Ideas

Wanted: A Company to Call Their Own

For those entrepreneurial types who aren’t keen on starting a company from scratch, creating a search fund to buy an existing business may be the way to go.

BY MEREDITH ALEXANDER

JOSH GREENBERG REMEMBERS the day he sat down in a Los Angeles conference room to talk to three men about buying their company. All three owners were in their sixties, while Greenberg and his partner, John Fowler—both Business School Class of 2000 alumni—were half their age.

“I want to be tactful here,” said one of the owners as the meeting began, “but I have daughters who are older than you. What makes you think you can sit in this chair and run this company?”

A new MBA, Greenberg couldn’t say he’d had years of experience or that he knew the industry inside out. He had just formed his search company, Montebello Capital, a few months before. Yet his goal was indeed to sit in the CEO’s chair and run a business that someone else had built, to get to know it and make it his own.

In the course of the meeting, Greenberg realized he would have to sell himself before the company’s owners would even think of selling their business to him. But that challenge is just one part of Greenberg and Fowler’s endeavor: They have raised a search fund and are seeking to buy an existing company, which they plan to manage themselves.

Search funds consist of money raised to allow an entrepreneur time and resources to research, find, and buy a company. Despite the uncertainty inherent in the model—it can be difficult to find a good company to buy and tough to convince its owners to sell, among other challenges—search funds are rapidly gaining in popularity among Stanford MBAs and those still studying for their degrees. Search funds are a remarkable shortcut for today’s new entrepreneurs who want to own and run a business.

“It’s the most direct route to owning a company that you yourself manage,” says H. Irving Grousbeck, Class of 1980 Consulting Professor of Management, who pioneered the search fund model. Since search funds began in the mid-1980s, Grousbeck has promoted them as an ideal way for new MBAs to get management and operational experience quickly.

The first search-funders were students who approached Grousbeck when he was teaching at Harvard Business School in 1984. They began with $80,000 they planned to use to pay their expenses while seeking a company to buy and soon raised more money. After their success, the model began gradually to gain followers. Today, the GSB’s Center for Entrepreneurial Studies has knowledge of about 60 individuals who have raised search funds, about 25 of them Stanford MBAs. Searchers do not need an MBA—theoretically, anyone could raise a fund—but the MBA stamp “gives investors some comfort,” Grousbeck says.

And a Stanford MBA seems to help most of all—especially for those students who encountered Grousbeck, who has made himself available to advise many prospective search-funders. A search fund begins with the prospective entrepreneur talking with previous search-funders and reading about their experiences. Most launch their project at the School’s Center for Entrepreneurial Studies, where Linda Wells, MBA ’93, director of programs and resources, keeps the most extensive files in the country on search funds. (She gets calls not just from Stanford students and alumni but also from Harvard and the University of Chicago.)

Wells has seen the number of inquiries skyrocket of late. “For a while, I was handling five inquiries a week,” Wells explains. In the past year, five Stanford groups have begun to raise funds, and at least two additional sets of graduating students have formed groups.

After doing the preliminary research, the next step is raising an initial round of money, usually around 15 units of $15,000 or 20 units of $20,000 in seed capital. Entrepreneurs use this money (the “search fund”) to pay expenses for the approximately two years they plan to spend searching. Investors buy an option to invest further once the company is found (they are given pro rata right of first refusal on the investment) and often get a stepped-up investment as well (their $20,000 could be worth a $30,000 chunk of the company). To acquire the company, investors chip in, and the balance of the transaction is financed through equity or debt.

But how can recent graduates who have no real experience step in and run a company? That question is at the forefront of many sellers’ minds, as Greenberg learned. It may not be as hard as it sounds. Grousbeck has a favorite metaphor he uses to describe his approach.

“The company is like a horse and jockey going around a track,” he says. “Very gradually, you change jockeys. Your objective is just to keep the horse running around the track until you familiarize yourself with the situation. Then, after one or two years, you can make changes,” Grousbeck explains.

It’s a model that worked for Jim Ellis, MBA ’93. Working after graduation as a casewriter for Grousbeck, Ellis overlapped with Kevin Taweel, MBA ’92. Although Ellis had worked as a consultant and Taweel had been an investment banker, both knew they wanted to pursue entrepreneurial careers. But they realized that they lacked specific ideas for forming a startup and began to consider buying an existing company.

Ellis liked the fact that older companies are more stable than brand-new companies. “It seemed like a lower-risk approach to being an entrepreneur,” Ellis says. “The idea behind the search fund is that you’re purchasing a successful, ongoing business.”

Ellis and Taweel raised a fund together and started investigating the towing business, admittedly an “unsexy” industry. After making offers on 20 towing companies, they decided to seek farther afield, delving into the dispatch business. “That turned out to be a pretty good business for us—it’s not as difficult; there aren’t as many bad capital issues,” Ellis says. They made an offer on Road Rescue, a 40-employee company in Houston, Texas, in 1994 and were owners by 1995.

Today, their company—now relocated and called Asurion—has expanded into wireless services and grown by 40 times. Last year it won Ernst & Young’s entrepreneur of the year award for Northern California. The investors are happy—they have received from 30 to 40 times their original equity investment in return. Taweel and Ellis plan to keep the company until they can no longer grow it. Grousbeck is still a mentor: He sits on the company’s board.

For the past five years, search funds had been losing favor as company owners asked outrageous sums for their businesses in light of the stock market’s heady rise.

But today, search funds are back in play as company valuations have come down to earth. It also has become easier to find investors as the search fund model has gained more exposure. Some investors already have been part of a previous search fund and know what to expect.

There are a few issues, however, that should make prospective search-funders think twice. First, it can be impossibly hard to find a good company to buy. Locating the right company to purchase—and convincing its owners to sell—can take years, and at times, it never happens at all. Then investors lose out completely, and searchers have seen years of their lives vanish. Stanford grads sometimes have a tough time sorting through companies because they tend to have more insight into the pitfalls of a business, Grousbeck says. “They’re such good analysts,” he remarks. “Those that don’t buy a company are maybe too picky.”

Gaining bank financing is another hurdle —more of an issue today after many banks were burned with bad debt in the dot-com bubble. In addition, small deals never have been much of an attraction for investment bankers. Many search-funders are turning to sellers and asking them to provide financing options through installment payments and sellers’ notes.

Another downside is that the long months of searching for a company can be lonely and isolating, Grousbeck says. Ellis advises joining industry trade groups and doing as much networking as possible—a convenient way to do research and be sociable at the same time.

But the upside at the end of a search fund—owning and running your own business within, say, two years after forming the fund—keeps pulling them in. Josh Greenberg knows that search-funding is taking a toll on his wife, Susanna, MBA ’00. For now, she is the primary breadwinner in the family, and she must live with the thought that her husband may have to move to Ogden, Utah, or even farther afield, to be near the company he eventually buys. But it’s still worth it, for a few reasons. Not only does Greenberg get to work every day with his dog, Dignan, and one of his best friends, Fowler—he also is grateful whenever he walks into his office and sees the “Montebello Capital” sign on the door.

“Every day I see that placard, I think, this is great,” he says. “There are little nuggets of gold out there. With a search fund you buy the time to turn over the rocks and look for them—that’s an incredible experience.”