Skin in the game
When angel investors and VCs first consider investing in search funds, they often like 90% of the concept. They particularly like the risk/reward profile as complementary to their early-stage investments, and they really like discovering another asset class that still enables them to work directly with promising entrepreneurs.
On the other hand, two elements give them significant pause. First, searchers rarely buy high-growth tech companies. In fact, the companies they buy are often quite unsexy, and prospective investors need to be able to get excited about investing in the acquisition of a commercial window washing business when their historical success has been in AI algorithms.
Second, they balk at the idea that searchers take a salary during the search phase. This element stands in stark contrast to much of the rest of their portfolio, in which founders are often going for years with no income. They want to see “skin in the game.” Some even go so far as to say they want to see their entrepreneurs “suffer,” saying that this is the only way the entrepreneur will give her full effort.
I’d like to talk about this idea of “skin in the game” as it pertains to the search fund model. I’ve already discussed why it makes sense to pay a searcher to search, but I’d like to zoom in on this particular concept of “skin in the game” in this post.
As I understand it, the premise in these early-stage investors’ minds is that if an entrepreneur suffers financially, then she will be hell-bent on grinding quickly through the early days of a startup’s lifecycle so that it can either turn a profit or raise the next round of capital, either of which may mean additional income for the founder. It’s about the psychological pressure and driving the hunger for success, as it aligns with returns to investors.
The search fund journey is different. There are two points worth considering here:
Searchers are under plenty of stress and already have strong incentives to succeed.
Because the objective of the search is different from that of a startup, it makes sense to employ a different approach to support good decision making and avoid panic buying.
The stress
Having searched myself and coached dozens of searchers, I can attest to the fact that the pressure to succeed is very real, and it comes from multiple sources:
Economic
Most search fund entrepreneurs are alumni of top-tier MBA programs. Even if they’re not, they’re typically high-achieving executives, but since we have some data on MBA earnings, we’ll start with that group.
A newly-minted Stanford MBA working in private equity earns an average base salary of US$176k, plus an average signing bonus of $53k and an expected performance bonus of $155k, totaling $384k in first-year compensation. If we assume a 10% bump in salary in year 2, that alum’s 2-year earning potential is $732k.
By contrast, the median searcher compensation during the search period is $108k/year * 2 years = $216k. That’s a $516k difference, which means searchers are effectively paying $516k to choose this path over comparable options chosen by their peers. (I was far from a viable candidate for a PE firm, so my opportunity cost was a bit less, but there are plenty of searchers who would be great additions to a top-notch PE firm.) If an entrepreneur chooses to launch a search fund further into her career, the short-term opportunity cost is potentially even greater.
And that’s just during the search phase! Post-acquisition, searcher-CEO cash compensation for the first three years is about $225k/year, which is a marked improvement over the searcher’s search-phase compensation, but still a far cry from that of her peers in PE.
Add to this opportunity cost the ~$200k of student debt that many searchers carry, and the financial implications are impressive. Of course, the big opportunity for the searcher is the slice of equity she may earn for a job well done. If all goes well, she’ll come out on top. But then again, all may not go well.
Social
The MBA community can be a bit of a pressure cooker, especially during the program and in the early post-MBA years. Big-name brands descend upon campus to recruit the top talent, and students keep tabs on who landed the jobs at the big consulting firms, banks, and tech firms. People also know which peers are starting their own businesses or returning to the family business. It is also well known who in the community has decided to go buy a business, via a search fund or otherwise.
When an aspiring entrepreneur announces her intention to search for and acquire a business, the goal can sound so lofty, risky, and, to some, unrealistic, that the message certainly raises some eyebrows and doubts within the community, as well as from family and friends. (See my post “Nobody understands what you do.”) As most entrepreneurs will attest, the doubt is tangible and heavy.
Deciding to pursue a search was hard for me. Telling all my classmates that I was graduating with no job was hard. Relocating myself and my wife with no promises or security was hard. Teaching GMAT on nights and weekends to generate some income while I raised my funds was hard. Answering the weekly “How’s it going?” questions without any substantial progress to report was hard. Seeing my classmate receive a promotion to partner when I was a year into my search (so quickly?!) and had just lost my first deal was hard.
And like me, many searchers embark upon this path in their early 30s, right when their nuclear families are starting to form and grow. They start realizing the cost of raising kids, and the fact that someone may have to stay home with little-to-no income for some time. They dream about the life they would like to provide for their families, and that dream comes with a price tag and spousal expectations.
Searchers feel the exceptionally high expectations of their families, their spouses, their friends, their classmates, their mentors, and their investors weighing on them from the day they make that announcement of their decision to pursue entrepreneurship, all the way until they’ve started generating big returns to their investors and made some money for themselves. This means a period of socially-induced anxiety and pressure that lasts 5-10 years if all goes well, and much longer if things turn sideways at any point.
Intrinsic
While the entrepreneurial culture incubated in Silicon Valley and spreading internationally teaches us to embrace failures, the concept secretly terrifies all high-achieving entrepreneurs. More precisely, even if they are accepting of failing in certain endeavors, they can think of nothing more depressing than being a failure. Note the difference.
In particular, the search fund entrepreneur is often someone who has played by the rules her whole life - been hired by great companies, performed exceptionally well at those companies, and been accepted to and excelled at the world’s best educational institutions. Even if she has had some entrepreneurial experience, most of her major life events have been relatively risk-free successes. The decision to assume additional risk of failure is only palatable because of the long-term possibility of achieving real, noteworthy success.
When I launched my search, my mentality teetered between this has to be a home run, so swing for the fences and this has to be at least a mild success, so that my next venture can be a huge hit. (See Home run or base hit?) But either way, my assumption was that this venture was worth the associated risk because it opened up a possibility to very substantial success. Anything less would be a hit to my ego.
Top-tier MBAs have never been accused of being too humble. They fully believe they can do great things, and they often do. But that psychological bar they set for themselves is sometimes unreasonably high, and only superhumans will meet their own expectations of themselves.
Avoiding panic buying
Given the pressure to succeed searchers are already under, successful search fund investors favor searcher economics that maintain the pressure but avoid the level of stress that will cloud judgement. There is a reason compensation at private equity firms is never commission-only, even for business development roles. In general, PE is focused on relatively long-term returns, and firms therefore want their executives to maintain a long-term mindset when seeking, diligencing, and executing deals.
Imagine hiring a recently-minted MBA into a PE role. She’s $200k in debt, about to get married, and driven to achieve. However, she starts earning a salary only when she sources and closes on an acquisition. In this scenario, despite her best intentions, she is much more likely to look for the quick deal - any deal - so that she can draw a salary and start paying her bills. Her mindset is short-term, and her stress centers around meeting her personal financial obligations.
If we remove this person from the context of an established PE firm, the picture gets even worse. She can’t benefit from the daily accountability or guidance to help her make objectively sound decisions, and she’s spending her own money to source a deal, driving her deeper and deeper into debt and further clouding her judgement. The pressure to buy quickly turns to near-panic, and we enter hazardous territory.
The search fund investor wants to avoid the panic buy, and history has shown that not only funding the costs of the search but also paying that searcher just enough to avoid panic is one effective way to enable a professional search and support good decision making.
