Partially Self-funded Searches and the 1.5x Step-up

February 20, 2020

by a searcher from Georgetown University - The McDonough School of Business in Brooklyn, NY, USA

Does anyone have any experience working as a partially self-funded search? How does the 1.5x step-up work, given that a portion of the search is self-funded. Would the self-funded portion also be entitled to the 1.5x step-up? How would the search fund capital be valued at the time of acquisition?

For example, consider a search fund budget of $500k in total. If it was fully funded by outside investment, I understand the step-up to $750k towards equity value. However, if the budget is $500k, and the searcher puts up $200k and raises $300k, how would the economics work for the searcher-funded portion? (I'm assuming here that the investors, who put in $300k would be entitled to the 1.5x step-up, yielding $450k of equity value. How would the $200k searcher investment be handled?

Thanks.

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Reply by a searcher
in New York, NY, USA

I’ll defer to traditional SF investors to confirm (though I’d have to imagine that most if not all of them would agree with John). To me, partial self-funding makes no sense. I’d argue that the 1.5x step-up isn’t nearly sufficient of a reward to compensate the search capital investors for their risk. The “free option” to invest the subsequent deal capital at relatively attractive pre-negotiated terms is just as valuable as (if not more important than) the step-up. This is also one of key reasons for why self-funded searchers often end up with much more than 25% of equity.

So in your case, I assume the $200k is more or less the limit of your personal capital and you wouldn’t be subsequently contributing the pro rata share of the deal capital (if that’s not the case, then you should just be self funding entirely). So then essentially, you’d be making a risky investment but only getting back [half] of the reward (i.e. you get the step-up, but you already know you won’t be able to exercise that “free option” when you’ve found a deal).

Just my two cents but if you’re able/willing to put up $200k towards your search, you’ll be much better off if you just do a frugal self-funded search. Many self-funded searchers have closed deals with much less than $200k of total search costs. Happy to discuss further and help you brainstorm if you’d like. Best of luck!

Reply by an investor
from Northwestern University in Tampa, FL, USA

This could be done many ways, but if the searcher actually contributes the $200k as you described, I would expect that to convert to $300k of equity in the underlying deal at closing. If you are using a traditional search fund structure and contributing your own cash, I would expect it to be treated the same as an outside investor's interest. Also, I would not confuse this with your carry. At closing, other stakeholders may want to push back on your search equity or carry. You need to be extra clear up front that you will receive equitable treatment as both an investor and a search operator.

Keep in mind, when the time comes to close, the more outside capital you raise, the more likely you are to feel pressure pushing back on the value of the search equity ($0-750k in this example). This will be a point of negotiation with equity investors. Best of luck!

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