Investors Pay a Young Stranger to Hunt for a Small Business to Run
The target is usually a profitable, founder-owned company too small for private equity, and the new boss gets heavy coaching from the board.
Joys of Compounding · Will Thorndike - Lessons from the Eternal Outsider - [Joys of Compounding, EP.28]A group of 10 to 15 investors hands a young, would-be chief executive enough money to do almost nothing but look for a company to buy for two to three years.
That is the search fund, a roughly 40-year-old idea now also called entrepreneurship through acquisition, which means buying an existing business in order to run it. Investor Will Thorndike says the model was pioneered by Irv Grousbeck, a Stanford business professor, and works in three steps: fund the search, buy one business, and then run it.
The searcher, usually a recent business school graduate with no prior experience managing people, lives off that first pool of capital while hunting full time. The target is almost always the same kind of company: profitable, growing, and small, often making $1 million to $3 million a year in cash, which is the money left after paying the bills.
Those sellers are often founders from the baby boom generation who want to retire. Their companies are too small for private equity firms, which need larger deals to justify their time, and there is often no family member ready to take over. Thorndike says the number of such companies keeps rising as the population ages.
Buying is only half the plan. The deal usually uses a little borrowing, but not a lot, and the searcher becomes the chief executive on day one. To make up for the lack of experience, the new company gets a three- or four-person board that includes former chief executives, operators and longtime investors.
That board works closely with the new boss, especially in the first two to three years, teaching how to hire, set prices, and manage cash. Thorndike says the community runs on a pay-it-forward ethos, with professor Irv Grousbeck spending huge amounts of time guiding new chief executives by telephone.
What began slowly, just seven funds in its first 12 years, now exceeds 100 new searches a year. Thorndike says he expects supply to keep pace with demand as retirements create fresh inventory, and that prices have not been dramatically affected so far.
Questions people ask
Do searchers get paid while they are just looking?
Yes. Investors provide a small monthly salary to cover living costs and the expenses of looking, like travel to meet owners and lawyers to review books. In exchange, if the searcher finds a company, that early money typically converts into a larger ownership stake in the acquired business.
What happens if the searcher never finds a business to buy?
The search ends and the remaining money is usually returned or written off. Investors accept that some searches will fail to find a suitable business within the two- to three-year window, and the searcher then typically seeks another job, often with help from the same investor network.
How do the original investors make money?
When the company is bought, the original backers get the right to put more money into the deal and own shares alongside the new CEO. They profit if the business grows and is later sold or continues to pay out cash, with the CEO's stake growing as the company performs.