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Startup 3.0: Supporting entrepreneurs, building entrepreneurship

Startup 3.0: Supporting entrepreneurs, building entrepreneurship

Entrepreneurship through Acquisition, also known colloquially as the Search Fund, is an emerging avenue through which aspiring entrepreneurs can quickly give shape to their entrepreneurial spirit leveraging their own managerial abilities.
<h4><strong>What is it?</strong></h4>
The Stanford Center for Entrepreneurial Studies defines search fund as "An investment vehicle through which investors financially support an entrepreneur's efforts to locate, acquire, manage, and grow a privately held company. The model offers relatively inexperienced professionals with limited capital resources, a quick path to managing a company in which they have a meaningful ownership position."

Although many variations exist within search funds, the most common one is where the individual raises a fund from investors to "search" for a company and then buys the company with a mix of debt and equity capital. This process typically takes 18-24 months. The individual gets a meaningful equity stake in the company, operates it for 5-7 years typically, before exiting usually by selling it to a strategic acquirer or a lower middle market private equity firm.

Compared to the other two models of entrepreneur capacity building (Entrepreneur-in-Residence and Venture Studio) which help you launch a venture from the ground up, search funds would make you an entrepreneur through acquisition (EtA).

Typically, the company for acquisition would be one with stable and recurring revenue, strong EBITDA margins, in a fragmented industry, with favourable industry trends, history of profitability and growth, low capex and multiple levers of adding value post acquisition. Generally, companies that first-time acquirers typically look for fall in the $1 – 3million EBITDA range.

While the concept of acquiring an existing business is as old as doing business itself, search funds as a separate asset class are relatively new and niche. According to the Search Fund 2020 study by Stanford, the number of new search funds stand at 51 in 2019. As an asset class, they generated 32.6 per cent IRR and RoI of 5.5 times. One of the most well-known examples of a successful search fund is Asurion, which was acquired for $6 million by two Stanford Business School graduates in 1995 and is now a multibillion (yes, billion!) technology insurance company used by approximately one in four people in the US.
<h4><strong>Who should do it?</strong></h4>
The common profile of a searcher is someone around 30, usually an MBA, with a few years of solid work experience under their belt though investors are becoming more comfortable backing non-MBA searchers especially if they have specific expertise (industry or functional).

Having seen many friends go down this route, there are some common personality traits I observed. The first was a desire to do something entrepreneurial and independent without necessarily being wedded to an idea or an industry. The idea of operating a company was appealing to them as opposed to preference for a sector or a need. Another is a penchant for being a generalist: enjoying finance, operations, strategy, people management and going into the weeds of running a business day to day as opposed to being biased towards a particular function. Lastly, there was a desire to own an already functioning business as opposed to going through the process of establishing one from scratch.
<h4><strong>Pros and Cons</strong></h4>
No other path allows for becoming a CEO of an established business at such an early age. The experience is hard to replicate and would be valued in the market very highly after exiting. Purely from a financial perspective, the median equity compensation for those who had exited the business was $3.25 million with a per-year value of $0.67 million for every year of operation and the median compensation was $253,500 (base salary plus bonus). Risk adjusted, these are better economics than most traditional jobs including investing roles and are only topped by outcomes for start-up founders with very successful exits which are outliers not the norm.

Search funds offer the same flexibility and independence as start-ups and arguably a better work-life balance and less uncertainty given the businesses are already functioning and steadier. Overall, the chance to go deep in an industry, understand how to grow a business and build a team are all invaluable skills and learning experiences.

On the flip side, the best search is one that is industry and geography agnostic. Many investors in search funds encourage the searcher to carry out a geography agnostic search in order to maximize the chances of finding the best business to buy. Simply put, you will have to move to whichever city the business is based in. While the move may be possible for the searcher, it could be the very difficult for their partner. Similarly, the industry the company operates in would usually be a traditional industry given the desire for stable and recurring nature of the cash flows. These would usually not be frontier/disruptive technology industries usually associated with start-ups (if at all that could be considered a con).

If you want to work in blockchain, machine learning or autonomous vehicles, want to only live in a large urban hub, want venture type growth and returns, this is probably not the ideal path for you. If you like operating and growing an existing business, if you are flexible putting down roots for a few years in a relatively smaller place and if you want a solid payout from a risk-return perspective, this is a great option.
Startup 1.0 was when investors felt comfortable backing entrepreneurs and ideas and then sitting back hoping to reap returns. There was minimal support and the entrepreneurs had to figure out solutions without any playbook. In Startup 2.0, there was more hands-on support in additional to the financial one as venture capital became more competitive and investors had to compete for the best deals. As the ecosystem becomes even more mature and competitive, there is the coming of Startup 3.0 which is biased in the favour of the entrepreneur. Investors are willing to go even earlier, put more resources than ever and back promising individuals without an idea or a team. If you've ever wanted to pursue entrepreneurship, now is the time to do it!.