CHAPTER 5

Paying for Your Search

Depending on the search parameters you chose in the last chapter, the cost of your two-year search may be over $1.0 million. Even if you search alone, use brokers, and keep your search focused, the two-year cost of your search is likely to be almost $500,000. Assuming that you are like most professionals, you probably don’t have those resources at hand. This chapter focuses on how to get the money you need for your search.

A partnered, national search that uses direct sourcing usually requires raising money from investors at the outset of the search. The vehicle you’ll use to raise that money is commonly called a search fund. It pays for the out-of-pocket expenses we identified in chapter 4 (“Anticipating the Cost of Your Search”)—about $230,000 for the average partnered search—along with broken-deal costs plus a modest salary and benefits for the searchers. The salary it provides you is usually roughly $80,000 per year—less than what most searchers would make if they took a job—so that you also absorb some of the risk of not finding a company to buy and have a sense of urgency in your search. Usually, the fund is large enough to support up to two years of searching. So, the outside cash raised in a search fund for a single searcher who is searching directly and nationwide is about $300,000. The searcher effectively contributes the difference between $300,000 and the total costs of the search through a lower-than-market salary during the search. On average, partnered searchers raise twice that, about $600,000.

Some single searchers who have a regional focus and who rely on brokers decide to forgo raising money from investors to fund their search; these entrepreneurs seek capital from investors only once they have a deal in hand. We call that a self-funded search. The advantage of postponing outside investments is that more potential investors are willing to invest in a promising acquisition than in a promising searcher. That means that you can strike a better deal with investors by postponing fund-raising. But self-funding changes the nature of the search and can also reduce the likelihood of success.

Self-Funded Search

If you decide to fund the search yourself, frugality will need to govern your every decision. Self-funded searchers are usually willing to invest every penny of liquid assets they can muster to fund the out-of-pocket costs of their search; they will use any cash they have and borrow from their homes, their credit cards, and their retirement plans to get cash to fund their search. They do whatever they can to minimize expenses. Often, the searchers rely on their families to help fund their living expenses by depending on a working spouse or by living with parents because the searchers cannot pay themselves a salary or cannot use their limited cash for living expenses. Self-funding enhances the potential reward but surely also adds enormous stress to the already psychologically challenging search process.

As described in chapter 4, Ari Medoff self-funded his search and carefully minimized every expense, even going as far as living in his in-laws’ basement for the duration of his search. He concentrated his search along the East coast of the United States from Pennsylvania through Georgia, which reduced his travel expenses (in addition to reflecting where he wanted to live). He used unpaid interns to assemble a database of smaller-firm owners and to conduct an emailing campaign. Instead of hiring a law firm to incorporate his acquisition entity Arosa, LLC, he used a law clinic operated by local university law students, who performed the service at no charge. His total out-of-pocket search costs were less than $25,000 for about 14 months of searching.

But it was a risky strategy with little flexibility. For example, when his acquisition fell apart just a few weeks before closing, the broken-deal costs nearly put an end to Ari’s search. After a hiatus of a few months, he resurrected his broken deal and successfully acquired a home nursing care business in North Carolina. But his entire experience could just have easily not turned out so well.

Later in this chapter, we give some advice on approaching potential investors. But first, let’s explore the choice of raising capital to fund the search.

The Search Fund

Search-fund financing provides greater resources for a more comprehensive national search. More importantly, if you don’t have the money to search for one or two years, this path opens the way. You’ll raise these funds by approaching investors who might be willing to contribute to the fund in exchange for a first look at investing in the target company as it is being acquired and a cut of the profits once the acquisition is complete. Investors contribute money and get a share of the profits; you contribute talent, effort, and time and get the other share. It’s like agreeing on how to slice up a pie, except no one knows how big or tasty the pie will ultimately be when the agreement is made. Or if there will even be a pie: If the search doesn’t result in an acquisition, investors simply lose their money.

The search-fund approach to becoming an entrepreneur through acquisition accomplishes three goals: First, it provides the needed funding for your search. The fund raises enough capital to pay for your out-of-pocket search expenses and a modest salary for two years. Second, it establishes a network of investors interested in providing equity capital for an eventual acquisition once you find the right business to buy. Third, sellers often ask prospective buyers to demonstrate that they can afford to buy the business; a search-fund group of high-net-worth investors is strong evidence that you can finance an acquisition.

David Rosner and Greg Geronemus created a search fund called Footbridge Partners in the fall of 2011. Greg had about a half decade of experience in the financial services and health-care sectors, while David had a similar length of experience working with a variety of smaller and midsize firms. Both men were committed to becoming entrepreneurs through acquisition, but both had spouses who were tied to the New York City area, so they planned a geographically focused search. They wanted to fund their search using investors. They began with individuals they knew and worked their way to a commitment of $550,000 in search capital from six investors. We’ll follow their story as we show you how the process works.

Creating an offering memorandum

To launch the fund-raising process, you’ll need to provide potential investors with a formal offering memorandum so they can understand your plan, the budget for your search, and the proposed terms for investors. When David and Greg created their offering memorandum, they had a lawyer look it over to make sure it was in compliance with the various regulations that govern investment fund-raising. Also, once they raised capital, their lawyer would need to draft a partnership agreement that followed the terms of the deal in their offering memorandum. For all these reasons, it’s a good idea to have an attorney review the document.

