years ago? What are those numbers?
Karen Spencer: We’re approaching 180+ this year for 2017 that’s the one where I feel like I’ve got the hardest data on, and then five years before that you’re looking at 29 search funds that we’ve been able to learn about through our community.
That’s been impressive. What do you think is driving that hockey-stick-like growth for search funds?
Karen Spencer: I think Mark alluded to it, the more that schools teach about it, the more articles are read, and I know that there are more schools coming online that are teaching it, the more searchers there will be. I think that it’s a much more compelling path with the baby boomers retiring as well.
Are these searchers buying businesses typically from owners who are retiring, or what other circumstances are the owners selling from?
Karen Spencer: Typically it’s somebody who is retiring. So if you think about a baby boomer, they’ve run their company 30 years, they don’t have a family successor for the business, and maybe not somebody in the house that is capable of running it or financially able to buy the business. They might have a life event, a sickness or illness or something else may happen where they finally think, ‘okay, now is the time for me to think about a successor.’ And it’s a great moment for an enterprising person to step in and buy a company.
Looking at the search process more in-depth, what are the typical steps for a searcher from going from nothing to acquiring the company? I assume there’s a fundraising stage, then there’s the search stage, what do each of those look like?
Karen Spencer: I think the first stage is learning what a search fund is. And that can take a little bit of doing. Luckily we’ve got a ton of resources, just to put a plug in for us, on Searchfunder.com that help people in getting started. And then the next step is interviewing other searchers and investors to really understand what the dynamics and the nuts and bolts are. And then I think you’re moving on to finding sources of financing. How are you going to fund that time? Is it going to be through a pool of investors or are you going to be able to do it on your own?
Mark Yuan: What we tell searchers, and it’s almost a carbon copy of what the professors at Harvard Business School will tell you to do. And in some ways we built the community around these needs. We tell them, before you think about launching your own search fund, the best thing you can do is to intern with current searchers and, like Karen said, there’s probably 180 searchers out there in the market right now and others that are in the search phase.
If I look on the site now, probably 95% of them are hiring interns because searchers are always looking for help. Because if you think about the process of reaching out to business owners, it’s similar with private equity. It’s a lot of cold calling. It’s a lot of diligence and a lot of roll-up-your-sleeves hard work, and as a result it takes about two years to find a company, that’s the average speed, and you can use as much help as you can get.
And it’s a great way to see if search is right for you before you commit. We tell everybody this, ‘you’re thinking about doing a search fund, I hope you know that searching really sucks, like it’s probably going to be the worst.’ It’s basically door to door sales. The idea is that business owners probably, for the most part, aren’t interested in selling and don’t want to talk to you. They’re hit up by brokers multiple times a week.
Luke and I were talking to a business owner and he was telling us that they have set up a special hotline just for people who say they want to buy his company so they can direct it through them. It was some guy named Frank and we’re like, ‘what’s Frank like?’ ‘Frank does not exist.’
You have a lot of solicitation, it’s a 99% rejection rate and all of this is at the end to do just a single deal. So, if you can stomach the search phase, your reward is that you get to be a CEO at a relatively young age.
Luke Tatone: One thing I would add to that that would be more encouraging to a prospective searcher, for most searchers I think the first six months to a year is just learning how to search efficiently. And the first couple of business owners you talk to, which are very hard to get in front of, you’re going to mess it up and that’s just a part of the process. But by the time you’ve done it a few times, you can credibly present yourself as a serious buyer and that might be six months to a year in your search that you’re finally in a position to actually consummate a deal.
But that said, a lot of times searchers put an arbitrary timeline on when they’re going to stop searching. I think our belief is that if you’re patient and if you’re doing the right things and executing your plan daily, buying a company is a very doable thing. And you might lose the desire to search after you see what types of businesses are available. But if you’re committed and determined, it’s our belief that a competent searcher should be successful if they give it sufficient time.
And so within that searching process, what sorts of people are they talking to? Is it just directly reaching out to owners? Do a lot of searchers reach out to brokers as well? What kinds of people get involved in the search process?
