To Start-Up or to Search Fund, That Is the Question

I spent the majority of my 25-plus-year career helping run a large media company as chief financial officer and then founding and managing a venture capital fund. I will freely admit that my success—financial and otherwise—has come largely in starting companies from whole cloth. When the stars align in the start-up game, the payoff is huge. No doubt.

But I have lived through the dark underbelly of the start-up world, too. My venture funds were vintage 1999 and###-###-#### For those readers who were still in diapers then, the mid 2000s were perhaps the worst possible time to be trying to grow adolescent VC-backed companies still in need of capital to prove out their business model. I started companies during that period that turned out to be quite valuable. But it took a decade of brutally hard work to get there. In the end, I was not convinced I got paid adequately for the risk on the winners. And they were not all winners; the mortality rate was very high.

Fast forward to 2016, and I’ve been astonished by the lengths to which many major business schools are trying to keep the pure start-up entrepreneurship flame alive despite all evidence that perhaps not everyone can be the next Mark Zuckerberg. I am all for disrupting existing markets and for the power of technological innovation. But my observation is that we in America have repeatedly embraced the fantasy of get-rich-quick schemes based on market bubbles, only to see a total collapse of capital flows, valuations, and devastation to everyone along the food chain. When I was last in the South of Market area of San Francisco, it felt remarkably like 1999 all over again.

Don’t get me wrong. In every single market environment, somebody will have an idea about a product or market that will lead to a start-up that will generate scale and wealth for its founders. My point is that for average morons like me and you, making money in the start-up game is highly dependent on factors far outside our control. My grand slams were completely dependent on being in the right place at the right time in the market cycle, not on any fundamental business achievement. And those companies that we built up through a down market made us money, but our success was diluted by the need to raise capital on less-than-attractive terms.

Over a long stretch as a professional start-up VC investor, I would say that 10% of my companies hit it out of the park, 40% eked out some kind of success that was far less than anyone hoped for but still made money for cash investors (not necessarily for the founders), and 50% failed to return capital. While unscientific, I think my data is pretty representative of the market as a whole. Very, very few VC firms make market-beating returns over multiple market cycles. And as a rule, if you are starting a company, you should think your chances of “succeeding” (meaning building a business of scale with life-changing wealth coming your way) are likely around 1 in 10, assuming you are brilliant and land a quality group of investors to get you off the ground.

Call me crazy, but those seem like shitty odds to me.

The other factor, of course, is that most start-ups need successive rounds of financing to get a foothold. So, by definition, as an entrepreneur, you must spend a disproportionate amount of your time sucking up to VCs and raising capital rather than actually running your fledgling business. Because the VC world is intractably political, being good at raising money is not necessarily a sign that you can actually build and run a business. It’s about power point under pressure, not managing people, building actual technology, or cultivating customer loyalty—i.e., the stuff that really matters in the end. A lot of VCs are egotistical assholes (which is yet another reason why I got out of the industry), and to do well with them you need to speak their language and be kind of an asshole yourself. Again, this is not a good goal if you are trying to lead a company and build a customer base.

I believe that the way to succeed most reliably is to eliminate as many things as possible that you cannot control and double down on your own abilities. Starting a search fund is a much more effective way to do that than starting a company, in my opinion. There will always be those high school students who are dead set on playing in the NBA, and some tiny percentage of those kids will actually make it (start a company that becomes a unicorn). But getting an education at a great college is a much more reliable way to succeed. Let’s look at why.

Not all business school students who set out to raise a search fund achieve even the first step. But the vast majority do. Search fund investors are generally willing to roll the dice on a plausible searcher just for the option value of looking at whatever deals they are able to uncover. Let’s put the failure rate of students trying to raise a search fund at 25%, though I think the number is actually a lot lower than that.

Once the search capital is closed, it’s a matter of finding an attractive company to buy—attractive enough that your investors will back you in the acquisition. Seventy-five percent of searchers end up buying a company. That means of all the people who make a serious effort at raising a search fund, half end up owning and running a company.

Before I get to the equity math, let’s compare what that means for the search-funder-turned-CEO versus the start-up founder. From the search deals I’ve been around, the CEO is in charge of a company that has upward of $10 million in revenue, very substantial profit, strong growth prospects, and dozens of employees. The only thing to do is all the stuff that he or she actually studied in business school: building an effective sales and marketing organization, building a customer success function, thinking hard about product development, and putting in place great human resource policies. In summary, lead an organization of scale across all major management disciplines. This isn’t three guys around a table doing skunk works to invent something that is VC fundable. This is a real company with real customers, real profits, and real asset value. Day one.

The search fund equity model gives the searcher equity in the business based in three buckets: for doing the deal, time vested, and based on the cash investor’s IRR. Cash goes back to the investors first, and the searcher shares in the upside. If he buys a business for $10 million and grows it to $50 million in value at exit, let’s say, the upside would be $40 million, of which he might expect to get a quarter, or $10 million. That level of return is very much in line with the historic norms reported in hundreds of search fund companies by Stanford’s study.

Ten million dollars isn’t unicorn money, but it’s not too shabby for five to seven years of work by a young professional just out of business school. It doesn’t depend on hitting a capital market bubble just right, sucking up to VCs, or even coming up with a uniquely brilliant idea to dis-intermediate an existing market. It requires having a plausible argument about why search fund investors should give you a little capital, building deal flow to find a company to buy, and then proving yourself a capable leader.

Search funds are not for everyone. Unlike many of our business schools, however, I don’t understand the national obsession with start-up entrepreneurship. Those schools, their students, and frankly our country as a whole would be better served if some portion of the human and financial capital deployed against the dream (and, all too often, the fantasy) of a grand slam start-up was focused instead on finding great small businesses to own, manage, and improve.