08 Aug Understanding Search Funds as an IT Services Seller
Search Funds: What are they and why do they matter to a seller? In this episode, we cover what happens when you encounter a search fund as a seller and what to expect.
EPISODE TRANSCRIPT
Mike Harvath 0:02
Hello and welcome to this week’s Shoot the Moon podcast broadcasting live in direct from Revenue Rocket world headquarters in Bloomington, Minnesota. As you know, Revenue Rocket is the world’s premier growth strategy and M&A advisor IT services companies. Today we are talking about search funders and with me today are my partners Ryan Barnett, and Matt Lockhart. Welcome, guys.
Matt Lockhart 0:29
Hey Mike! Definitely an interesting topic. We obviously are running across search funders on a regular basis, some of which have their, you know, sort of their house in order and others that maybe not so much, but it’ll be a good, interesting topic to explore.
Ryan Barnett 0:49
Thanks guys. Ryan here, and appreciate everyone tuning in today on this week’s podcast. When we look at our work, we do M&A for buyers and sellers and today we’re going to talk about what a search fund is and why it matters to a seller. And I’m going to go back in time a little bit. The term search fund actually originated in Harvard Business School way back in 1984. It was popularized in Stanford, and following 10 years after that. And it’s been steadily adopted by a number of business schools and entrepreneurs really across the world. So there’s a great study published July 14, that looked at the 2022 fund of search funders. And I’m just going to be very prescriptive here, in describing a search fund is it’s an entrepreneurial path undertaken by one or two individuals, which we call searchers. And they form an investment vehicle with a small group of investors. Some are our mentors, some help search some help acquire, and some are just straight up investors within that, they look to become the CEO of a company and run that company for about six to 10 years. And when they can put themselves in place, and they can run the company, typically they’re going to take over as the founder, they will oftentimes move to the city in which the company that they’re buying is in, and they will go and run the company and do well. So typically, they’ll go through a phase where they’ll raise capital for six months, they’ll look to buy a company for 12 to 24 months, operate that company for four to seven years. And then take an exit after that time. So again, this is a great study on this. Peter Kelly, Lecturer in management and Sierra Heston, assistant director over at Stanford did a great study on executing and taking a look at this. The IRI the return on investment and IRR and search one is actually really impressive. And it’s an investment tool that can be very powerful. That being said, talking to a searcher from a seller’s perspective, can be a little bit hard. So today, we’ll kind of walk through why that matters for a seller and what you should do and what you shouldn’t do. So let’s hand this over to Matt. First, when a company a seller is looking to sell their firm, they’re typically looking for strategic cultural and financial fit. Matt, can you just help us dig into the strategic fit of where a search fund fits in a customer in a company and how that may may work?
Matt Lockhart 3:39
Yeah, it can be done in a couple of different lenses. Right? You know, one is just from many searchers, who, you know, may convey themselves like a private equity fund, right? Where they have the capital, they have a thesis or experience or a discipline around, you know, the target acquisition space. So for example, you know, if you’re in the managed service space, these individuals have studied it, they understand it, they, they may have worked for financial firm, a private equity firm with holdings in that space. And so they’re demonstrating not just an interest in the space, but an experience in the space that would be, you know, viable for a seller to consider a search funder on the other end, you know, potentially, a seller is looking to, you know, kind of sell in with an appropriate partner, in which they they aren’t interested in, you know, a full acquisition and walking away, immediately. And they would potentially entertain a search funder who has a longer term outlook has the capital to allow a seller to, quote unquote, take chips off the table, but then be involved and just, you know, and transition over the overall responsibility of the ownership of the firm over a longer period of time. Yet, in that way, they could really increase the the overall enterprise value of of selling their firm. You know, again, in that, in that lense, you need to take a longer term view, you may be more involved earlier on in a transition, you may be doing some teaching and et cetera, et cetera, to a search funder. But there are, you know, obviously real viable, you know, strategic fit opportunities in looking at the search fund community.