Mark Yuan: For most searchers it’s maybe 60/40 or maybe 70/30. Where the 70, or the larger part of the time, is spent on that direct outreach and a smaller portion of the time is spent on broker outreach since most businesses for sale are represented by brokers so that’s a great source of leads.
But at the same time, if you can find a business that’s not in a competitive bidding process where you’re one of the few buyers, rather than many, then that’s a much better position for you. But I would say that as the internet gains traction, information becomes more free, we’re seeing the broker route as becoming more and more accepted. That being said, if the owner is interested in selling he’ll probably engage a broker and be more widely listed than in these proprietary deals where you’re the only buyer. Eventually I think they’ll probably go away as the market becomes more efficient.
Luke Tatone: We hear a lot of brokers that maybe a year ago were resistant to the idea of working with searchers, they’re now aware that it’s a phenomena that’s not going to go away, and searchers are here to stay. The numbers are only going to increase. We were talking just the other day with a broker who is putting on a major conference in a couple of months and he was just astounded by the number of closed deals.
I think there is a growing acceptance of the search fund path as legitimate and it does seem like you will have a convergence where brokers who already have these relationships with companies are going to be more willing to work with searchers and they’ll be more action there than perhaps there has been in the past.
Are there some pros and cons to working with brokers versus the direct outreach?
Mark Yuan: For the direct outreach, the pros are you might find a deal that’s not in a competitive process and you’d be able to pay a smaller multiple, which everybody on the buy side wants and it’s better for investors, better for you. Also you might uncover some companies that could be more interesting or more niche. But the biggest problem with reach out is that the owner might not be serious about selling. So a searcher can, and often will, waste probably months corresponding and doing diligence on a company only to have the owner at the end of it say I’m not really that interested.
Whereas if the owner has engaged a broker, he’s already made a mental commitment to not pull out. Searchers on average will research in-depth maybe six or seven companies to buy one. And the idea is that a lot of times deals don’t happen because the owner pulls out.
Karen Spencer: I would include in that discussion on broker outreach. Just general outreach to say a local business alliance your own network of folks in finance and banking, people who are likely to know about businesses and that might be for sale. So, I think when we say broker outreach, we also mean just that broader outreach to that network too.
How many are searching within a certain region like a city or state, versus having a more national scope where they feel more comfortable with the idea of, maybe they have to go work in Des Moines or Chicago and maybe they’re from San Francisco?
Luke Tatone: Definitely if you go down the traditional search fund route, the investors are going to require that you are open to buying a business anywhere. You just don’t have the luxury of being too picky geographically.
But that said, anecdotally and, we do have this data and we haven’t organized it in a way that’s easy to publish yet, but we probably should, the location of the searcher and the number of miles to their acquisition target is actually pretty close. My guess would be it’s probably within a two hour drive, or something like that. And if you think about it, it makes sense because if you’re working on a warm lead with a business owner, if you can hop in the car and go see them face to face, it’s an easy thing to do than jumping on a plane, it’s just a higher probability that you’re going to have a positive interaction. And I think you do see that play out. There’s a business you hear about where they literally were on the same street as where they happened to be conducting their search. Then there’s others that are completely across the country. But I would tell prospective searchers to think hard about where they’re locating themselves while they’re searching, because there’s a high probability that their acquisition is going to be within that region.
Karen Spencer: We see that self-funded searchers tend to have more geographic constraints, they have a spouse who is constrained by geography or they have kids that they don’t want to move. And that’s one of the things that is enticing about the self-funded model is being able to say I really want to live in a certain geography and I will find a business in that area. The trick of that is that you have to be much more flexible about what type of business you’re going to buy at that point.
Mark Yuan: In the traditional model where investors are paying your search costs and you’re drawing a salary for the two years you’re searching and essentially you’re not taking any personal risk, the reason that they, at least in the U.S., they require you to search the entire U.S. is you have investors committed to you and they have a certain amount of capital they need to put to work so you have to buy a larger company. And to buy a larger company, if you just look at the numbers there’s orders of magnitude more companies say under $10 million in revenue than over. So it’s just a supply of businesses issue.
