The Compelling Economics of the Self-Funded Search Model

Anyone who grew up studying business or investing knows the value of equity.

Wealth is not built by trading time for money.

It’s built by owning great assets.

And directly benefitting from the economic value those assets create.

Here’s the problem:

You often need capital to own equity.

But that’s not always the case….

Today, we’re going to look at the Self-Funded Search Model.

A powerful strategy whereby an individual “Searcher” uses other people’s money to acquire a profitable business and run it as CEO.

Let’s dive in:

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Today’s Goal:

If you’ve read my newsletter for any period of time, you’ve heard me talk about ETA:

Entrepreneurship Through Acquisition

It’s a spin on the normal approach to business ownership.

Rather than starting a business from scratch, you acquire one.

You buy customers, suppliers, employees, etc.

For many of us, it’s much easier to go from 1 to 10 than from 0 to 1.

Today’s issue assumes:

• You want to buy a stable and profitable small business

• You want to retain as much equity as you can

• You don’t have much money

• You aren’t afraid of debt

If that sounds like you, this newsletter is going to be highly valuable.

Debt:

Say you want to fund the purchase of a $1 million small business.

You can cover 90% of the purchase price using debt.

Likely a combination of:

1. Seller note: a loan from the seller, and

2. SBA debt: a government-backed loan from a bank.

SBA debt is generally the majority and offers competitive interest rates, long repayment periods, and flexible collateral.

That last piece is the key.

The SBA is lending against the cash flows of the business.

Unlike traditional lenders, the SBA does not require hard asset collateral (eg. machinery, real estate, etc).

In exchange, the SBA requires a personal guarantee.

A promise that you as the borrower will pay back the loan no matter what, even if the business goes bankrupt.

If you acquire the right business—with stable and diversified revenue and clear growth opportunities—98% of the time you will be fine.

The business’s cash flows will comfortably cover your loan payments.

In fact, you’ll probably be able to pay it down quickly post-closing thereby eliminating default risk.

Gross Equity Step-Up:

Now for the remaining 10% of the purchase price.

You can raise the remaining 10% from outside investors.

But here’s the catch:

Rather than receive 100% of the equity in the business—which, on the surface, would seem like a fair allocation given they put up all of the initial equity—these investors receive just 20%.

You keep the remaining 80% of the equity for yourself, despite not contributing a single dollar.

This is called the “Gross Equity Step-Up”.

In this example, the investor contributes 10% of the purchase price and you give them a 2.0x “step-up” on their contribution.

So they own 20% of the common equity.

Importantly, this “step-up” can range, generally between 1.5-2.5x.

The higher the step-up, the more investor friendly.

The lower the step-up, the more searcher friendly.

Self-Funded Search v. Traditional Private Equity:

Traditional Private Equity:

• The PE firm raises capital from investors.

• The PE firm takes a 2% fee on the assets it manages for those investors.

• The PE firm participates in 20% of the equity distributions after returning the investor’s initial capital plus a preferred return (see here for details).

Self-Funded Search:

• The Searcher raises capital from investors.

• The Searcher takes no management fee, but instead draws a reasonable salary (eg. $150K/yr).

• The Searcher participates in 80% of the equity distributions after returning the investor’s initial capital plus a preferred return.

In both arrangements, investors need to get back their invested capital + a preferred return (interest) before the Searcher/PE firm receives any distributions.

The Searcher’s Value:

You’re probably thinking, “Why in the world would an investor ever agree to these terms?”

Here’s why:

1. Deal Sourcing - you (the Searcher) went out and found a great business worth buying and convinced the seller to sell to you. That’s not easy and can take years to do. This article assumes you fund the “search” for the right business, which may just mean you keep your day job and pursue a target on the side. If your investors are funding the search (eg. paying you a small salary so you can focus on the search full-time) the economics may shift.

2. Personal Guarantee - you are literally putting your house, retirement funds, and financial well-being on the line. If things go poorly and you default on the SBA loan, you will lose everything. Your investors do not have that risk.

3. Sweat Equity - this is the biggest difference from the traditional Private Equity approach. You are actually running this business as the CEO. It is your sole focus, potentially for years. You are pouring reputation, blood, sweat, and tears into its success. In a way, investors are betting on you more than the company itself.

Important Caveats:

Anytime you try to simplify a complex idea, there may be details that get passed over.

Here are two important ones:

• 90% debt-to-value should not be the goal. Utilize creative financing (eg. earn-outs) and consider raising 20%+ of the purchase price from investors to reduce the loan-to-value. Owning 50% of a business with 50% loan-to-value is usually a better risk-reward equation than owning 80% of a fully levered business

• Expect to contribute 1-2% of the purchase price yourself. This may be required by the SBA lender to approve the loan and often brings comfort to potential investors.

📚 Go Deeper:

Investor Economics in Self-Funded Search Acquisitions (Video)

Buying a $6,400,000 Business With a $100K Net Worth (Thread)

A few closing thoughts:

I have a family that depends on me for their financial security.

I no longer have the risk tolerance to sign up for a 90% SBA loan.

However, in my opinion, the fully levered Self-Funded Search Model is an exceptional strategy for someone early in their career who wants to take a big swing when they have very little to lose.

This is a popular strategy for fresh Ivy League MBAs because they are already saddled with debt, want to be business leaders, and have connections to alumni with deep pockets.

Sadly, very few non-Ivy leaguers ever learn about this concept.

I’m doing my best to change that.

As always, reply with any questions.

If I receive several of the same ones I’ll turn it into a future newsletter.

Happy Saturday folks,

Danny