How much capital should I raise for my search fund?
When I took the search fund plunge, the first formal step in my journey was raising search capital. I would use this capital to fund up to two years of looking for a company to buy, including travel, tech, data, office supplies, startup costs, some diligence, and a living wage for myself.
I had never raised capital before, and I was nervous. Fairly quickly, I needed to answer two questions:
How much capital would I raise?
From whom would I raise it?
I owe you a post on the second question, but in this post I’ll address the first. Funding the search can bring a multitude of benefits from both the investor’s perspective and the searcher’s perspective, and taking a thoughtful approach to raising the right amount of search capital can pay dividends down the road.
“What is the right amount,” you say? The answer lies in-between too much and too little.
Too much
Like many searchers, I was very wary of raising too much capital. My reasons were three-fold.
First, search capital is expensive. Due to the search fund convention of offering investors a 50% “step-up” on their search-phase investment, I would effectively be offering these early-stage investors a ⅓ discount on shares in my acquisition vehicle. Every dollar I raised for my search would need to be returned 1.5x before my equity was worth anything.
Second, I wanted to show that I was humble and scrappy. This was the first time I had ever raised capital, and I had an unusual background coming into the search. I didn’t want to give investors any more reason to reject me than they already had. Who was I to ask for that much money without a company in hand?
Finally, I was just habitually cheap and didn’t want to spend more of my investors’ money than necessary. Especially as a b-school student on loans, I was not planning on living large.
Too little
By the same token, my search was stationed in an expensive part of the country for my wife’s job; living expenses were not inconsequential. (When I mentioned this to one investor, he responded, “And why is that my problem?” Touché.) I also had student loans to repay.
I had also been told about the importance of travel in the search, and I wanted to ensure that I had enough cash to hop on a plane when needed.
Finally, my entrepreneurship professors had chanted cash is king enough times to make me believe it. I did not want to have to wind down my search early because I didn’t have enough cash.
Just right
Stanford GSB tracks fundraising trends over time, and I have plotted the results of the 2022 study below, which show a median raise in the US and Canada of US$425k/principal in the 2020-21 period. I have also shown how the amount raised per principal has grown over time. Since the 2012-13 period, we seem to be hovering around inflation-adjusted 2006-2007 levels. 2020-21 figures are at a 10.7% premium to 2004-5 figures and -7.2% relative to 2006-7.
Is US$425k per principal the right number for you? That depends on several variables:
Cost of living and doing business in your target market
Size of your target market, and therefore the frequency with which you will be on aeroplanes
Your salary
Regulatory or personal requirements for health insurance and/or pension plans
Your sourcing strategy
But even after accounting for these variables, you may still be waffling between a few figures. To help you quantify, let’s look at two scenarios, one in which you raise $300k (Scenario A), and one in which you raise $500k (Scenario B). In either case you end up using 75% of your search capital, so you have some capital left over at the end of the search, $75k in Scenario A and $125k in Scenario B.
To the prospective searcher, Scenario B may initially feel like a disaster outcome. “Oh no, we raised all that money at the discounted share price when we didn’t need to!” However, the maths tell us a less extreme story. That extra capital gets rolled into the deal, reducing the equity capital requirement at deal time. The net effect in this scenario is that you have to return an extra $250k to investors vs. Scenario A, a 3% difference, assuming an $8m equity capital requirement at deal time.
If you use all your search capital, that difference bumps up to 3.6%:
Now let’s say all goes well and you 3x your investors’ capital, returning $25.5m. That extra $200k you raised equals a measly 0.8% of capital returned.
How else can you compensate for that difference in capital raised/returned? Will the additional search capital enable a more robust search, resulting in more favourable price and terms on your deal? Will it enable you to buy a better company with which you can create more value for investors? Or, if your business is cash flowing $200k/month, can you simply extend the holding period by another month or two?
And what if you fail to buy a company? You have failed to return investor capital to investors, which is undoubtedly a failure, but the amount of search capital you raise will have zero effect on the goose egg shape of the value of your equity.
At SMEVentures we raise a bit more search capital than other searchers in Australia have raised to date, but we do so confidently because experience has taught us exactly how to spend that capital to maximise ROI on the search. We know that every dollar is well spent.
But even if you are a green searcher without that experience-born confidence, my view is that it is wise to give yourself every opportunity to run a robust search process. You’re better off improving your chances of doing the right deal by ensuring you have enough in the coffers to conduct a thorough, professional search. Though you may wince at every dollar you take today, if that dollar brings you closer to a 35% IRR, both you and your investors will consider it one of the best investments they’ve ever made.
The legal structure on this varies by market. Ask your lawyer.
For each period I averaged the monthly figures of 12-month percent change in CPI for All Urban Consumers (CPI-U) as quoted by the U.S. Bureau of Labor Statistics.
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