So if you go traditional, because you have to put more investor capital to work, you have to search nationally because locally there’s just not enough companies. Whereas if you’re self-funded and you’re going to be the primary financial benefactor of your deal, there’s no equity requirements. If you’re happy with a business that’s spins off $800,000 in profit every year, something that might be too small for a cadre of professional investors, you can look for that company in your local area.
We’ve been touching a little bit on it, but what is the normal size range of these companies in terms of owner earnings or EBITDA? Is it $1 to 4 million? $1 to 5 million? And then what multiples are they finding on these companies?
Mark Yuan: For self-funded searchers, usually what you see is something under $5 million in enterprise value and if you get very lucky you could buy something much larger. But you can buy good businesses between $1 and 2 million in EBITDA for a 4 or 5x multiple, and at those multiples it becomes very easy to do a leveraged buyout type deal. When you get into some of the traditional search fund deals that are a little bit larger, the average equity injection on those deals, just the equity portion of the deal, is around $8 million. So you’re looking at companies where the enterprise value is probably $15-20 million. Those sometimes the highest multiple we’ve seen is probably 7x that searchers are paying. So it’s still in the financial buyer multiple category and they’re definitely not strategic acquisitions.
What do you think makes these companies have such low multiples? As you move up the chain of company size, multiples seem to tend to expand, especially if they’re publicly traded. Why are these small companies still traded for such a small multiple in comparison?
Mark Yuan: It’s just a matter of supply and demand and access. For a smaller company there are less buyers. Appraisers will say, ‘we can appraise your company based on these formulas, but at end of the day your company is only worth what someone is willing to pay for it.’ So for smaller companies, where it doesn’t make sense for a large private equity group or a strategic to go out there and acquire a $2 million company, it could probably cost them more money to research it than the revenue of the whole company, the individual buyers are their only option. Everybody would sell to a strategic acquirer at 20x if they could.
For a lot of searchers, that’s a lot of their whole strategy. As an individual, I could go out and maybe I could buy like three or four of these $2 million companies, now all of sudden it’s attractive to a bigger buyer and they turn it around and sell it.
Luke Tatone: We see in general that search funds are efficient below the threshold of where it’s efficient for private equity firms to play. Maybe the twilight is up to, very aggressively, $5 million, and somewhere around $2 million it becomes really clear that it’s difficult for private equity.
And then we’re always asked, ‘what’s the lower bound?’ And I think in that case it usually comes down to the opportunity costs for the searcher, considering how much they value controlling their schedule and being their own boss. But you could use the search fund model to buy a very very small company with $300,000 or $400,000 in EBITDA if you wish.
What kind of companies are these searchers usually looking for? I assume pretty stable recurring revenues is a common one that is looked for and desired, but they also don’t want to just buy a glorified job. So what companies usually come up?
Mark Yuan: They tend to be a stable boring businesses, if you will. On the face of it, the easiest explanation for it would be good LBO targets, traditional, good LBO targets. So companies that already are not levered very high so that you can pay for a portion of that position with debt. Companies that the searcher can run so they tend to be simple in operation. But say the searcher is a software developer or something and they are confident in running a software company. We see software-as-a-service business as being pretty popular right now. Of course low customer concentration, high recurring revenue, those are concerns that when you hand over a company, it’s not that all the customers of the company itself belong to the owner, rather than the company. So that’s always a big danger.
Some fun examples, we know searchers who’ve bought companies that you would be like, ‘wow that’s a good company, but I would have never thought this was an actual company.’ For instance, somebody who tests all of the fire hoses for fire houses up and down the East Coast, or somebody who does the billing for ambulances on the West Coast. When an ambulance picks you up, apparently there is a whole software system behind that that can manage the billing, I imagine a lot of people aren’t able to pay extreme ambulance fee. There’s also companies manufacturing ketchup nozzles.
So it tends to be medium sized companies in industries where their functions are pretty essential. They’re stable and they’re not really going away and the owner is generally selling the company because they want to retire or for a non-business reason. We don’t really see a lot of turnaround situations or startups being purchased, because at the end of the day, the searcher’s a financial buyer and you find a company based on the financial strength.