Raising the fund

Once you have the offering memorandum in hand, your next step to raising a search fund is to find investors who might be interested in such an investment. Recognize that a search fund is an unusual investment, particularly when compared with the public market investments that dominate the portfolios of most high-net-worth individuals. That means you may need to expand your network to find enough investors interested in funding your search. David and Greg created a list of forty-five contacts who knew them and who either had the resources to invest or could connect them to people who might invest. The two partners started by reaching out to people on their list who knew them best. “Getting our first investor was the key,” Greg said. “That person ends up serving as a reference for other investors because they know us well. Also, no one likes to be the first investor, but once you have an investor, it creates momentum.”

Between October and December 2011, the two partners worked their way through their prospect list, sending emails first and then following up with calls and meetings wherever there was interest. “Each investor was different,” David observed. “Sometimes, we would get a quick yes in our first conversation. Other times, we would have a whole series of meetings ending with a no. We probably could have been a little more decisive in putting aside prospects who didn’t express strong interest early on.” By the end, Greg and David had commitments for $550,000 of search capital from six investors. This was a smaller group of investors than is typical—a more common number is 10 to 15 investors, each contributing $30,000 to $50,000, but more importantly, the two partners assembled the capital they needed to fund up to a two-year search for a business.

Negotiating the terms

Most search funds have similar agreements between the searchers and their investors, but there is some variation. Here are the terms David and Greg negotiated:

1. If an acquisition was identified, the searchers were obligated to offer it to their investors.
2. If an acquisition was completed, the investors’ original search investment (the $550,000) would be “rolled in” to the acquired company, and shares would be issued for that capital. Even if an investor chose not to invest in the acquisition, they would receive shares for their earlier round of capital. Most commonly, the initial search capital is rolled in at a 50% premium to reflect the risk of being in the initial round, so the entrepreneurs would have to repay $825,000 rather than $550,000 before participating in the profit pool.
3. The first proceeds would go to investors until capital had been returned, plus a payment of a minimum annual rate of return (usually in the range of 6–9% annually) called a “preferred return”.
4. The two partners would share up to 35% of the remaining profit pool if the venture hit various return targets. In the Footbridge partnership, there was also a catch-up payment to the entrepreneurs once the preferred return had been paid to investors. This meant Greg and David would collect up to 35% of the amount paid as preferred return and 35% of all the remaining profits.

Closing the fund

The final step in the fund-raising process is to close the fund. That’s when documents that define the fund are signed and when investors actually send the searchers the committed funds. David and Greg closed their fund in February 2012, about six months after they had begun their fund-raising. With the money in hand, they began their search. While they limited their search to the area surrounding New York City, they used every available means, including brokers, direct outreach, and local networking, to find prospects. In 2013, they identified and acquired a 20-year-old travel company located in New York City. The firm provided high-quality, exciting group tour packages to some of the most fascinating countries in the world.

Approaching Investors

If you decide to do an investor-funded search as Greg and David did, you need to approach investors early in the process to get the fund in place before you begin searching. But even for self-funded searchers like Ari, approaching potential investors early on will lay the groundwork for reaching out to investors for acquisition funding once you have a deal in hand. And even investor-funded searchers need to keep in contact with other investors who might be willing to fund the acquisition itself. The search investors may be unwilling or unable to provide all of the funding you want at the time of the acquisition.

Let’s now turn to specific recommendations that will help you move from an introductory meeting with a prospective investor to a commitment by them to invest.

Starting with people you know

Begin with family, longtime friends, clients, business associates, former or current bosses, and others who know you well. These people already believe in your personal capabilities, so you’ll only need to sell the merits of your investment opportunity. With strangers, you’ll need to sell yourself as well as the opportunity.

Starting with a group that is predisposed to believe in you has two benefits. First, you gain experience at pitching to investors in front of a supportive audience. Attracting investors is like most other tasks—you will get more skillful with more repetitions. Second, fund-raising works best when you take advantage of the network effect. No prospective investor wants to be the first one to commit; they derive confidence from the fact that others who know you well and have seen this opportunity have already signed up. That’s how it worked for Greg and David. “Our first call,” Greg recalled, “was on my former boss, who was very supportive. He decided to invest.”

Then, when an investor commits, you should keep the momentum moving forward. For example, “I’m trying to build an investor group that works well together. Is there anyone you know who you’d suggest I speak to?” You will find that investors are very willing to share opportunities they like with their friends and colleagues. Again, Greg’s former boss introduced the two searchers to other potential investors, some of whom invested in their fund.

If your personal network doesn’t include a sufficient number of potential investors, however, you’ll need to reach out beyond it. There is a community of investors who regularly invest in search funds and who generally welcome the opportunity to evaluate potential searchers and introduce them within their informal investor network.

