Search Funds in SaaS

Every now and then, I'm approached by M&A grads who want to start a search fund in the SaaS space and take a shortcut to entrepreneurship - which prompted me to dig a little deeper.

The search fund concept is almost 40 years old and traces back to a Stanford professor who originated it in 1984.¹ It is essentially the smallest form of private equity: an individual or small group of individuals raise capital for the sole purpose of buying, operating - and, in the best case, growing - a single business.

1. Initial capital to fund the search (“search capital”):
   This capital is being used to cover a modest salary and admin expenses during the search period.

2. Capital to fund the acquisition (“acquisition capital”):
   Once a target is identified and the terms negotiated the searchers will raise money to buy the business.

The goal is to exit in 5-10 years and generate decent returns for all stakeholders involved.

Studies by IESE BS (covering international search funds) and Stanford GSB (focusing on Canada & US) show that “searchers” have been most interested in the software sector in recent years:

It is obvious why they are eyeing Software / SaaS companies:

• Predictable model through recurring revenue,

• Significant scale effects,

• High (gross) margins,

• Growing market,

• ….

Also, the idea of skipping the early stages of figuring out product-market fit and taking something that has already reached a certain size makes total sense.

But while this sounds very tempting at first, it also seems to have some drawbacks.

1. According to the mentioned studies, only 3/4 of search funds manage to acquire a business (2/3 in Canada & US),

2. The median time from start of search to acquisition is 22 months (20 months in US & Canada),

3. Only 1/3 of funds that acquired a business are able to generate an ROI >2 (1/2 in US & Canada),

4. From tracked exits, 1/5 ended in a total or partial loss (1/3 in US & Canada),

5. The good looking IRR averages (19.4% internationally, and 35.3% in the US & Canada, respectively) are heavily skewed by a tiny proportion of highly successful search funds.

As you can see, the chances of success are not much greater than if you start from scratch. Aside from the learnings, many would have been better off (and less stressed) investing their money in an all-world ETF.

Beyond that, there are a few more reasons why I'm critical of search funds in the SaaS space specifically:

1. Competition
   The fact that SaaS companies are attractive acquisition targets was recognized by many other players long before:

   1. Other search funds

   2. Small to medium-sized PE firms

   3. Large PE firms

   4. Large strategics / Fortune 500

   This list also represents the ascending order in regards to the depth of their pockets. Which brings me to my next point.

    

2. Financial discipline

   Search funds have a limited budget and are often considered “low-ballers”, as they can pay the least. No strategic value that can be priced in, no shared resources or synergies with other portfolio cos, etc. The median EBITDA multiple for search fund deals has been hovering at ~6.0x.² If you recall, that was the median ARR multiple for private SaaS M&A deals not so long ago (now at 5.2x).³ Given these constraints, closing a deal depends largely on the seller's level of desperation.
   

3. Brand

   Search funds usually have no brand / track record. Since no one knows you → little to no inbound deal flow and bad conversion rates with outbound. I've seen firsthand the tremendous impact (qualitatively and quantitatively) that growing brand awareness can have on business flow.

4. Deal Flow

   Because of 3.), many searchers rely on deal sourcing agencies or a network of M&A brokers to provide them with opportunities. However, the former comes with monthly costs plus success fee. With the latter, you always find yourself in competitive processes with other bidders. Ultimately, both are not ideal because of 2.).

    

5. Deal structure / Speed of execution

   Search funds are known for complex, less founder-friendly structures that aren’t really competitive. If they still manage to agree on terms with a seller and conduct a due diligence process, they first need to secure committed funds (“acquisition capital”) from investors to close the deal. They, in turn, often run their own check before transferring the money - which can lead to a "no" or at least drag out the process. As the saying goes: Time kills all deals!

6. Skill set

   I’m a big fan of platforms like Acquire.com, Flippa, and Co. where small to medium sized software businesses change hands. The rise of these platforms has significantly lowered the hurdle for M&A.

   However, ownership of the listed businesses tends to change from one techie to another. Successfully running a software company is beyond the capabilities of most searchers, who usually have a more generalist view and lack deep technical knowledge (unlike other acquirers!).

So let's summarize:

• While the search fund concept makes sense and can be a possible shortcut to entrepreneurship, the success rate is not as high as one might think. It is worth considering to rather start a business from 0.

• There are a few things to consider when starting a search fund in the SaaS space that might make it more difficult than in more “boring" industries.

• If you're a techie looking for a hobby project, or a strategic add-on investment for your existing SaaS business, acquisition marketplaces can be real goldmines.