I love looking at companies within this micro PE range because you discover companies that are doing things you didn’t even think was a business. Like the very companies described, obviously there’s a nozzle on my ketchup bottle, but I didn’t know that there is a whole business behind just that one little piece. What other examples have you run across in your experience with search funds?
Mark Yuan: There’s a really good company and we did an interview with them. What they do is they lease plants to office buildings so you walk into a big building like, ‘man, they got good plants inside here.’ Someone has to like water them and do all that, but rather than hiring someone to water plants, it’s cheaper to just lease the plant with the maintenance itself. And that’s a local, sticky business where every city would need that. I believe Karen actually had a really good interview with a buyer of one of those businesses, it really interesting.
Karen Spencer: It’s all over the range. The interesting part is that they’re never going to be on Fast Company or Forbes magazine because they’re not sexy businesses. They’re going to generate cash. You’re talking about pool maintenance in sunny areas, ambulance services, insurance services, therapy, autism therapy or drug therapy, businesses that you can understand and that people need and that provide an essential service.
Mark, when we met for coffee, we talked a little bit about this company that was in the pet funeral services. Would you be a touch on that just a little bit?
Mark Yuan: One of the first searchers out there, he purchased a pet cemetery and subsequently went on to roll up various pet cemeteries and pet cremation services in the pet bereavement industry. I think he’s a pretty big national player now.
I guess the most famous example of a search fund story, one that you’ll hear at every search fund conference and they’ll teach it to you every business school as a case, is a company called Asurion. And if you’ve ever bought any electronics through Amazon and you get insurance on your cell phone, chances are Asurion’s the insurance company backing it. I think it’s a multi billion dollar company now, but it started as a search fund when two Stanford graduates, I think in the early 90s, went out and they bought a roadside tow truck service company. They said, ‘towing is like insurance, because what if you can pre-purchase towing?’ Now there’s roadside assistance programs that you can buy. And then they realized, ‘everybody calls for towing with their cell phone. Why don’t we expand insurance options to cell phones?’ And they did a hard pivot and there was clearly a vacuum in the market for insurance on cell phones. They’ve taken over in the market through this search and acquisition and hard pivot. Some of the original proprietors of the Asurion deal are some of the biggest investors and searchers now, which is something else that we see.
The life cycle of the successful searcher is you graduate from business school, you buy a company, you are somehow wildly successful in your exit of that company, and then you continue doing search funds as now an investor in the community. So most searchers, the people who are backing them, the investors, are former searchers.
Do you remember what they purchased the company for, what the purchase price was?
Luke Tatone: I want to say $5 million and I think there’s important lesson there. One of the most attractive things about going into a search fund for an entrepreneur is that you can pretty much control your downside, if you are patient. If you can buy a good business, with good cash flow, and now you’re in business, which is difficult to do, there really is no cap on your upside. And there are certainly lots of examples of companies that have started out as maybe a $5 million acquisition that have gone on to be very substantial companies.
So when these searchers are looking for these companies and they’ve found a few that they’re interested in, what kinds of things do they do to convince the seller that they are a good buyer of their business? I would assume a lot of these sellers probably founded the company themselves and have worked maybe a large part of their lives in the company. I would assume a lot of them care about who’s buying from them. So what kinds of things do owners care about the buyer?
Luke Tatone: I hesitate to say it that’s a myth, but I suspect that it’s a myth. Buyers, again from our perspective, if there’s a tie may lean towards the son or daughter they never had. But economics drives most transactions and that’s difficult for a searcher because you’re usually the buyer of last resort because you can afford to pay the least. Which is why you have to search for two years or more. So the name of the game from my perspective would not be from the standpoint of differentiating yourself from the strategic buyer or perhaps a private equity firm or something like that, but just being patient and they’ll come a time where you’re the winning bid and you just want to be in the market when that happens.
Karen Spencer: I think the distinction, in talking with successful buyers, is the owner of the company making the decision to want their employees to have further careers beyond when they leave the company. And at that point you really are looking at a search, but I think it’s really the only model that fits because you have a built in CEO stepping into that path. The employees have some assurance that if you perform well, they’re going to be staying on and they’re not going to end up getting laid off for strange things going to be happening that you might fear with a different type of buyer.