Selling your search

Raising money is a type of sales call, and the fundamental rules of selling apply:

Arrive on time

This simple act communicates respect for the investor with whom you are meeting and quietly demonstrates that you are an organized person. One longtime investor in private companies commented: “If someone isn’t able to arrive in my office on time, why should I believe they are capable of more difficult tasks?” Of course, no one invests in you because you arrive on time, but arriving late makes a terrible impression.

You should also send your offering memorandum to the investor at least several days before your meeting.

Look the prospect in the eye

You are selling your capability and confidence as the leader of a smaller firm, not just presenting an investment opportunity. Know your material cold—no notes—and turn the meeting into an eyeball-to-eyeball conversation between you and your prospective investor.

Tune into their language

Businesspeople speak a variety of dialects; you need to assess which one they speak and talk that way. If your investor is an expert in an industry that you are targeting, use the terminology of that business. If the investor isn’t familiar with the business, brandishing buzzwords will signal to them that they are getting involved in something they don’t fully understand, rather than proving how expert you are. Instead, speak in plain English.

Time your presentation

Early in the meeting, ask your prospect how much time they have. You should be flexible enough to adjust the arc of your story line to whatever time you are given. And you may have to keep readjusting: If the prospective investor asks questions, you may have to shorten your presentation again, whereas if they seem engaged and unhurried, you can add detail to make your pitch more compelling. Before the meeting, think through how to add and delete sections of presentation in response to your prospect’s availability and level of interest.

Act like a peer

You want to establish a respectful relationship of equals. Investors want to back a CEO whom they respect, and they in turn want to be respected for the importance of their financial contribution and business experience.

Tell stories

One of the challenges when approaching investors is that many of the claims sound alike:

“I’m going to buy low and sell high.”

“I’m looking for a business that has high barriers to competition.”

“I’m going to improve marketing to generate more revenue.”

Prospective investors who are infrequently pitched for private investments find abstract language like this unconvincing, while investors who do receive lots of pitches find this abstraction doesn’t really differentiate one entrepreneur from the next. For either audience, staying general is not very effective. Instead, tell stories about different businesses that you have encountered.

Sharing relevant stories will accomplish three valuable goals: First, it breathes life into your plans by taking an abstract idea like “barriers to competition” and linking it to an understandable real-life situation. Compare these two ways of making the same point:

“I’m looking for a business that has high profit margins because it has high barriers to competition. This could be the result of high transportation cost, a well-known brand, or a reputation for not messing up.”

Versus:

“I’m looking for a business with high profit margins because it has great barriers to competition. One business I looked at, Castronics, threads metal pipe for oil and gas drillers. The pipe is really bulky and heavy, so moving it around costs about six times what the actual threading costs, and as a result, competitors from outside the region are way more expensive. Also, it’s really important to the drillers that the pipe arrives on time and that the pipe lengths fit together perfectly. For this reason, customers are really cautious about experimenting with other suppliers. That’s why the company generates such attractive margins, and it’s exactly the type of business I’m looking for.”

In addition to engaging your listeners, sharing stories also gives them more information, making it more likely that they will follow your thinking and agree with your choice when you eventually come to them with a potential deal. One prospective entrepreneur we know illustrated for investors each of the characteristics she was seeking in an acquisition by briefly describing a business that she had screened and that had the characteristics. Later, when she described her proposed acquisition, investors often jumped in to say, “I see why you like that business—it has all the criteria you are looking for!”

Finally, weaving relevant business anecdotes into your presentation signals your own breadth of experience. A common question asked of every first-time entrepreneur is whether they have enough experience to become CEO of a business now. At some point in your discussions with investors, you will have to address this question directly, but before you do, it’s valuable to create confidence that the answer is yes.

Indeed, in these initial conversations, it’s not just the acquisition that’s being evaluated; you are too. You are the prospective CEO of the company. These meetings are both investment presentations and job interviews, and investors will be assessing whether you are serious, hardworking, thoughtful, and mature. Be conscious of this, and convey these qualities in your conduct.

The Next Communication: Creating the Virtuous Circle

The end of each meeting is a key moment in which to manage momentum: You don’t want your potential investors to feel rushed, but you do want them to believe that this investment has a time limit; they need to make a decision soon, or the opportunity will be taken by others. If prospective investors sense that there is no cost in waiting, they will simply defer making a commitment.

End each investor meeting with a proposal: “I’d like to give you a call in a couple of weeks to see if you have any questions and to update you on my progress”—and then follow up. When you do follow up, ask your prospect if they have any questions and then answer each question carefully before talking about how your fund is progressing. Momentum is a critically important ingredient when you are raising equity. Properly managed, momentum leads to a virtuous circle in which an investor commits to your plan, encouraging other investors to commit promptly so that they don’t lose their opportunity.

Next Steps

You’ll know from your budget work in chapter 4 how much money you’ll need to raise. This chapter should have helped you decide how you’ll fund the search, either by funding it yourself or relying on investors. Either way, you’ll need to develop a network of investors that will either invest in the eventual acquisition if you self-fund or pay for the search and the acquisition if you raise a search fund. As you approach investors, you’ll need to explain what kind of business you want to buy and why it is a good idea. That’s the topic of our next chapter.