Buyers and Builders
00:27:49 · Greg Geronemus
[00:27:49] S1: Sure. Yeah. So as I said, back in 2010, there was... When I was... Started learning about this ecosystem, there was really one show in town that was traditional search. When people refer to a search fund, often they're referring to traditional search. The category has broadened, and now the the umbrella of entrepreneurship through acquisition has many subcategories. The two main ones, although I think the the picture is shifting, but the two main ones over the last ten years or so have been traditional search and self funded search. I'll start with traditional search. Traditional search, you... It can be a solo entrepreneur or sometimes it's partnered like I was lucky enough to have to have David. Occasionally, you'll see a trio. But the basic concept is that you you raise seed capital, we call it search capital, which buys you the... Which buys the entrepreneurs two years worth of runway, typically, sometimes two and a half years, to go out and hunt for a business to buy. Most of that capital goes to keeping, you know, to some modest salary for the searchers or entrepreneurs, and then some miscellaneous operating expenses, legal, tax, tech tools for sourcing, and usually a provision for dead deal costs in the event that you get far along on a deal and it doesn't end up going through. The investors in that case, they take the risk that you don't find a deal. The benefit that they that they get is they get a right of first refusal on any deal that you find, and they get a... Some preferential economics on that acquisition. So they get what's called a step up. Any dollar that they put in, they get a dollar fifty's worth of credit into preferred equity in that in the transaction. Typically, traditional searchers will will go after larger deals. I think half or so are larger than 12,000,000 of enterprise value. Seeing traditional search deals get bigger and bigger. So I think that's... We saw that stat recently, but I think that you'll see deals increase in size. One of the big benefits of traditional search is not only the opportunity to go after a bigger asset, but also the ability to have those investors that back you from the outset, support you during the search, and a subset of them, two, three of those investors will join your board and really coach and mentor you all the way, all the way through, hopefully, towards a a successful exit.
00:30:47 · Greg Geronemus
That is traditional search. And when people talk about the great returns in search, they're usually referencing the Stanford study. The Stanford study exclusively consists of traditional search. Self funded search has emerged in a meaningful way in the last ten, twelve years or so, and that's sort of the practice of hunting for a deal without upfront search capital. So the self funded part refers to the search phase. So it could be you, Mikk. You could say, you know what? Done with podcasts. I'm gonna I'm gonna look for a business to buy, and I'm gonna go without salary. I'm gonna hunt for a company. And, you know, at the time of the acquisition, typically, you're raising some equity from third parties. Some people are in a position to put to... If they have significant savings, to write the entire equity check themselves. And from a debt perspective, self funded search has not exclusively, but largely become synonymous with SBA loans where searchers have to put up a personal guarantee. There's some benefits to the SBA. It's a great SBA loan program. It's a great program. There obviously... There's some downsides as well with the personal guarantee. And for the most part, in contrast to traditional search deals where the deals can be a bit larger, Self funded search is largely associated with smaller deals. Often, you know, three in the sort of three to eight million dollars of enterprise value, but off... But also many times quite a bit smaller than three. You'll see, you know, a lot of these deals are $600,000 of EBITDA or seller's discretionary earnings, and searchers are buying them for $2,100,000. So we're talking about, you know, all all search deals, even traditional search in the world of investments and private equity. It's it's all small potatoes, but self funded search is quite a bit smaller. So there's a lot of debate as to what the the best model is and what somebody should pursue. You know, I have... I certainly... I'll admit I have some biases. I think when it comes down to it, it's really a matter of personal preference and people should do exhaustive research and understand their personal circumstances to really figure out what's best for them. There's no question that self funded search is, it's a great option for many. It's also not possible for most people.
