Search funds represent a unique and increasingly popular path to entrepreneurship, allowing aspiring operators (known as “searchers”) to raise capital, acquire an existing small-to-medium-sized business, and step in as the CEO. This model, often termed “Entrepreneurship Through Acquisition” (ETA), relies on a distinct economic structure that aligns the interests of the searcher and their investors. Understanding how both parties are compensated is crucial to appreciating the mechanics and appeal of this asset class.
Phase 1: Funding the Search
The journey begins with the searcher, typically a recent MBA graduate or mid-career professional with operational ambitions, raising a relatively small amount of initial capital (often $300,000 – $750,000) from a group of investors. This capital funds the “search phase,” covering the searcher’s salary and operating expenses
Investors providing this initial search capital take a significant risk, as there’s no guarantee a deal will be found or closed. To compensate for this early-stage risk, they typically receive the right, but not the obligation, to invest a pro-rata share in the eventual acquisition. Crucially, they often receive a “step-up” on their investment if an acquisition occurs. This means their initial search capital converts into equity in the acquired company at a premium, frequently around 1.5x its original value, enhancing their potential returns.
Phase 2: The Acquisition and Capital Structure
Once a promising target company is identified and put under Letter of Intent (LOI), the searcher returns to their investor group (and potentially new investors) to raise the significantly larger amount of capital needed for the acquisition itself. This includes the purchase price and potentially additional growth capital.
The capital structure usually involves a mix of equity from the investors and debt (often including seller financing and traditional bank loans). Leverage plays a key role in amplifying potential returns, directly impacting the final search fund IRR (Internal Rate of Return).
Operator Compensation: Sweat Equity and Performance
The searcher’s compensation transforms upon successful acquisition. They transition from a modest search salary to becoming the CEO of the acquired company, earning a market-rate salary appropriate for the size and industry of the business.
However, the primary economic incentive for the searcher lies in equity ownership. This equity stake is earned over time and is designed to reward long-term value creation. A typical structure involves the searcher receiving rights to roughly 20-30% of the company’s common equity, subject to vesting conditions:
- Time-Based Vesting: A portion (often one-third) vests purely based on tenure, typically over 3-5 years. This ensures the operator remains committed to leading the business.
- Performance-Based Vesting (IRR Hurdles): A significant portion (often two-thirds) vests only upon achieving specific performance milestones for investors upon exit. This is where the search fund IRR becomes paramount. The equity might vest in tranches.
A tiered structure powerfully aligns the operator’s financial outcome with delivering substantial returns to the investors who backed them. The operator is highly motivated not just to run the company well, but to grow it significantly and achieve a successful exit that generates a strong search fund IRR.
Investor Returns: Measuring Success with IRR
Search fund investors, often experienced entrepreneurs, executives, and high-net-worth individuals, are attracted by the potential for high returns. Their returns primarily come from the appreciation of their equity stake when the company is eventually sold or recapitalized.
Key elements influencing investor returns include:
- Equity Ownership: They hold the majority of the equity, reflecting their capital contribution.
- Step-Up: As mentioned, search-phase investors benefit from the premium conversion of their initial capital.
- Exit Valuation: The ultimate sale price of the business is the primary driver of returns.
- Leverage: Judicious use of debt can amplify equity returns (and also increase risk).
The IRR for search funds is the benchmark metric used universally in the search fund ecosystem to measure the success of an investment. Historical studies have shown that, in aggregate, search funds have delivered impressive gross IRRs, often exceeding 30%, although performance varies widely between individual funds. Investors target these high IRRs to compensate for the inherent risks, including the possibility of a failed search or acquiring a business that underperforms.
The Exit: Crystallizing Value
The typical holding period for a search fund investment is 4-7 years post-acquisition. The exit, usually through a sale to a strategic buyer or another private equity firm, is the event where both the operator’s vested equity and the investors’ returns are realized. The final search fund IRR is calculated at this point, determining the ultimate payout for all stakeholders and triggering the vesting of the operator’s performance-based equity tranches.
The economics of search funds create a symbiotic relationship. Investors provide capital and mentorship, taking significant financial risk for the potential of outsized returns, measured primarily by search fund IRR. Searchers provide the operational leadership and sweat equity, accepting modest initial compensation for the chance to run a company and achieve significant personal wealth through performance-based equity. This tightly aligned structure, centered around acquiring and growing a business to achieve a successful exit and a strong search fund IRR, has proven to be a powerful engine for both generating investor returns and launching the careers of aspiring entrepreneurs.
