Advantages and Disadvantages of Search Funds: What Should Entrepreneurs and Investors Know?

Search funds have established themselves as an innovative model for business succession, but they come with specific advantages and disadvantages for all parties involved. This article highlights the key strengths and weaknesses of this model, helping potential searchers, investors, and business sellers make informed decisions.

What are the main advantages of search funds for searchers?

Entrepreneurial opportunity with reduced risk

The greatest advantage for searchers lies in the opportunity to take over company management immediately without having to build a business from scratch. Unlike a startup, a search fund offers:

Acquisition of an already established, cash flow-positive company
Existing customer base and market presence
Established processes and an experienced team
Faster path to a leadership position

Access to capital and expertise

Search funds enable entrepreneurs with limited personal financial resources to access significant capital sources:

Financing of the search phase by investors (in the traditional model)
Capital for the acquisition that would otherwise be unattainable
Advice and support from experienced investors
Valuable network for future growth and development

Significant ownership stakes

Although searchers typically do not hold the majority of company shares, they can still acquire meaningful ownership stakes:

Typically 20-30% ownership in the traditional model
Higher stakes in self-financed or single-sponsor models (30-50%)
Vesting structures that grant additional shares upon achieving performance targets
Potentially much higher ownership stakes than comparable employee positions

What advantages do search funds offer investors?

Attractive returns

Search funds have historically delivered very attractive returns for investors:

Average IRR (Internal Rate of Return) of 30-35% in U.S. studies
Opportunity to diversify into the mid-market
Capital allocation to smaller companies often overlooked by larger private equity funds

Typically, search fund returns exceed those of private equity funds, often with lower leverage and a more moderate risk profile.

Active involvement

Investors can exert more active influence than with many other investment types:

Typically a seat on the advisory board or supervisory board
Direct communication with the CEO
Opportunity to contribute expertise and network
Higher transparency and more direct influence than with larger funds

Ethical investment opportunity

Search funds offer a more sustainable alternative to traditional private equity approaches:

Longer investment horizon (typically 5-10 years)
Focus on sustainable growth rather than radical restructuring
Preservation of jobs and company culture
Support for succession planning in the mid-market

What are the advantages for selling entrepreneurs?

Succession solution preserving company identity

For entrepreneurs looking to sell, search funds provide an attractive alternative:

Sale to a committed entrepreneurial type rather than an anonymous financial investor
Higher likelihood of preserving company culture and identity
Possibility of a gradual transition with onboarding time
Often better cultural fit than strategic buyers

Access to professional capital

Sellers benefit from the professional investor base in the background:

Greater transaction security through experienced financial partners
Professional acquisition process with clear structures
Potentially higher valuations due to more efficient capital structures
Opportunity for the seller to retain part ownership and benefit from future growth

What are the disadvantages of search funds for searchers?

High time commitment and uncertainty during the search phase

Finding a suitable company involves significant challenges:

Average search phase of 1.5 to 3 years
High number of companies to evaluate (typically several hundred)
No guarantee of success despite intensive efforts
Often reduced or no salary during the search phase

It is quite possible that the searcher may not complete the search phase for 2.5 years. It is important for the searcher to view the search phase as an investment in themselves rather than a period of inactivity.

Dependence on investors

The relationship with investors can be complex:

Pressure to find a company within the financed search period
Potential conflicts of interest when selecting the company
Need to consider various investor preferences
Continuous justification pressure toward investors

Challenges of acquisition

After the acquisition, searchers face particular challenges:

Steep learning curve in taking over management
Cultural integration and employee leadership
Dealing with the predecessor’s legacy
High investor expectations for growth and returns

What are the disadvantages for investors?

High risk during the search phase

Investing in search funds carries specific risks:

Possible total loss of search capital if no company is found
Dependence on the searcher and their capabilities
Limited influence over the search process
Often long capital lock-up without interim returns

Management risk

Management risk is particularly pronounced in search funds:

Dependence on a often inexperienced CEO
Limited options for management change without significant disruption
High importance of personal chemistry between investors and searcher
Potential conflict between short-term performance and long-term value creation

Liquidity constraints

As a niche strategy, search funds have liquidity limitations:

No established secondary market for search fund shares
Long-term capital commitment without exit options
Dependence on the exit strategy of the searcher
Limited transaction sizes and thus scalability of the strategy

What are the disadvantages for selling entrepreneurs?

Limited transaction size

Search funds have typical size limitations:

Typical focus on companies with €1-5 million EBITDA
Limited financial capacity compared to larger private equity firms
Often lower valuation multiples than strategic buyers

Risks of management change

Transition to a new, possibly inexperienced CEO carries risks:

Potential loss of customer relationships
Uncertainty for employees and possible turnover
Challenges in transferring implicit knowledge and relationships
Organizational adjustment difficulties

How do the advantages and disadvantages differ in the German market?

The German market has some particularities:

Advantages in the German context

High succession demand in the German mid-market with around 500,000 companies seeking succession in the coming years
Strong culture of the "Honorable Merchant," which fits well with the search fund model
Many owner-managed companies with strong local roots
Good financing opportunities through development banks and house banks

Disadvantages in the German context

Lower awareness of the search fund model
Higher skepticism toward private equity-like structures
More complex labor law framework
Cultural differences in negotiations and expectations

How can the disadvantages of search funds be minimized?

For searchers

Thorough preparation and realistic expectations before starting the search phase
Careful selection of investors who align with the personal vision
Clear communication with all stakeholders
Involvement of the predecessor entrepreneur during the transition phase

For investors

Diversification by investing in multiple search funds
Thorough due diligence of the searcher before investing
Active support rather than just providing capital
Realistic expectations regarding timelines and returns

For selling entrepreneurs

Careful evaluation of the searcher and their investor base
Structured handover process with sufficient onboarding time
Clear agreements on continuation aspects such as company culture and employee treatment
Possibly retaining partial ownership to minimize risk

Conclusion: Who are search funds particularly suitable for?

Search funds offer a unique model for business succession with specific advantages and disadvantages. They are particularly suitable:

For searchers who:

Think entrepreneurially but do not want to start from scratch
Are willing to make a significant personal commitment
Can and want to collaborate with investors
Have a long-term perspective for their entrepreneurial activity

For investors who:

Seek access to the mid-market
Are willing to actively support and contribute expertise
Have a longer investment horizon
Aim for higher returns with moderate leverage

For selling entrepreneurs who:

Desire sustainable continuation of their life’s work
Are looking for a committed successor personally involved
Are willing to invest time in onboarding
Value cultural continuity

With careful structuring and realistic expectations from all parties, search funds can create a win-win situation and provide a valuable solution to the challenges of business succession.

If you want to learn more about the financial aspects of business succession, explore business valuation methods or how to buy a company with little equity.