00:33:40 · Greg Geronemus
The idea of working without any income, incurring deal expenses for one, two years. That's just... That's a nice idea for many, but it's not... It's often not on the table. But for those who have savings, it can... And they have an interest in a particular... Maybe they wanna go for something really small, maybe more a lifestyle business where they have... One of the benefits or features is that you can own a greater percentage of the company, sometimes up to 60 to 80% of the company. Whereas in traditional search, you're often owning more in the 25 to 30% range. There's also a perception of... I think this is maybe more perception than reality. The opportunity for greater autonomy in self funded search. You don't have a board. It doesn't feel like you have anybody to answer to. Self funded search has often become a vehicle for people who have a hard geographic constraint. So, you know, if somebody is... They're living in Milwaukee, Wisconsin, their family's rooted there, they wanna go find a business to buy, and they can't move. They're not gonna move, but they wanna be an ETA entrepreneur. They're not raising a traditional search. Traditional search investors, Footbridge, others will not back a Milwaukee focused traditional search. The odds of acquiring a business, especially one of sufficient scale, are just too low to be backable. But could somebody find a very small business that they could SBA finance and raise a little bit of outside equity? Sure. So that can be a good reason to go self funded. Where I think you have in this sort of self funded versus traditional search debate, where I think you have people get it sort of incorrect or wrong is there's a belief that in self funded search by virtue of the larger ownership percentage that there's greater economic upside. And I think that that is simply a fallacy. That's just not correct. People conflate ownership percentage with dollars that you can earn, And there's just so much more nuance to that. It is... Yes. It's a larger percentage of the pie, but it's a much smaller pie. So that's that's one. Two, there are significant and really difficult implications of being in a really small business. You have less cash flow to reinvest. It's much harder to attract and retain talent. It's much harder for an operator to extricate themselves from the day to day of a business.
00:36:37 · Greg Geronemus, Mikk
Because you a small business, a small team. If you have five people on your team and one person sick, that's a 25... 2020% of your workforce is out, and that's a bit of a crisis. So it's harder to take a step back and think strategically. You also don't have... Often don't have the benefit of a board to coach you and mentor you during difficult times. And I... I've got a much longer list than there... Than that, but I always encourage when people are thinking about self funded versus traditional search, whether they have the capital and is stashed away and the ability to do self funded search or not, just think about and do the math. Because if your motivation is around economic upside, there's more nuance than you might think on the surface. [00:37:33] S0: I found a... I'm quoting you in here what you've said previously on one of the podcast and again, you, traditional search is a win win for both investors and entrepreneurs. I think this sums up. Let's sum up this part.
00:37:33 · Mikk, Greg Geronemus
[00:37:33] S0: I found a... I'm quoting you in here what you've said previously on one of the podcast and again, you, traditional search is a win win for both investors and entrepreneurs. I think this sums up. Let's sum up this part. [00:37:49] S1: Yeah. I mean, look, I think, you know, there are a lot of advocates of self funded search describe or create this construct where traditional search is this sort of predatory concept... Predatory model where investors are taking too much of the equity or... And not giving enough equity to traditional searchers. I I think that the data speaks for itself that that's not true. There are people who... The many people who have made, in some cases, tremendous fortune, and in a lot of cases, a small fortune on traditional search as entrepreneurs. There's a lot of rest that traditional search investors are taking and a lot of work that they put in to support search entrepreneurs. And they're deserving of the rewards that they get. And certainly traditional search entrepreneurs are deserving of the rewards that they get. And I think the model has been around for many years. I think it's beyond fair and I really do believe it's a win win. There's plenty of upside to go around. [00:39:08] S0: We covered one side. We covered the self funded search side when it comes to the ownership, which could be like 60 to 80% of the business. But can you elaborate the ownership structure for traditional search?
00:39:08 · Mikk, Greg Geronemus
[00:39:08] S0: We covered one side. We covered the self funded search side when it comes to the ownership, which could be like 60 to 80% of the business. But can you elaborate the ownership structure for traditional search? [00:39:22] S1: So it's 25 to 30% depending on whether it's a solo searcher or a partner search. And it's broken down into tranches that vest for different reasons. So let's just go with a partner search for a second where you can get up to 30% of the economic upside. A third of that 10% vests at close as a reward for closing the transaction. 10% vests over time, typically a four year time vest. And then the remaining 10% vests subject to performance IRR hurdles. You begin to invest into that... The the third tranche at a 20% net IRR, and you max out on that third tranche through a... With a 35 net or higher internal rate of return. [00:40:22] S0: Okay. And now the last topic, the rise of committed capital vehicles and holdcos. Over the last two years, we've seen an explosion of committed capital vehicles and permanent holdcos. What do you believe is driving that trend? [00:40:39] S1: Let me take a step back and just explain how the... What the model is and how it how it differs from traditional search, and then I'll I'll get into sort of [00:40:46] S0: the Okay.