Searching on the Side (Updated)

February 5, 2023 | Issue #78

Big Deal Small Business: Searching on the Side (Updated)

February 5, 2023 | Issue #78

Housekeeping notes:

• As this newsletter has grown, so has my thinking on various search & EtA-related concepts. To that end, I am updated & re-publishing some old posts, starting with this one.

• At original publication, this post went to ~250 people. This time it’ll go to over 10x that number, so thank you for everyone’s ongoing support.

• Lastly, the newsletter is now on Substack as Twitter shut down Revue. Please add this email to your safe senders list.

The most common question I get from prospective searchers is which model to choose (traditional vs self-funded, proprietary vs brokered, etc.). My answer is usually something along of the lines of…just start! This post is the longer version of that answer.

So if you’ve dabbled with the idea of search & SMB buying but haven’t made the leap, this is the post for you. Please share with anyone you think this may help.

Traditional vs Self-Funded

I’m not going to do a full recap on the various search fund models, but at the highest level there is traditional search or self-funded search. There are a LOT of subcategories & twists on those models, which Justin summarized well here, but the key initial distinction is traditional vs self-funded.

A traditional search involves raising funds upfront to cover the costs of searching (deal costs and your salary). At time of acquisition, the folks who put up the initial search expenses will be the investors in your deal.

A self-funded search has you pay for search costs & living expenses yourself. At time of acquisition you might put in all the equity yourself and own 100% of the business, or you may go raise equity from investors at that point.

Why I Chose Self-Funded

I first learned about small business acquisition when I invested in a friend who started buying music schools. He’s the extreme of self-funded searching. He acquired & started operating his first school while keeping his day job, which isn’t really plausible for the vast majority of SMB acquisitions. (Incidentally, this is also my best performing personal investment to date, not any of my institutional PE investments — not thanks to anything I did, this guy just crushed it.)

His advice was to keep the day job as long as possible – it extends your runway, you avoid getting “deal desperate”, and it allows you to confirm if you actually want to do this before you dive headfirst into it.

Shortly thereafter, a friend at Stanford started raising a traditional fund. He taught me about the other end of the search spectrum – the full metal jacket approach of full-time searching, programmatic proprietary outreach, $2-3M+ EBITDA businesses, etc.

I started to appreciate the breadth of search fund models and needed to learn more.

I had a dozen or so similar conversations with search fund accelerator guys, search investors (both individual & institutional), and traditional & self-funded searchers. I read HBR’s Guide to Buying a Small Business and Brent Beshore’s Messy Marketplace. The full list of resources is here.

Eventually, I landed on a self-funded search for a few reasons:

• I wanted to learn more about small businesses before committing to buying one. I didn’t have MBA years to do that exploration, so raising a traditional search fund seemed premature.

• Given my professional network, I was confident I could raise the equity once I found a good deal — this bore out once I got to an actual deal. Matching investors to a deal can also be easier than matching a deal to a built-in investor group. If you raise a traditional fund with software-focused investors, you may have to pass on a great old-economy deal.

• Traditional search fund investors can provide a lot of M&A support, which is crucial for a career operator trying to get a deal done. But I have M&A experience, so I was less worried about deal execution and more worried about post-closing operations. As a result, institutional investor support was less valuable to me relative to the small business operator-investors that became an informal sounding board post-closing.

• Last but certainly not least, I wanted to have control of my destiny. This meant, among other things, having the option to own my business forever. I only wanted to raise money from individual investors (as opposed to funds that need to return capital) who are aligned with a 20+ year vision. In that vein, a self-funded search generally results in higher total equity ownership and governance control of the company for the searcher.

That all said, in a self-funded search, I, you know…have to self-fund the search. I pay both deal costs and living expenses as I search, which are material.

As a result, I kicked off my self-funded search “on the side” i.e. while I kept my day job, which allowed me to manage my overhead through my income. Notably, this all happened during the height of work-from-home, which allowed significant flexibility.

I recognize this may not be possible for some folks without that kind of workplace flexibility, but it’s how I launched my search.

Launching a Self-Funded Search

Given there’s no fund to raise, there’s no real “launch” of a self-funded search. You just…start. There’s a huge benefit to this – you can test it out, iterate, and figure out what you like. The only initial cost is buying an official-sounding domain and setting up an email address so that brokers take you seriously.

