Written by Eduardo Zaldivar, Managing Partner, Mosaic ETA
In our previous articles, we’ve talked about the exciting possibilities of search funds, a form of Entrepreneurship Through Acquisition (ETA). Let’s take a step back—what exactly is ETA?
ETA is a business model where an individual (often referred to as a “searcher”) acquires an existing company (or companies) rather than starting a new one from scratch. ETA involves searching for, acquiring, and operating a small or medium-sized business with the goal of growing and improving it.
Over time, a few different approaches to ETA have been created, and the field will undoubtedly continue to evolve. At Mosaic, we don’t believe any approach is better than the rest. We believe the best approach depends on the individual goals and characteristics of the searcher. In this article, we will briefly explore the different flavors of ETA, and then dive into the drivers that have made the traditional search model in particular so successful.
The Various Approaches to ETA
Traditional (or “Core”) Search Fund: In this model, the entrepreneur raises an initial pool of capital—usually around $500,000—from a group of investors to cover the costs of searching for a business to acquire. This initial capital is used for expenses including a salary for the searcher (the searcher dedicates her full time to the search, which can take as long as two years), travel, technology, and for service providers like lawyers and accountants. In return, the investor group gets a legal first right of refusal to invest in the company that will eventually be acquired.
Once the right business is found, the searcher goes back to the initial group of investors for additional funding and buys the company. The searcher becomes the CEO and gains equity ownership in the company as they achieve certain milestones. The new CEO creates a board composed of members of the investor group and external advisors, then runs the company for 4-7 years on average.
Self-Funded Search: refers to entrepreneurs who choose to self-fund their search for a company to acquire using their personal savings. This approach allows more control over the search and acquisition process but requires more personal financial risk. For example, many self-funded searchers fund a large portion of their business acquisition with loans from the U.S. Small Business Administration (SBA), which often requires a personal guarantee.
Independent Sponsor: Refers to an individual or group who identifies potential acquisition targets and then raises capital on a deal-by-deal basis from investors to fund the purchases. This differs from a self-funded searcher, who primarily uses debt financing and her personal funds to acquire a single company. Additionally, independent sponsors often hire external executives to lead the acquired companies rather than running them personally as CEO.
Holding Company Model: The holding company (“HoldCo”) model refers to a strategy where an entrepreneur intends to acquire multiple businesses. The HoldCo entrepreneur often seeks to acquire companies that are more valuable together due to economies of scale (often called a “roll-up” approach) or other synergies. Entrepreneurs using the HoldCo model often acquire companies with the intention of owning and operating them for an extended period of time, sometimes indefinitely.
What is the secret behind the high returns—35% IRR over the past 40 years—produced by traditional search funds?
While there are multiple factors that make traditional search funds so successful, we’ll touch on three of the most important:
#1: Searchers are Talented, Coachable, and Incentivized to Perform
Searchers often come from high-performance backgrounds (top MBA programs, finance, consulting, military, etc.) and are earlier in their careers. These traits make them eager to scale the steep learning curve of being the CEO of a newly acquired company. Additionally, they earn equity ownership in the acquired company as they hit ambitious performance goals, which incentivizes commitment and excellence in execution.
#2: High Value-Add Investors
Search funds are fundamentally a CEO apprenticeship model, where experienced operators-turned-investors mold talented leaders into successful first-time CEOs. Most investors primarily add value across two stages:
- Pre-deal Diligence. Investors provide industry expertise and deal experience to help searchers surface critical information and negotiate the acquisition.
- Operating Support. After the searcher acquires, investors leverage their pattern recognition and personal operating experiences to help the new CEO navigate the challenges of running an acquired business. A subset of investors sit on the board of the acquired company, supporting the new CEO throughout the investment lifecycle.
#3: Resilient Businesses & Industries
Decades of learnings have led nearly all search fund investors to align on a set of criteria for target acquisitions and industries. While generally desirable, these criteria are particularly important for search fund investing, where the aim is to minimize execution risks for a first-time CEO. Below are a few of the traits that searchers seek in target companies and industries:
Target Company Traits:
- High recurring revenue
- Long, stable history of profitability
- Sufficient scale (e.g., >$1.5M of EBITDA)
- Multiple avenues for growth
- Low customer concentration
- Solid middle management
Target Industry Traits:
- Large, fragmented industry with many companies in target size range
- Meaningful industry growth (ideally >2x GDP growth)
- Healthy and sustainable profit margins
- Straightforward industry operations
- High barriers to entry
- Low cyclicality & seasonality
Each of the different approaches to ETA has its strengths and weaknesses. We hope this introduction has given you a strong foundation from which to explore the different models and helped you understand what makes traditional search funds in particular attractive and exciting to both searchers and investors alike.
Eduardo Zaldivar is a Managing Partner at Mosaic ETA. Prior to co-founding Mosaic, he was a private equity investor and startup operator. His greatest inspiration is his mother, who was a successful small-business entrepreneur despite the challenges of being a woman, first-generation immigrant, with only a middle school education. Eduardo received his MBA from Stanford, MPA from Harvard, and Bachelor’s from Texas A&M University. He resides in Dallas, Texas and enjoys hosting community building events, reading classic books, and volunteering with his local church. Follow Eduardo on LinkedIn.