Ryan Barnett 6:16
Yeah, I think the goal that searchers ultimately run a successful company. And to make it a something that they can return investment to themselves return on investment to their investors and be successful at it. I think there is a fit in which if someone comes within the industry, they can be better suited to execute. And this is a label this podcasts a little differently and might be our plea to search funders is when search funders, on average, they will look at, you can be hundreds of firms, before they go and execute. We really encourage you to take a look at the industries that you’re in and start to specialize in the industries and really consider if you’re going to have discussions that the niche that you’re finding is fairly tight. But it’s not enough that you can make an impact in the people that you’ll be managing and working with are confident with your ability to execute within that. Mike, would you be able to take a swing at culturally what sellers could should consider when talking to a search Hunter?
Mike Harvath 7:36
Yeah, I think you alluded to some of it, you know, I think passion for the industry is critically important for a search funder, and some background or at least understanding of the business. And I think the unfortunate thing is many search funders get a, you know, take a bad rap, because oftentimes they’re looking in a generic way at all kinds of companies that could potentially be a fit there are somewhat non focused in their search. And they tend to want to pay a lower below market multiple for the companies. And so we see those types of searchers not being very successful, in some cases not being successful at all. I think the formula for success and IT services is to say, you know, if you’re looking at someone who’s looking at buying your business, as a seller, who is a searcher is to say one, you know, are they singularly focused on your part of them the space, right IT services, whether that be a managed service provider, where there’s certainly a lot of interest, or app implementers, or custom development shops or SAS company, whatever it might be, but are they focused fairly narrowly on your space, and they have done their homework and know the space. Two, they’re adequately capitalized. Right? They’ve raised enough money have commitments and capital to structure a deal that would make sense. In from a cultural perspective, you guys are aligned, like you can work together, right? Because you’re going to be mentoring this person for some period of time and training them on your business. And you need to be able to show up together every day and work together for some period of time to be able to get them up to speed, manage, run and lead the business and certainly they have to have you know, very good leadership skills in order to do that. I mean, we’re in a people based business people based industry, if they do not have those leadership skills, it’s going to be very, very challenging to manage, run and ultimately acquire as a searcher. People based businesses so you know, I would hold that standard pretty high when you’re thinking about cultural fit. It, you know, you got to think about Kim, my people work for this person. Right? And, you know, super important. So, you know, evaluated, I think in that lens like, hey, if this person tomorrow was to be sitting in my chair, you know, how would how would the rest of the team see them? And did they see them as a leader that could get them to the next level?
Ryan Barnett 10:23
Yeah. And to add on to that a bit, some of this goes back to think of where search funds were built. So a lot of the search fund activity that we’ve talked to is a person who has been educated at a top tier school. We’re talking Harvard, Stanford, some of the Columbia we’ve seen very top educated people, we’ve seen people that are had been independently financially successful. We have seen people who’ve had careers at some of the largest companies in the in the world, you see Amazon, Google, Facebook, take people who will go and start and look to buy their their own, their own fit. And you’ve got a lot of independent thinkers who are out there who are trying to put their own mark on things, where sometimes becomes challenging is that alignment of what they’ve done in a large corporate environment doesn’t necessarily align itself to actually running a company. And that’s a very big hurdle. That’s culturally, a lot of sellers have a hard time understanding.
Mike Harvath 11:36
Yeah, I mean, I think I would add that, you know, their, their history, sort of their upbringing is important. Right? You know, do they come from a family of entrepreneurs, for example, which many of these search funders do? Have they worked in that business? Have they been exposed to what it takes to run a small business? And, you know, then happened to be educated at top tier school. Like Warren, or Stanford, or Harvard, or one of the top, you know, probably 25 schools, business schools in the country, will all be talking about search funds. I think it’s not enough as a search funder to just be a graduate of one of those schools, I think sometimes students come out of those schools, and they say, Well, you know, I can fundraise, or I come from an affluent family, I was trained and went to school, a Top Tier Business School, I can run any business. And where that may be the case, the nuance of actually doing that, culturally, and being respected amongst the peers and a human capital base business, like IT services is oftentimes missed. So I think, for searchers that are coming into our industry, that’s critically important. They come with a big leg up if they’ve been, for example, worked in industry and in a services company, when and maybe got their, you know, MBA, and then came back out and said, Okay, now I’ve been played operating roles and an IT services company, as a full time, you know, employee or as someone who, you know, went back to get their MBA, secondarily, I’m now coming into the market looking to acquire a company that’s sort of a different cultural and experience base that, you know, we don’t see very often, I certainly would welcome it, if we saw more searchers that had that profile. They exist, but certainly not many. And I think having relevant experience in professional services, certainly, whatever that level might be, will be a big leg up if searchers want to be, you know, acquiring it, services companies.