So near the end of the search process when they’ve found a company that’s interested in selling to them, how does their process of running the search fund change from looking for companies to now doing due diligence? It looks like it’s a pretty different skill set. How does that transition work and how does that process work?
Mark Yuan: I would say that looking for companies is actually a small part of the search, even though it is two years. It’s not very hard to find brokers, it’s not very hard to find listings of businesses and reach out. In fact, a lot of that could even be automated with today’s technology with CRMs and what have not. Most of the searcher’s time is actually spent looking at individual businesses. And it takes probably two or three months to diligence a company…
Karen Spencer: In the U.S.
Mark Yuan: Right, in the U.S. You have to see if the owner is hiding a plane in the books or something like that. It happens all the time in these sized companies. Most of a searcher’s time is spent towards diligence, rather than generating leads and you have to kiss a couple of frogs in order to find a business that you want to buy.
It could be a number of things whether the finances are off, or you find it’s not a business you want to run, or the owner gets cold feet, and that sort of thing. But once you can get to an LOI, which is exclusive between the owner and the buyer, to do that diligence I would say that most searchers strive to spend most of their search phase in LOIs with one or more owners. And the key is even though you’re spending most of your time on each individual business, it is important to keep the funnel going on the other side generating leads. So if your LOI falls through, you can get work diligence on the next company.
If they’re hiring interns, and it sounds like the vast majority are, is it the intern’s job to primarily look for deals and source them?
Mark Yuan: An intern spends a lot of time figuring out a source deals, but they also might do the first cut of the screening. So a lot of searchers won’t even talk to the owner until one of their interns knows this business is worth looking at. And maybe the intern has the first conversation with the business owner and the interns that are most effective tend to be future searchers who are currently in business schools that are going down that path. So they are pretty motivated to talk to these business owners and can represent the searcher pretty well because they’re not that far removed from the search, maybe just one or two years.
What percentage generally of companies that have a signed letter of intent, how many of those roughly close after that is signed?
Mark Yuan: We’ve seen searchers, if you get lucky, maybe the first company they look at you buy. And so we’ve seen searchers been able to complete a search in four months just because they got incredibly lucky. But usually somewhere between five and seven is the average. So you would get to like a signed exclusivity with the owner five to seven times before you find a company to buy.
So each hurdle of the process has a low probability of success. Let’s say they get through all those hurdles and they finally find a company they like, they buy it, the owner’s happy, how do they structure that deal? What do most deals look like?
Mark Yuan: It’s gonna be vastly different between self-funded and traditional searchers because for a traditional searcher, where you’re drawing a salary from your investors while you’re searching, the terms of the deal are locked in before you ever find a company. So as a condition of your group of investors providing you the money to live on while you’re searching, they say when you find a company this is what you’re going to get in those situations. The searcher can earn up to 30% and maybe 25% of the common stock in the company, subject to preferred returns and things like that on the investors.
Now for a self-funded deal, it’s wide open because the idea is there’s nothing. You don’t have any pre-negotiated contracts so once you find a company, you can negotiate with investors with banks to get whatever terms you can get. But usually it comes down to say like a $5 million deal, you’ll probably get $3 million of bank debt, you’ll probably get the owner to kick in about $1 million through a seller note, and you need that to have the owner assure you that he’s telling you the truth. There is a condition that the owner gets paid out over time from the revenue of the company. And then on the final million dollars in a deal, that can sometimes go to friends and family, sometimes you’ve got a professional investors who will kick in the final amount.
So then the deal structure is significantly better for the self-funded, self-funded being the one who self funds the search process up until this point, are significantly better than those who have their salary paid for during the search?
Mark Yuan: Exactly, but usually, and this is one thing that’s overlooked so I wouldn’t exactly say it’s absolutely better, because the one thing that the banks were going to want you to do if you’re self-funded is they want you to personally guarantee to them. So if you run the business into the ground, you’re now personally on the hook for $3 million whatever you borrowed from the bank. Whereas in the traditional model you assumed zero financial risk.
