An introduction to entrepreneurship through acquisition and the secrets to its success

Written by Eduardo Zaldivar, Managing Partner of Mosaic ETA

In our previous articles, we talked about the exciting opportunities presented by search funds, a form of entrepreneurship by acquisition (ETA). Let’s take a step back – what exactly is ETA?

ETA is a business model in which an individual (often called a “finder”) acquires an existing company (or companies) rather than starting a new one from scratch. ETA covers finding, acquiring and operating a small or medium-sized company in order to develop and improve it.

Over time, several different approaches to ETA have emerged, and the field will undoubtedly continue to evolve. At Mosaic, we don’t believe that any one approach is better than the other. We believe that the best approach depends on the individual goals and characteristics of the seeker. In this article, we’ll briefly discuss the different versions of ETA, and then delve into the factors that made the traditional search model, in particular, so successful.

Different approaches to ETA

Traditional (or “basic”) search fund: In this model, an entrepreneur raises an initial pool of capital – usually around $500,000 – from a group of investors to cover the costs of finding a company to acquire. This seed capital is used for expenses, including searcher’s fees (the searcher devotes all of his or her time to the search, which can take up to two years), travel, technology, and service providers such as lawyers and accountants. In return, the investor group obtains a legal right of first refusal to refuse to invest in the company that will ultimately be taken over.

After finding a suitable business, the prospector returns to the initial group of investors for additional financing and purchases the company. The searcher becomes CEO and, upon reaching certain milestones, gains equity in the company. The new president creates a management board composed of members of the investor group and external advisors, and then manages the company for an average of 4-7 years.

Self-funded search: refers to entrepreneurs who decide to independently finance the search for the company they want to acquire, using their personal savings. This approach allows for greater control over the search and acquisition process, but requires greater personal financial risk. For example, many self-funded prospectors finance a large portion of their business acquisitions with loans from the U.S. Small Business Administration (SBA), which often requires a personal guarantee.

Independent sponsor: Refers to an individual or group that identifies potential acquisition targets and then raises capital from investors on a deal-by-deal basis to finance the purchases. This differs from a self-funded seeker who uses primarily debt financing and his or her personal funds to acquire single business. Additionally, independent sponsors often hire outside executives to run acquired companies, rather than running them personally as CEO.

Holding company model: The holding company model (“HoldCo”) refers to a strategy in which 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 the “roll-up” approach) or other synergies. Entrepreneurs using the HoldCo model often acquire companies with the intention of owning and managing them for an extended period of time, sometimes for an indefinite period.

What is the secret to the high rates of return – 35% IRR over the last 40 years – achieved by traditional exploration funds?

While there are many factors that determine the success of traditional exploration funds, we will discuss three of the most important:

#1: Seekers are talented, trainable and motivated

Searchers often come from top backgrounds (top MBA programs, finance, consulting, military, etc.) and are earlier in their careers. These features make them eager to gain knowledge as the CEO of a newly acquired company. In addition, they gain equity in the acquired company by achieving ambitious performance goals, which motivates commitment and excellence in execution.

#2: High value-added investors

Search funds are essentially a CEO apprenticeship model in which experienced operators-turned-investors shape talented leaders into successful first-time CEOs. Most investors add value primarily in two stages:

• Diligence before the transaction. Investors provide industry expertise and deal experience to help prospectors obtain critical information and negotiate an acquisition.
• Operational support. Once acquired by a searcher, investors use their pattern recognition and personal operational experience to help the new CEO navigate the challenges of running the acquired company. Some investors sit on the management board of the acquired company, supporting the new CEO throughout the investment life cycle.

#3: Resilient companies and industries

Decades of experience have led almost all exploration fund investors to align with a set of criteria for target acquisitions and industries. While these criteria are generally desirable, they are particularly important when investing in search funds, where the goal is to minimize execution risk for a first-time CEO. Below are some of the characteristics searchers look for in target companies and industries:

Features of the target company:

• High recurring revenues
• Long, stable history of profitability
• Sufficient scale (e.g. >$1.5M EBITDA)
• Many paths of development
• Low customer concentration
• Solid middle management

Target industry features:

• A large, fragmented industry with many companies in the target size range
• Significant development of the industry (preferably >2x GDP growth)
• Healthy and sustainable profit margins
• Simple operations in the industry
• High barriers to entry
• Low cyclicality and seasonality

Each of the different approaches to ETA has its strengths and weaknesses. We hope this introduction has given you a solid foundation for exploring the different models and helped you understand what makes traditional exploration funds particularly attractive and exciting to both information seekers and investors.

Eduardo Zaldivar is managing partner at Mosaic ETA. Before founding Mosaic, he was a private equity investor and startup operator. His greatest inspiration is his mother who, despite the challenges of being a woman, a first-generation immigrant, with only a high school education, became a successful small business entrepreneur. Eduardo earned an MBA from Stanford University, an MPA from Harvard, and a BA from Texas A&M University. She lives in Dallas, Texas and enjoys organizing community-building events, reading classic books, and volunteering at her local church. Follow Eduardo further LinkedIn.