What to Know About Investor Equity in Search Deals

Investor equity in search deals involves investors funding acquisitions in exchange for ownership stakes. Here’s what you need to know:

• Equity Structure: Investors typically hold 80-90% preferred equity, while searchers (buyers) retain 10-20% common equity.
• Returns: Investors receive 8-16% annual returns, with profits distributed after their capital and preferred returns are paid.
• Control: Searchers maintain operational authority but collaborate with investors on major decisions.
• Performance-Based Equity: Searchers can increase their equity share by meeting growth or profitability milestones.

Quick Overview of Funding Options:

This model is ideal for entrepreneurs, MBA graduates, and small business buyers targeting acquisitions between $5-30M. To succeed, focus on building strong investor relationships and negotiating terms that align with your goals.

Search Funds as Investment Vehicles: Understanding Investor Equity

Main Parts of Search Deal Equity

Types of Equity: Preferred and Common

Preferred equity gives investors the first claim on distributions and a set annual return, usually between 8-16%. On the other hand, common equity provides searchers with 60-80% ownership, allowing them to share in profits after investors' returns are satisfied.

Performance-Based Ownership

Search deals often include ways for searchers to gain more equity by hitting specific performance goals, such as:

• Achieving EBITDA growth targets
• Meeting revenue milestones
• Completing strategic initiatives
• Reaching certain profitability levels

These achievements can directly increase the searcher's share of common equity.

Standard Equity Splits

In a typical structure where investors hold 80-90% equity, a $10M acquisition with 15% equity ($1.5M) would allocate 90% ($1.35M) to investors and 10% ($150K) to the searcher. This is a notable contrast to private equity deals, where management stakes are usually around 5-10%, highlighting the searcher's active involvement in operations.

How Investor Equity Payments Work

Return Rates and Thresholds

Investor equity payments often depend on the risk associated with the business. For stable businesses, return rates typically range from 8-10%, while ventures with higher risk might require 12-16%. Some agreements include tiered rates that increase as specific milestones are reached, aligning payments with the company’s performance.

Payment Order and Structure

Equity payments follow a structured process, often referred to as a "waterfall." Here's how it typically works:

This structure ensures that investors recover their capital and earn a return before profits are divided.

Balancing Investor and Buyer Returns

The search fund model creates a system where both investors and buyers benefit, striking a balance between equity and operational needs. Common negotiation strategies include:

• Offering smaller preferred return rates in exchange for a larger equity share
• Linking increases in equity to performance metrics like EBITDA or revenue
• Combining fixed compensation with equity-based rewards

Before equity payments are made, businesses prioritize cash flow for operational stability and debt obligations. This ensures the company remains healthy while meeting investor expectations.

These mechanics provide the framework for negotiating terms, which will be discussed further in upcoming sections.

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Getting Better Equity Terms

Funded vs. Self-Funded Search

The way you choose to fund your search - either through external investors or your own resources - plays a big role in shaping your equity and control. Self-funded searches often give you more negotiating power because you're showing personal commitment by covering the search phase on your own.

Your funding choice sets the tone for negotiations, but the strength of your relationships with investors will ultimately shape the final terms.

Building Investor Relationships

Once you've decided how to fund your search, the next step is building strong relationships with investors. These connections can directly influence the equity terms you secure. It's not just about asking for money - it’s about showing how you can deliver value. Investors with experience in search funds often prioritize operational know-how and industry insight over purely financial metrics.

To impress potential investors, focus on:

• Detailed market research: Show you understand the landscape.
• Clear growth plans: Lay out how you’ll drive business success.
• Specific operational improvements: Highlight areas where you can make a measurable impact.

Keep investors engaged with regular updates on key metrics and milestones, ideally through quarterly reports.

Protecting Your Equity Share

While performance-based incentives help align goals, you also need contractual protections to ensure your equity stake remains intact during the ownership period. These safeguards can prevent dilution and protect your interests.

Consider these strategies to secure your share:

• Milestone-triggered vesting: Tie equity to specific achievements, like hitting inventory turnover targets.
• Anti-dilution clauses: Guard against losing equity if new shares are issued.
• Management incentive plans: Align team goals with business success.
• Buy-back rights: Retain the option to reclaim equity under certain conditions.

These measures help ensure your equity position stays strong while aligning with performance goals.

Managing Equity After Purchase

Maintaining Business Control

Once equity terms are finalized, it's essential to put safeguards in place to maintain control. Here are some key mechanisms:

Investor Rights and Limits

While searchers typically maintain day-to-day control, investors often have rights that influence critical business decisions. Common protections include board representation (usually 1-2 seats) and veto authority over major matters, such as taking on significant debt or selling the company. These measures balance operational independence with investor oversight and reporting requirements.

Exit Planning and Taxes

When planning an exit, align timelines with investor expectations and take advantage of potential tax benefits under Section 1202. This section allows for tax-free gains if specific criteria are met, as outlined in the initial equity agreements:

"A $5M acquisition sold for $20M could yield $10M tax-free under Section 1202"

To qualify, the company must meet these conditions: maintain C-corp status, have gross assets under $50M at the time of stock issuance, remain actively operational, and have a five-year holding period for directly issued stock.

For flexibility, consider partial exits before a complete sale. Options include dividend recapitalizations or selling minority stakes.

Conclusion: Main Points About Search Deal Equity

Key Points Summary

Investor equity structures are built around three main components that drive successful acquisitions. Research indicates that successful search deals often achieve a median pre-tax internal rate of return (IRR) of 32.6%. The decision between funded and self-funded searches plays a major role in equity terms, with self-funded models typically allowing operators to maintain a larger ownership stake.

Action Steps

To make the most of these equity structures, consider these steps:

• Model investor returns within an 8-16% range based on the business's risk level.
• Secure operational control using well-crafted shareholder agreements.
• Tie equity vesting to clear EBITDA or revenue milestones.
• Set up clear governance frameworks to streamline decision-making.
• Design performance-based incentives to align interests.

Building strong relationships with investors is essential for securing good terms. By understanding and applying these equity principles, searchers can structure deals that meet investor expectations while keeping entrepreneurial benefits intact.

FAQs

How much equity do you get in a search fund?

Search fund entrepreneurs generally keep 15-30% equity after an acquisition. The exact percentage depends on factors like:

• The structure of the deal
• The size of the acquisition
• The entrepreneur's level of experience

For instance, smaller deals ($5-10M) often result in 25-30% equity, while larger acquisitions ($20M+) may lead to 15-20% equity. In a traditional funded search, equity typically falls between 15-25%.

Vesting schedules are usually structured like this:

• 25% at the time of acquisition closing
• 25% annually over the next three years
• 25% tied to hitting specific financial goals

Experience plays a big role too. Seasoned operators might secure up to 30% equity, while first-time searchers often receive around 20%. This performance-based approach helps align incentives and protect equity. For tips on negotiating better terms, check out the sections on Building Investor Relationships and Protecting Your Equity Share.