So then once they’ve bought the company, what things should the searcher be doing in that maybe first six months or first year as they begin to keep acclimate to this new role?
Luke Tatone: I think the best practices, or the general wisdom, is that you do nothing. And in the first six months maybe year what you’re really trying to do is understand the drivers of the business, and probably the biggest mistake you can do is lay off a bunch of staff and make changes. Give yourself some time to understand the business that you’re running. And then oftentimes the things you need to do are just obvious at that point. Put in a sales team where none exists or update technology, just low hanging fruit that doesn’t require massive disruption but provide an obvious advantage to the business.
Karen Spencer: But that doesn’t mean you get to kick your feet up on the desk and just have a placard that says CEO. They’re working really hard those first six months. Typically these businesses don’t have robust accounting systems set or financial systems so some of the back operations stuff gets done during that time period so that you actually know what money is coming in and what’s going out and really understand the financial engine of the company.
How long do these searchers hold the companies for? I assume they can hold them indefinitely if possible, but do a lot of them sell after 5 to 10 years or so?
Mark Yuan: The average holding period, if you look at the studies that Stanford publishes, is around seven to eight years. I think it’s up to the searchers and the investors what they want to do with that. Sometimes the investors want out because they have LPs themselves that expect a return and the searcher might recap the company where the searcher continues to run it while some of the investors get out. It’s like any private equity owned company at that point. And most of the traditional deals are structured with an IRR hurdle as part of the searchers compensation. So they’re definitely watching the clock. If anything that would be what would drive a searcher and a good business to one exit in the self-funded model. Then you’re in the driver’s seat. the ticking time bomb and you could potentially hang onto a good business indefinitely.
So is Searchfunder.com a pretty fair representation of the search fund market as a whole? Do you have maybe 80% of the search funds out there are on Searchfunder.com or what’s that number?
Luke Tatone: We aspire to have everybody. I think if you compare us to something like the Stanford report, which is the gold standard for search fund analysis and financial information, it’s been going on for probably 10 years and every couple of years they come out with a great report that’s fantastic. They’re able to get detailed financial information and they have a very in-depth report, but their definition of a search fund is somewhat narrow, it’s defined as the traditional search fund.
We make it our goal to have like a big tent view of search funds. We include the self-funded guys, we include the accelerators, and as new varieties and ways of doing search funds pop up, we make it our business to reach out to those searchers and try and bring them into the community. So I think that the scope of our data and our outreach, while it’s completely crowdsourced, is very nearly comprehensive. It’s a good day when we find a new search fund that we didn’t already know about.
Mark Yuan: I would say in terms of the user base, of the people who are active in the community we probably have 80% plus. It’s a function of the lively discussion on the community, people can come in and basically ask questions when they’re just trying to get started. So we tend to capture people who are very early in the search process and we can keep them through.
We didn’t touch on this before, maybe I should have, but all three of you went to M.I.T., which is right next door to Harvard and their search fund program. Why didn’t the three of you start search funds? Why did you start search fund site instead?
Luke Tatone: This is back when it was hard to do a search fund. At M.I.T. Sloan, the business school where Mark and I attended, Karen actually went to the engineering school so she is the real genius.
Karen Spencer: I’m glad they admit that, I was course 10 for any M.I.T. people listening.
Luke Tatone: think that year there were 10 or 15 self-funded searchers out of Harvard Business School and a couple of them were in my classes. In fact there was a guy that was in a class I was a T.A. for in M.I.T. that was telling me about a search fund and we knew what it was but we didn’t have any concrete idea such that it was realistic for us to launch a search when we graduated. We were scratching our heads and saying well this seems like a really good opportunity, and both Mark myself are very entrepreneurial and wanted to do something entrepreneurial. We just found it, at that stage, to be pretty difficult, that was before there were any search fund conferences. The folks that were in search funding were very very helpful, once you were in the community. But getting into the community wasn’t very straightforward and we figured we could just bring the benefits of social media to the space, and I guess we got exceptionally lucky in that the space has taken off exponentially and we hope that we’re building a tool that’s useful and brings transparency and hopefully accelerates the time it takes from not knowing anything about a search fund to being right in the thick of things. For us it was a long and circuitous journey to get to where we are today.
