Like many recent MBA graduates, Joshua Greenberg wanted to run a company. There were just two problems: He didn't have a bright idea that he could turn into a business, and he didn't have the money to buy someone else's company and install himself as CEO.
Greenberg didn't let those minor details stand in his way. Instead, he teamed up with former classmate John Fowler to launch what is known as a search fund. The two Stanford University grads raised $400,000 from 12 investors, mostly members of Stanford's robust alumni network, to start San Francisco-based Montebello Capital. Their mission: buy a company, help it grow substantially, sell out in five to seven years, and distribute big gains all around.
Greenberg and Fowler, both 34, scouted for companies in the logistics industry, hoping they would find a diamond in the rough. Eighteen months later they bought Aero Logistics, a 10-employee trucking company in South San Francisco, for $4 million. "The owner wanted to cash out," says Greenberg, who was a strategy analyst with Charles Schwab before getting his MBA. "We could step in with a fresh set of eyes and see untapped potential. We wanted to rebuild the sales force, rebrand the company, and standardize accounting procedures."
For aspiring entrepreneurs who are short on ideas but big on connections, search funds can be a quick route to CEO-dom. Since H. Irving Grousbeck, professor of management at Stanford University's Graduate School of Business, hatched the idea in 1984, some 71 funds have been formed. Twelve are operating now. So far, the idea hasn't spread beyond the campuses of elite MBA programs, but the method could be copied by anyone with access to investors and deep industry knowledge. "The funds have a proven track record of helping young entrepreneurs take the helm of operating companies," says Jim Ellis, a lecturer in management at Stanford who mentors many searchers.
The search fund model is straightforward: Searchers tap their networks to raise about $200,000 to $400,000 in first-round funding. That money supports them as they comb fragmented industries -- such as trucking, waste management, and sprinkler systems companies -- hoping to find businesses in the $5 million to $20 million range that have sticky succession issues but solid growth prospects. When they find a good candidate, searchers go back to their investors for a second round of financing that will enable them to buy the company. A 2005 study by Stanford's Center for Entrepreneurial Studies found that the funds had an average annualized rate of return of 37.3%.
The promise of high returns makes finding investors the easy part. Landing a company that is profitable, growing, and has an aging founder willing to sell to a couple of fresh-faced MBAs is much trickier. Deals often collapse near the finish line. Many searchers make bids only to find bogus financials or CEOs with cold feet. Rich Kelley, a principal at private-equity firm Search Fund Partners in Menlo Park, Calif., who invested in Greenberg's fund, says heated competition for small companies has driven up prices in recent years. "It takes unbelievable determination" to buy one of these companies, says Kelley. "The mechanics of doing the deal are tricky, and there's a lot of competition." In fact, about one-quarter of search funds closed without making an acquisition, according to the Stanford study. "The actual search is like boot camp," recalls Greenberg. "It's nerve-racking, and the bank accounts get drained. It's lonely and long."
THE RIGHT TEAM
The grueling process is one reason most searchers form partnerships. The partners then develop a formal proposal to woo investors, including an executive summary, company criteria, and a hoped-for timeline for exiting the business. First-round financing should be enough to cover a two-year search, the amount of time Grousbeck thought was needed to find a company. Money goes to salaries of around $75,000, office expenses, and bare-bones travel. "Searchers are notoriously frugal," says Janet M. Dunlap, an attorney at Goodwin Procter in Boston who prepares offering documents for searchers."One client was living in his mom's basement."
Most searchers se-cure first-round funding within five months, according to Ellis. Investors typically plunk down $25,000 in the first round, says Dunlap. In return, they get equity positions of 5% to 10% in the fund.
Savvy searchers look for investors who will bring more than money to the table. Marshall Johnson, 36, started a search fund called North Point Capital Partners with fellow Duke University MBA Frank Young in the spring of 2005. To help him scour deals, Johnson enlisted investors who were ex-CEOs, including Joe McErlane, a former head of health-care reinsurer National Benefit Resources. Johnson also brought in Arthur Monaghan, a principal at Granite Equity Partners in Minneapolis, whom he met through a classmate. Now Monaghan is alerting the searchers to potential deals. He has shown Johnson and Young six so far. "We can insert Marshall [Johnson] in a company because we've already vetted him as part of our due diligence for investing in his fund," he says. "That gives us leverage."
After homing in on an industry, searchers can shorten their learning curve by finding an expert to open doors for them. "Find a river guide," counsels Ellis, one who will allow you to use his name while setting up meetings and who can educate you quickly about a sector's ins and outs. Narrowing a search by geography is also common. Johnson and Young, who have raised $400,000 from 14 investors in three months, are scouting for companies in the recycling industry in the upper Midwest.
Malte Bernholz decided to cast a wider net. Before launching his Boston-based fund in August, 2004, with partner Joel Milne, Bernholz interviewed 40 searchers who had been through the process. Once they learned that limiting a search regionally had hurt some funds, they decided instead to look at candidates nationwide. And because most searchers have at least one deal crumple, Bernholz decided he would keep searching for the right fit -- even while negotiating. "There's a risk of settling for deals that aren't good," he says. Early on, Bernholz, 34, and Milne, 31, focused on litigation support companies. "The industry is growing 11% a year and is very fragmented," says Bernholz. The partners raised $600,000 to finance their search. A year and a half later, they went back to their investors and raised enough money to buy Action Legal Document Services in Charlotte, N.C., in January. "The company had good management, was profitable and revenues were growing over 20% a year," says Bernholz.
As early as possible, advises Ellis, searchers should size up sellers. Are they willing to write a term sheet? They should also allow you to talk to customers and employees, as well as to collect financial information. And searchers shouldn't get caught up trying to snag a bargain. "Pay a good price for a good company," says Ellis. "And don't try to be a good manager in a bad industry."
Staying open to possibilities that may not be in your original plan can help your odds of success. Ellis offers his own experience as an example. In 1993 he and partner Kevin Taweel launched a search fund and started targeting towing companies. Their research eventually led them to dispatch services, and they bought Houston-based Road Rescue for $8 million in 1995. The company blossomed into Asurion, a wireless player as well as dispatcher, with revenues of more than $700 million. "We were able to expand our products, tap into wireless growth, and make acquisitions," says Ellis. "That accounts for our success." And it's the kind of payoff that makes many searchers' entrepreneurial boot camp all worthwhile.
By Constance Gustke