I started the process as a partnered search with a close friend who is also in private equity. We agreed that there was no reason to quit our jobs for now. We were both cognizant of the fact that many searches can take 20+ months.

We agreed that we would spend three months searching on the side to confirm that 1) the opportunity set exists, 2) we enjoy the process of search enough to potentially do it for 20+ months, and 3) we want to own & operate a small business.

Below were our conclusions:

Does the opportunity exist?

The short answer was yes, but we realized it would be very difficult for a small business to take on the cost of two new “executives” at the same time unless the business is larger than $2-3M of EBITDA.

There is a much longer answer around the “right” size of business to acquire, which is among the posts I intend to re-write & re-publish soon.

During my search process, there were some days that I was in the Nick Haschka mindset, just wanting to close quickly on a $400K SDE service business so that I can start operating and building equity & experience.

Other days, I didn’t want to look at anything with less than $1M in EBITDA, let alone SDE, because there needs to be enough “there” there to work with and grow.

We ultimately landed on a target range of $750K to $1.5M of SDE or EBITDA with a wide industry focus but only one of us going into operations post-closing.

(By the way, if you’re not sure what SDE or EBITDA means, read this post).

This was an incredibly wide range as businesses go through significant change as they move from $500K to $1M+ in earnings. More to come on deal size & parameters in future posts.

Do we enjoy the process of search enough to do it for 20+ months?

The answer for me was yes, the answer for my partner was lukewarm at best.

For myself, while dealing with brokers day in & day out can be exhausting after a long day of work, I found myself invigorated with every new CIM or set of financials. Each represented a new life & set of opportunities.

My favorite part of my day job in PE were the management meetings, where I got to listen to executives talk about how they run their businesses. But that’s a small part of the overall PE job.

The search process is basically dozens of management meetings in a much shorter timeframe, which I truly enjoyed.

On the other hand, my partner enjoyed more of the deal-side aspects of PE relative to me, so for him the prospect of trading a job he excelled at for 20+ months of mind-numbing search was a tougher sell.

Do we want to own & operate a small business?

These are two different questions baked into one – we were both in the business of ownership (as private equity investors), and neither of us were in the business of operations (we had top-notch management teams in place). We both enjoyed capital allocation as an intellectual exercise, but I felt a calling to move toward operations.

As we reviewed dozens of small businesses in tandem, my partner saw clearly that his calling remained in capital allocation, whereas I cemented my desire to work with people and get into the unsexy weeds of a business. (Sometimes I question that desire now that I’m nearly a year into owning & operating a business myself.)

This process required self-reflection from both of us, but ensured that we landed in a spot that we were both happy with.

So what did our search end up looking like?

The answers to those three questions made it clear we had the wrong partnership model.

We transitioned our process from a partnered search (where both partners are actively searching and go into the business post-closing) into more of a solo search with a closely-aligned backer.

I managed the deal funnel, which involved handling the brokers, the NDAs, the initial diligence, owner calls, etc. When I found a deal worth digging into, my partner and I split the deal costs. I led diligence, but he reviewed my work & legal docs, serving as quality control both technically and qualitatively.

We had one deal die — we both shared the lost deal costs.

In the deal that closed, we both wrote meaningful equity checks into the deal. We shared some of the searcher equity as well, though much more when to me as the primary operator.

And now, I run the business full-time (and take a salary from the business) while he keeps his day job. But he serves on my advisory board and is my first phone call/email on anything “finance-related”.

In conclusion, the process of searching on the side yielded exactly what we wanted – we both figured out where we fit into the puzzle, neither of us gave up our day jobs too soon, and we’re both excited about our long-term partnership. While the final contours of our partnership are different than where we started, that was the whole point of the experiment.

Takeaways for Prospective Searchers

If you’re debating how to search, when to search, what search model to use, my experience would suggest you just start! Start getting deal reps and getting a flavor of what this world looks like.

Doing a self-funded search on the side is effectively free until you decide to pursue a deal — you don’t even have to make search model decision until that point. It’s very hard to pre-plan your search with no hands-on experience — get your feet wet and then re-assess what model makes the most sense for your life and your interests.

Would love your feedback on this post, either in my replies or on Twitter. I’m all ears. See you next week!

Thanks,

Guesswork Investing