Mark Yuan: Basically if Searchfunder.com existed while we were to business school, we would have definitely done a search fund.
Is that something you’d like to do in the future or is Searchfunder.com where you’d like to stay and observe search funds from afar?
Luke Tatone: Our hands are definitely full. A lot of people ask us that and if they grossly underestimate the difficulty of running a social platform. We like to think of ourselves as focusing on the picks and shovels of all the enterprising gold miners out there that are striking out on their own.
Karen, how did you join up with Luke and Mark here?
Karen Spencer: You know how they always say, ‘stay connected to your Alumni Association?’ It’s true. I wanted to do something entrepreneurial and I started talking to the head of the M.I.T. Alumni Association and he said, ‘I know these great guys, Luke and Mark, and you should talk to them’ and we hit it off and I’ve been with them since that day practically. It’s been a bit of fun ride. It’s been very fascinating to see that vision materialize over the last few years.
And there’s not just search funds on the site, there’s also banks and other intermediaries. So is the goal for the site to be more than just a place for search funds to communicate with each other, but also for them to get help, financing advice, consulting, those sorts of things, is that part of the goal?
Luke Tatone: I think that if you focus on what you’re trying to accomplish as a search funder, searching is actually somewhat unnecessary and redundant. Ideally what you would do is just immediately walk into an LOI, diligence it, and then transact or not and just do a series of deals under contract until you find the right business. And I think that we’re in a unique position to bring that into reality maybe in the next couple of years.
As in bringing on sellers of businesses?
Luke Tatone: Yeah and that happens to some extent. We have a number of intermediaries that bring businesses or at least intermediaries that are interacting with searchers. Most of the actual deal information happens off the platform.
We think that over time you’ll have intermediaries bringing businesses where the searcher can find a deal, find the debt, and pull together the equity all in one fell swoop. And that’s definitely a possibility on the horizon.
Is there a possibility that by bringing some of those businesses for sale onto the site that there will be a lot more competition for those companies and they’ll get better valuations?
Luke Tatone: I think that for searchers, cold calling businesses is probably always going to be a good chunk of what a searcher does. And if you’re lucky enough to find a business that is not currently represented, that’s your your best play. But I think as Mark was alluding to a while ago, as the number of searchers increases and as information becomes less asymmetrical, it seems that you’re going to be in a situation where the seller is not going to be stupid. All they have to do is Google one or two things to realize there is a huge market for their company. It’s probably true that over time valuations will will start to creep up, but there’s still a wide gap between say where the mature private equity sector is, but there’s a there’s a pretty wide gap between private equity and search funds and there might be another 10 or 15 years in this space where there are opportunities to be had for anyone who wants to jump in and give it a go.
Do you think there ever comes a time where a lot of these larger private equity firms figure out a more efficient way to buy companies in the search fund size and then it becomes a lot more competitive?
Mark Yuan: When we said we had about 80 percent of market it’s not just searchers it’s people engaging with search funds. We want Searchfunder.com to be a one-stop-shop for your social needs for searching, like anybody that you would need to meet to get your deal done, you should be able to find them. But some of those investors are actually private equity firms. So it’s funny you ask that because the way that private equity firms access these lower middle market deals is with search funds. Some famous private equity firms that use search funds to access lower middle market deals are Alpine investors, Housatonic Partners, and Petersen Partners in Salt Lake City. Joel Petersen the founder of JetBlue has a fund set up as well. They mostly do private equity but they do a lot of search too and PE firms back searchers and that’s how they access them. So they’re not necessarily doing it themselves, but they’re just seeking out these search funds because it’s too expensive for a PE firm to have in-house staff to source these deals and then have a bench of professional CEOs to go run these small companies. It’s just cost prohibitive.
Do you think that is an advantage for the search fund that will continue on for, like you’re saying, 15 years? Do you think it continues on to that point and something changes or do you think it keeps going?
