Self-funded search vs search fund — which path suits you?

If you want to buy and run a business, one of your first decisions is how to pay for the search and the purchase. Broadly, you can fund it yourself and keep most of the ownership, or raise money from investors and share the upside with them. These two paths are known as the self-funded search and the search fund, and they suit different people.

Where these models come from

Both models grew out of entrepreneurship through acquisition in the United States. The search fund model took shape there in the 1980s, associated with business schools that began teaching it, and it has since been used in many other countries. Self-funded search is simpler and older in practice: it is essentially an individual buying a business with their own money and borrowed funds. Both now appear in Australia, though the search fund model is less established here than in the US. For background, see what is entrepreneurship through acquisition?.

The self-funded search

In a self-funded search, you cover your own living and search costs while you look for a business. When you find one, you fund the purchase with a combination of:

• your own equity
• a bank loan
• vendor finance from the seller (see vendor finance explained)
• sometimes a small amount from friends, family or private investors

You usually own most or all of the business, and you make the decisions.

Strengths

• Ownership. You keep most or all of the equity, and so most of the upside.
• Control. No board of investors to report to, beyond your lender's requirements.
• Speed and flexibility. You can move quickly and pursue businesses that fit your own goals, not an investor's return target.

Weaknesses

• Personal financial risk. You may commit a large share of your savings and give personal guarantees to the lender.
• No salary while searching. You fund your own living costs, which can put pressure on you to buy too quickly.
• Smaller deals. Your capital and borrowing capacity limit the size of business you can buy.
• Going it alone. Without investors, you need to build your own network of advisers and mentors.

The search fund

In a traditional search fund, you raise money from a group of investors in two stages.

1. The search stage. Investors fund a modest salary and the costs of searching, usually for a defined period. In return they typically receive the right to invest in the acquisition.
2. The acquisition stage. When you find a business, the investors provide most of the equity to buy it, alongside debt.

As the searcher, you usually earn a share of the business over time rather than buying it with your own money. That share commonly vests in stages: part on completing the acquisition, part with time, and part depending on the investors' returns. Terms vary from fund to fund and are negotiated, so treat any description of a typical structure as a general guide only.

Strengths

• Less personal capital. You do not need to fund the purchase yourself.
• A salary during the search. You can search properly without draining your savings.
• Larger deals. Pooled investor capital means you can pursue bigger, more established businesses.
• Experienced backers. Investors in search funds are often former operators or acquirers who provide advice and introductions.

Weaknesses

• Smaller ownership share. You own a minority of the business, at least at first.
• Accountability. You report to investors and often to a board, and major decisions need their support.
• Raising money. You have to persuade investors to back you before you have found a business, which takes time and a strong track record.
• Investor expectations. Investors are seeking a return within a timeframe, which shapes what you buy and when it is sold.

Comparing the two

Ownership. Self-funded searchers usually own most of the business. Search fund searchers usually own a minority that grows with performance.

Personal risk. Self-funded searchers carry more personal financial risk. Search fund searchers risk their time and reputation more than their savings.

Deal size. Self-funded searches typically target smaller businesses. Search funds can pursue larger ones.

Control. Self-funded searchers decide for themselves. Search fund searchers share governance with investors.

Income while searching. Self-funded searchers usually have none from the search. Search fund searchers are paid a salary.

A worked comparison

Here is an illustration only, with round numbers.

Imagine two searchers each buy a business for $3,000,000.

The self-funded searcher puts in $600,000 of their own savings, borrows $1,900,000, and agrees $500,000 of vendor finance. They own 100 per cent of the equity, but they have committed most of their savings and guaranteed the bank loan.

The search fund searcher's investors provide the equity, alongside debt. The searcher puts in little or no cash and earns a share of the equity over time if the business performs. Their potential upside is a fraction of the business, but their personal savings are not at risk in the same way.

Neither is right in general. The best choice depends on your capital, your appetite for risk and the size of business you want.

Questions to ask yourself

1. How much capital can I commit without putting my household at risk?
2. Am I comfortable giving personal guarantees?
3. How long can I search without an income?
4. Do I want full control, or would I value experienced investors around me?
5. What size of business do I want to run?
6. Do I have the track record and network to raise investor money?

If you have capital, value control and are targeting a smaller business, a self-funded search may fit. If you have strong credentials, limited capital and ambitions for a larger business, a search fund may fit.

Australian considerations

Whichever path you take, plan the structure early. Investors usually invest through a company, and the share structure, vesting arrangements and shareholders' agreement need careful drafting by a lawyer. Raising money from investors may also involve regulatory requirements around offering shares, so get legal advice before approaching anyone. Self-funded buyers should consider whether a company, trust or combination suits their tax and asset protection position.

The real choice is not between two funding models. It is between more ownership with more personal risk, and less ownership with more support.

How we can help

Kainos Consultants helps buyers on both paths: modelling what they can afford, structuring the purchase entity, and preparing the financial material investors and lenders expect. Read about our entrepreneurship through acquisition service, or contact us to discuss your options.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.