Traditional vs self-funded search funds: how the models differ at the five key stages in a fund lifecycle

Self-funded searchers forego the initial search capital, instead funding their living and operating expenses themselves. Once a deal is identified they will then take it to investors to raise the necessary equity to complete. Self-funded searchers will typically take a majority stake of the company they acquire. Both models usually see the maximum amount of debt financing available utilised, with equity financing and then potentially a vendor loan note and/or an earn out filling the gaps to make up the total consideration. While utilised by both models we have found that self-funded searchers typically make greater use of vendor loan notes when structuring the consideration. 

In our experience at Buzzacott, in previous years we found the self-funded model to be more common. However, a greater number of institutionalised search investors along with the establishment of accelerator programmes has seen a rise in the traditional model. We now see traditional model searches making up the majority of transactions being completed. 

In this article we highlight how the experience differs for a traditional vs a self-funded searcher at various stages of the overall process.

Search phase

Right from the outset a key distinction will emerge between the two models in terms of the size of company targeted and the approach taken. 

Although there are some outliers in both models, self-funded searchers will typically target smaller deals (£1m - £10m Enterprise Value) whereas traditional searchers will target larger (£5m - £50m). Both are usually sector and geographically agnostic, however if you do wish to implement certain parameters (such as limiting the geography of your search to a particular region) then it is more straightforward to do this under the self-funded model. 

In terms of the actual search approach, both models will typically enlist the assistance of interns (normally current MBA students with an interest in Entrepreneurship Through Acquisition). They will use datasets/platforms to identify lists of potential target companies to reach out to. Key factors include sector, head office location, number of employees (a good indicator of company size if it is too small to publish medium sized company accounts) and age of shareholders (the search fund succession model is more likely to appeal to owners looking for retirement options that will continue their legacy). Platforms such as Beauhurst, MarktoMarket and MarketIQ are all useful resources for target identification. Searchers will also normally look to make connections with business brokers to obtain visibility of live, on-market opportunities.

Getting to LOI stage

One of the key obstacles to overcome for any searcher when looking to get a signed Letter of Intent in place is a credibility gap. Put simply the seller has to believe that you have the capability and funding to execute the proposed deal in order to be willing to enter exclusivity. 

In this regard searchers operating under the traditional model have an advantage. They can point to the search capital already raised and investors they have on their cap table as evidence that securing the funding to execute the deal will not be a problem (of course not all of the search capital investors will choose to follow on, but the perception is there). 

On the self-funded side there is more of an obstacle to overcome with some sellers/brokers requesting proof of funding before even being willing to share more detailed information on a company. We have seen that obtaining soft commitment letters from potential investors can be a good method to overcome this issue.

Closing a deal

When it comes to closing a deal which is under exclusivity we have found that deal size is normally the key factor when determining the timeframe. A smaller, self-funded deal will involve fewer investors to juggle, a less onerous bank due diligence scope and generally be more straightforward to close (so could potentially be executed in as little as 2-3 months. 

Traditional model deals can be straightforward, however on the larger deals there can be as many as 50 investors involved (often located around the world) all with different opinions, risk appetites and approaches to deal mechanics which can lead to the process taking longer. Therefore a key challenge for the searcher will be to ensure that all investors are kept informed and on-side throughout the process. 

Regardless of the model utilised we recommend that lenders and investors are informed of the transaction and provided with regular updates as financial/tax/legal due diligence is performed. This helps to ensure there is as small a period as possible between the conclusion of diligence and finalising a deal (reducing the need for any follow on work/updates to DD). It also means that if there are going to be gaps on a cap table the searcher has visibility on these in good time and so can look at other options.

If there is a gap on your cap table and the seller has offered to reinvest some of their consideration we highly recommend this option is taken (as you will have an investor onboard who fully understands and believes in the business). In our experience this has proven incredibly useful in getting a number of UK search deals over the line.

Operating the company

In both models the searcher will normally assume the CEO/MD position and become heavily involved in the day to day running of the company. Under the traditional model the searcher will have the guidance of investors to lean upon. Many of these investors are former searchers themselves so well placed to provide excellent direction. On the flipside to this, as a minority shareholder the traditional searcher is held accountable to the investors and could be sacked from the CEO position (although this is exceedingly rare). 

As majority shareholders, self-funded searchers have greater autonomy to run the company in any way they sit fit. However, they are unlikely to have that mentorship that the board of investors provides. If a searcher is confident in their ability to do this and has previous relevant experience then this may not be an issue, however it is still a factor which should be considered.

Exit

The first point to note with regard to exit is that this is an expectation under the traditional model (typically after 5 – 7 years of operation/value creation). Given the majority stake on the self-funded side there is less of an expectation, with some searchers choosing to stay on for an extended period as CEO. 

If the exit option is utilised then the outcome for the searcher depends on a) the percentage equity holding; and b) the value of the company at the point of exit. 

Under the traditional model the searcher will typically have 17% equity at exit (rising to 25% if certain IRR targets have been met). On the other hand a self-funded searcher will have over 50% of the equity (normally around 70%). So on the equity front a self-funded searcher is in a stronger position.

However the other key factor is valuation at exit. As already mentioned, traditional deals are typically larger (and can be a lot larger). Additionally, it is arguable that the accountability and guidance from the investors make it less likely that the business will fail. 

It therefore becomes a question of what is worth more, a smaller slice of a larger (and potentially more stable) pie or a larger slice of a smaller pie. Regardless of model used there are multiple different routes available to exit. A later article in the series will see Sriram Ainkaran provide potential avenues an exiting searcher could choose to take.

Conclusion

Ultimately our view is that both models are a fantastic option which can result in an excellent outcome for all involved. Both have pros and cons and the decision on which to go for ultimately comes down to personal choice. 

On the one hand a searcher might favour the self-funded model for the autonomy, flexibility and chance to be an owner manager of a business. 

On the other hand a searcher may be drawn to the traditional model for the financial support provided during the search phase (which may be needed if the search is being taken on straight after an MBA), guidance provided by investors and chance to run a larger company. 

If you have any questions about either model and would like to discuss them in more detail then please do get in touch. Our transaction services team has great experience in assisting both traditional and self-funded searchers in making successful acquisitions.