Luke Tatone: There seems to be an almost inexhaustible number of businesses that could be purchased. I suppose the best analogy would be private equity as a whole. So when you think back maybe 30 years ago when private equity was just getting going, the whole idea was, ‘look, the public markets are pretty efficient, but there’s all these enormous private companies that are being run inefficiently and we can just jump in. But on top of that get these fantastic returns,’ and basically that happened for decades.
But then what’s happened now? Capital flows in, there’s now five or six thousand private equity firms out there, there’s a trillion dollars in dry powder, and nobody can hardly buy anything, and the whole mechanism of the private equity asset classes is coming up against some structural difficulties that are not just attributable to being the top of the credit cycle. As Mark was saying, you have this economic threshold under which it’s just inefficient to play and that goes from, I don’t know where it is exactly, but it’s X number of million in EBITDA down to zero practically. And the search fund is efficient up to the point where the searcher’s no longer motivated based on the cash flow of the company. And for maybe a Harvard Business School grad that’s going to have to be, I don’t know, half a million?
So you’re really going from, within just a couple of decades, private equity plowing through down to say $5 million (EBITDA) and search funds maybe over the next two decades plow down to $50,000 and then it becomes inefficient for the financial buyer to buy it, regardless of their economic circumstance.
Two closing questions I always like to ask, first one being: what’s the most fortunate event to have happened to you by chance?
Luke Tatone: I would have to say meeting my team. I went into business school knowing that I’d already started a company previously and I’ve been an entrepreneur my whole career. I knew that I wanted to do something entrepreneurial, but it’s complete serendipity that I met Mark, a classmate in my section. He was determined to be a consultant and hopefully I got to him early enough and convince them otherwise. In many ways we perfectly complement each other.
And we were just unbelievably fortunate to add Karen to our team a couple of years ago. Karen’s probably one of the most talented people around. We feel exceptionally lucky to have such a well-balanced team, it gives us a lot of scope to tackle all of the challenges that the search funding community throws at us. And I think we have a fantastic foundation for growing whichever direction this whole thing takes us.
Mark Yuan: Luke touched on this earlier, we made friends with a student that was cross registered from Harvard in that M.I.T. technical sales class and that’s what made us aware of search funds. Without that serendipitous meeting and becoming friends with this Harvard student, we still might not know what search funds are today. It remains to be a relatively small slice of the things that students do.
Karen Spencer: I would have to say the same thing because the M.I.T. Alumni Association event that I went to is the first one I had gone to in a couple of decades. So it was just one of those serendipitous things and I went to Stanford and at the time I was at Stanford, search funds were around but I had a different band. I was much more in to big corporate, understanding how do companies really work, and less on the entrepreneurial side. So even having gone to Stanford, I wasn’t aware of search funds or cognizant of them. So without that one chance encounter at the alumni association, I don’t think I would have met Mark and Luke and certainly wouldn’t have had nearly as much fun.
And then my last question is, what’s the best business you ever seen. Is it that tow truck business most likely, or towing business with the phone insurance, or is there another one you’ve come across that was equally as impressive to you?
Karen Spencer: This is probably not the business school answer, but I think as the COO, I just love a business that operates well and efficiently and one that provides extraordinary customer service from the customer’s perspective. I can’t think of one that people would know unless you lived in Portland, Oregon. My favorite example of one is actually our old steakhouse here. Have you eaten at the Ringside Steakhouse?
Karen Spencer: Yes, that works like clockwork and my husband’s a musician so I spend a lot of time in restaurants and pubs and bars and I can pretty much tell you in about 10 minutes or less whether something works well or not. That business works incredibly efficiently from a customer standpoint there. I don’t think I’ve ever seen better.
My mother once returned a steak because when she got it, she was not as thrilled about it because she had hemmed and hawed about ordering between two different types of steak and they said, ‘Okay, if you’re not delighted by it, we will bring you the other steak.’ There was nothing wrong with the steak they served, it was perfectly cooked, but she just wasn’t delighted. And I was like, ‘Okay, every time my mother comes to town, that’s where we’re going to go.’
Thank all of you very much for joining me, I have had a great time chatting with you. I’m looking forward to having another one hopefully soon.
Karen Spencer: Yes, I’d love that.