Matt Lockhart 13:55
I think that’s a great point, Mike. I mean, if you think about, quite honestly, one of our existing customers, you talk about coming out of a big corporation, and he came out of Microsoft, right, and you wouldn’t characterize him as necessarily a traditional search funder. But he did just that he created some finance, I think his was more bank financing and personal finance and, and then found the right target company to buy as a first step. And we look at him, he’s grown his company over 12-15 years here and is doing great. But he had the applicable experience through his many, many years at Microsoft, and not just the technical experience, but you know, great business experience. And so, that is clearly differentiated from what we also Do you see is an increasing amount of MBA very smart individuals, very smart, young professionals who, you know, are looking at this as a first step in their career.
Ryan Barnett 15:16
Very interesting. Great, great point. Great point. I’m going to switch gears a little bit. One thing, when looking at this study from Stanford in 2022, the median price for an acquired company was actually 16 point 5 million. And the EBIT the multiple was 7.3x, EBITA. And actually 2.1 times revenue, those are higher prices than we’ve seen. Traditionally, one of the things that search funders are looking for is higher annualized recurring revenue. So you see, a lot of companies are searchers looking to acquire within services, software and tech enabled services, and technology because they can offer, access to that annual recurring revenue. The other side of that equation, if you’re paying that much money in a deal in seven times EBIT is a respectable number, it’s what we’re seeing a lot of deals trading near at now. Each search fund acquisition had a median of 16. Investors, and to a seller, that’s a lot of investors. Mike, I’d love to turn it over to you on the financial side of a transaction with a search fund. What does the searcher need to do to differentiate themselves? When it comes to the financial portions of the deal? And what does what does it mean to have 16 investors in the loop? And then what does the seller think about when they see that?
Mike Harvath 16:57
Well, again, it’s a great question, Ryan, I think what’s important, you know, for the search fund community to do is make sure they have their ducks in a row as it relates to how they put those investors together, follow their operating agreements, or build with those investors what the emitted capital is. And ultimately, you know what that means for a seller, they have to have a game on there, because a smart seller will be asking some pretty hard questions of a search funder to prove capacity to do a transaction at market, which means they have to have you know, committed capital, or maybe capital sitting in an account somewhere. And those are different things. And I think it’s important to be able to, to know the difference, commanded capital in an investment world is just someone makes a commitment, but doesn’t invest the capital until an LOI is signed. And ultimately, they agree on signing off on the deal. If someone has placed capital, it’s going to be sitting in an account and you can see it. And so search funders sort of vary in their ability to either recruit committed capital versus, you know, having access to a capital account. And I think understanding the source of the funding the agreements that the search funder has with their funding sources, and understanding what that means to the seller, will be pretty important. Because what they don’t want to do, obviously, as a seller, you don’t want to be in a situation where one that can’t secure the money when it comes time to close, or more importantly, that there’s some sort of strings attached to that money while you’re operating the business. And before maybe you’re fully either earned out or bought out. And there’s various structures that search funders use, while they’re trying, you’re transitioning the business to them. And you want to make sure that you’re ultimately going to be able to transact the entire transaction as expected. So there needs to be some scrutiny. But you know, I would say that same level of scrutiny should go into, you know, looking at funders in general, on transactions, if they’re a financial buyer and I position search funders as a financial buyer versus a strategic. Strategic tends to be an operating business that is buying your business as an add on or as market expansion strategy. versus you know, a financial buyer who may be a PE fund or family office or even a search funder. Those guys, you know, having access to capital and understanding those capital arrangements as a seller is pretty critical, regardless of the flavor of financial buyer and certainly in the context of a search funder,
Ryan Barnett 19:57
It’s a great point and in this year if you’re are a search funder, just being able to design a little bit better than the 15 individuals that are sponsoring you. I think that gives great insight, we have found that many search funds use a very similar template on a website, that language is is very, very similar that it to the point where you can almost immediately identify from a distance, if you get put in the class of a search funder, it may hurt your search. So it helps to differentiate those differential which you’re looking for the investors that you’re using had any access to capital, it may be just more than access to capital, it’s the mentorship and the guidance that they might be able to provide as well. One interesting note, also to think about, if you are looking for a quick, quicker exit search funders do fairly well here. So the the median time that a CEO or seller stays with the company is about four months after the acquisition. So in the last study of the Stanford was done only 13% engaged longer than two years. Actually 22% of them stayed less than one month. So oftentimes, if you’re looking for an exit from the business completely, they’re looking for a clean handoff a search fund is a very interesting method that could help you achieve your goals.
