For newly minted MBA grads, there’s an increasingly popular way to jump start their careers: search funds. Through these funds, recent MBA grads are financially supported as they look for a privately held business to acquire and eventually run as chief executive officer and part owner. Not only do search funds give fledgling entrepreneurs a jump start in becoming an owner and CEO, but this funding model can also lead to appealing financial returns for investors.
How entrepreneurial MBA grads can benefit from search fundsBY Rich GrisetNovember 10, 2022, 12:41 PM
Though search funds have been around for decades, their popularity has jumped in recent years. There were 11 search funds formed in the United States and Canada in 2010; in 2020, there were 66, according to Stanford.
The popularity of search funds is growing as an alternative path to entrepreneurship that’s different from starting a company, says Sara Heston, associate director of the Search Fund Project at Stanford Graduate School of Business’ Center for Entrepreneurial Studies and co-author of the school’s report. “It’s a way to be a boss, to be a leader, but not start at ground zero with your own idea. It’s stepping into an operating company that usually has cash flows that are stable, and then you can be a leader or an entrepreneur and guide people and build something.”
If you’re interested in entrepreneurship after completing an MBA program, search funds may give you a leg up. Here’s what you need to know.
What is a search fund?
Originating at Harvard Business School and further popularized by Stanford, the search fund model has been gradually adopted by other top business schools and entrepreneurs.
Essentially, search funds take the private equity model and apply it to a single company and install the searcher as its new manager. Searchers are generally younger entrepreneurs who wish to purchase and operate an existing financially successful business. These businesses are generally smaller with an EBITA (earnings before interest, taxes, and amortization) of $1 million to $5 million.
Pedro Vladimir Russell, a first-year MBA student at MIT Sloan School of Management and co-president of Sloan’s Entrepreneurship Through Acquisition Club, says that search funds offer “an exciting opportunity, but it’s not without some risk.”
“From a financial perspective, this type of model works very well with smaller businesses,” Russell says. “There are businesses that are typically not making enough money to attract large investors that want to invest large amounts of money to see a decent return.”
Part of the appeal of search funds is that beginner entrepreneurs can seek advice from their investors on how to make these companies grow.
“It’s an entrepreneurial path where an individual or partnership forms an investment vehicle with a group of investors to search for, acquire, and run a private company for six or more years,” Heston says. “It’s grown in momentum over the decades. What differentiates it from typical private equity is the mentorship that’s involved, and so investors are active participants.”
In traditional search funds, investors provide two years of funding for searchers to seek out a company to purchase. When it comes time to buy a company, the investors provide the capital. Heston says search funds have a special appeal for entrepreneurs who don’t have deep pockets, as they earn into their equity ownership.
Many MBA graduates learn more about search funds and gain access to investors through entrepreneurship centers at business schools, according to Heston. Once relatively obscure, search funds have risen in popularity over the past four years thanks to their inclusion in the curriculum at more MBA programs and an increase in the successful number of exits from owning companies, Heston says.
Once a searcher finds a company they want to acquire, they pitch it to their investor base, which has the right of first refusal to finance the acquisition. Once a company is acquired, the searcher usually gets 6% to 10% equity and can earn up to 25% to 30% more over the course of the lifespan of a company by hitting certain targets.
How successful are MBA search funds?
Not only are search funds growing in popularity, they can pay excellent dividends to investors. “Your overall [internal rate of return] is about 35%, which is a pretty solid return,” Heston says.
These high returns are caused by a few factors: “Some of it is bringing professionalism and new energy to the business. Perhaps it’s going into markets that you either didn’t have the energy or interest [to look into],” Heston says. Additionally, these new CEOs may embrace automation and bring “in new and fresh ways of thinking that can improve margin that can spur growth.”
Still, there are downsides to the search fund model.
“There’s always the risk [that] you spend two years searching for a company and you don’t find one,” Heston says, adding that she’s heard anecdotally that the search itself creates valuable learning experiences for searchers.
There’s also the risk of spending five years trying to grow a company for it ultimately to fail.“That’s rare, but it does happen, and that’s probably the most frustrating outcome for sure,” Heston says.
According to Stanford’s 2022 study, since 1986, all search investments have shown an averaged 5.2x return on investment.
And those returns come with a lower level of risk, Russell notes. “Compared to venture capital, search funds offer a much lower floor of risk,” he says. “From an investor’s standpoint, purely on the financials, it’s quite attractive.”
Though one out of three searchers don’t end up acquiring a business, the search fund model is still an attractive way for entrepreneurs to get ahead.
“For the other two out of three, the financial returns are fantastic,” Russell says. “You typically get paid between $100,000 and $153,000 a year to find a business. Once you operate a business, you set your own salary. Typically, CEOs are making over $200,000, $250,000 per year. You’re also retaining a large chunk of ownership in the business that you’re operating.”
For ambitious entrepreneurs, Heston says search funds are an excellent way to get ahead of the pack.
“If you want to be an entrepreneur and that’s your motivating drive, it’s a great opportunity to get to that point,” she says of search funds. “Some people don’t want to start at ground zero. They don’t have that great idea. They don’t want to build it from scratch. They want to develop ideas and be a leader, and this is a great path to do that.”