Matt Lockhart 21:36
That’s a little surprising that owners transition out that quickly. But that’s a great point learning from this study.
Ryan Barnett 21:45
Yeah, I was surprised myself. And I understand the the goal is to operate and understand the company. So, I think sellers should consider a search fund if they come within the industry, and they’ve lived and breathed by something very similar. I think if you’re coming straight from school, or you’re coming from a, let’s say, entrepreneurial company, or a enterprise level company and trying to become entrepreneurial sellers have a real hard time imagining their clients and their employees working for someone who doesn’t have the experience they just had grinding for the last 1015 20 years. And it’s very hard for them to pass the torch. I think a lot of people can pick it up and run with it. But to get a seller over that hump is actually one of the probably the biggest things that search funds have to deal with. When when it comes to evaluating opportunities.
Mike Harvath 22:53
Yeah, for sure. I would also add, you know, we’ve seen from a lot of search funders, you know, what we’ll call, at least in preliminary qualifications, sub optimal multiples are thinking about the market and a low multiple, believing that, you know, if you talk to 300 companies, you’re going to find someone who is either naive enough or desperate enough to sell if they’re willing to trade at a below market multiple. That’s just not the case. In our industry, I don’t think it’s the case in any industry, as I often say, I don’t think any unfair deals get done. And oftentimes what search funders pretend to do is you know, a couple ticks on even a multiple below market, thinking that if they buy it right, you know, and it gives them more thick ice for, you know, frankly, making mistakes and execution of growing and building value in the business. And I think that’s flawed thinking, certainly not proven out in this study, which is quite interesting. Where the average multiple is over seven. And I think the reason that it shows that the average multiple is over seven is because you know, there’s plenty of search funders who do pay market do understand the need to pay market, and are looking to transact deals. And this is a study of search funders who have actually, you know, in many ways, and that case transacted deals, versus those that just wish to transmit. And I think it separates sort of the search funders that are shoppers from those that are buyers. And I think if you’re going to take the time and you’re going to make the investment to be a search funder or if you’re going to evaluate them as a seller, you need to make sure that you’re talking to real buyers that understand the market well enough to know where real multiples are and to be prepared to execute on a transaction that’s there versus guessing and trying to, you know, bottom feed. And as I brought up earlier, I think that’s where certainly there’s plenty of people looking and most of the search funders that are in this sort of bottom tier aren’t going to be successful just because they are trying to transact a deal that doesn’t make sense from a seller’s perspective.
Ryan Barnett 25:28
Great, great. This is a great topic for us. We’re happy to discuss further. As you’re looking to sell your company a searcher could be a fit. With that, Michael turn it over you to to wrap it up.
Mike Harvath 25:47
Thanks Ryan and Matt with that we’ll tie ribbon on it. We wish you guys a great week. Look forward to you tunin’ to the Shoot the Moon podcast next week. Take care and make it a great day.