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New Entrepreneurs Seek Search Funds to Finance Takeovers of Baby Boomer Businesses

By: Heather Endresen, Live Oak Bank

No generation has had the impact on small business creation that the baby boomers have had over the past 50 years. As these baby boomers look to retire, a new model of entrepreneurship is emerging and seeking creative funding to take over these existing small businesses. These new entrepreneurs are flocking to the previously obscure search fund model in droves, finding success in securing both debt and equity financing.

Boomers Also Created an Unprecedented Small Business Boom

The generations that followed the baby boomers gravitated to careers working for the government or larger companies, seeking the security of health care coverage and a regular paycheck—so much so that there is now an entrepreneurial generational gap. This gap is visible when looking at the average age of business owners with under $10 million in annual revenue—which stands at 60 years old. The percentage of such businesses in which the owner is 65 years of age or older peaked at 38% in 2017, according to Barlow Research Associates.

Today, these baby boomer entrepreneurs are increasingly motivated to retire as they feel the time is finally right. “During the Great Recession and the recovery that followed, these business owners held on to their companies,” says John Barlow, president of Barlow Research. “They either were not sellable; they wouldn’t get the value that they think the company was worth; and/or they didn’t want to pass the burden of the ownership on to their son or daughter.  So they held on, and now things have improved. Their confidence in the nation’s economy and the future of their company is up, and they are finally thinking of making the movement in the ownership of their company.”

Current data reflect this sentiment. During 2017, 36% of all small business owners—those with $100,000 to $10 million in sales—said they plan to transition the ownership of their company in the next five years. That number is up from 27% anticipating a change in 2010.

This increase has occurred in all sales segments. Micro companies—with sales from $100,000 to $500,000—went from 26% planning to transition ownership in 2010 to 35% today; small enterprise companies—with sales from $500,000 to $2.5 million—went from 30% in 2010 to 42% currently; and business banking companies—with sales from $2.5 million to $10 million—went from 32% in 2010 to 40% today.

With far fewer entrepreneurs younger than the baby boomer, questions remain about who – if anyone –will take over these businesses.  Plans for future ownership vary according to company size. The Barlow data indicate that of those planning a change in ownership, 36% of micro companies plan to liquidate or shut down the business. Only 28% plan to pass on the business to family members, and the remainder has their sights set on selling the business and retiring with the nest egg the sale could generate.

D&B states there are 8.6 million companies in the U.S. with sales of $100,000 to $10 million. With 36% of all companies planning a transition of ownership (in some form) in the next five years, that could equate to more than three million small businesses going up for sale in some manner (liquidate, sell to third party, sell to family, sell to employees or sell stock to public).

The Exit Planning Institute estimates that about 4.5 million businesses with more than $10 trillion in value will transition over the next 10 years, with 20 to 30% being sold.

Sales of these companies have commenced. Data from Biz Buy Sell, one of the largest online business marketplaces, indicate that actual closed sale transactions for such businesses hit a record high in the third quarter of 2017.

The market appears to be ripe for acquisitions of these businesses. A recent report from IBBA and M&A Source, two large trade associations of advisors to the small and lower middle market businesses, indicates that although these companies are reporting sales growth and positive financial trends, the sale prices are remaining fairly stable with most companies selling between three to five times earnings.

Those healthy financial trends are also attracting a solid supply of debt and equity to finance these changes of ownership. Furthermore, the recent tax reform has made business ownership even more attractive due to the corporate tax rate decreases. As an example, many acquirers are able to access SBA loans. Since this type of loan has flexible terms, SBA loans are often the preferred financing vehicle for acquiring a business. At Live Oak Bank, the nation’s leading SBA lender currently, there is a dedicated SBA M&A lending unit to cater to the growing demand for these loans.

All of these trends are converging to create ideal conditions for an unprecedented passing of the baton from baby boomers to a new generation of small business owners.

The Next Generation

With the number of small businesses up for sale over the next five years, and with current taxes, financial performance and attractive multiples favoring strong investment returns, the conditions for acquisitions are opportune.

A new generation of young entrepreneurial talent is emerging, albeit from a somewhat surprising background, who are ready to manage and continue to grow these businesses. The phenomenon is occurring in elite business schools across the country. In an interesting shift, many of these young MBA graduates are opting to be CEOs on Main Street instead of Wall Street by acquiring their own businesses.

This new generation of entrepreneurs likes to do things differently—including when it comes to financing. Many are turning to the search fund model, and this process known as entrepreneurship through acquisition (ETA) is gaining traction globally.

In fact, the search fund as a defined method for finding and financing a business is seeing unprecedented growth. “The growth has been phenomenal,” says Karen Spencer, COO of searchfunder.com, a networking site for searchers and investors.

The amount of search funds has increased a whopping 428% over the last five years, increasing at a rate of about 40% per year, according to searchfunder.com.

The growth is being fueled by awareness of the model and its success. “More programs about entrepreneurship through acquisition are forming at the business schools, and I think that the awareness of the model because of that is greater. Also, various universities are having conferences about the model,” says Spencer. “There’s also the global expansion – now that there have been successful search funds in other markets, people are looking to do that.”

Mark Yuan, co-founder and CTO of searchfunder.com, adds, “There is also market pressure. We are in a time of record high asset prices. There is a ton of dry powder – un-deployed capital sitting on the sidelines committed to general partners at various asset management firms – that have too few deals to chase. Only smaller deals, less than $20 million, remain attractive and uncompetitive; however, these deals do not usually make sense for the cost structures of traditional equity firms. Such funds are able to access these companies because searcher salaries are low compared to private equity and outcomes do not have to be in the hundreds of millions to make the deal a success.”

Seeking Funding

There are three types of search funds—traditional, self-funded and single sponsor (also known as fund-less sponsors).

With traditional funds, searchers raise capital from a group of investors to look for a company within a certain geographical area. These investors have the right of first refusal on any deals, according to searchfunder.com.

“Traditional search funds are backed by about 200 investors in the country who have been doing this for 30 years—serial search fund investors. Those are backed by that cadre of investors and have certain stipulations,” explains David Slenzak, of Broadtree Partners, a search fund accelerator.

Self-funded searchers finance their own search efforts. Once they find a deal, then they look for outside capital. The terms are negotiated on a deal-by-deal basis, according to searchfunder.com.

“Self-funded searchers are younger people—aged 28 to 38—doing this for the first time, that are not using a cadre of seasoned investors to back them. They’re trying to do this with their own money—or maybe they’ve got one or two investors—and they rely heavily on SBA funding,” says Slenzak.

Single-sponsor or fund-less sponsors raise search capital from a single source rather than from a group of investors, sometimes even co-locating with their investor, according to searchfunder.com.

“Fund-less sponsors are self-funded; they’re just more seasoned. They know how to structure deals, and people will back them based on their prior track record,” says Slenzak.

Back to School

As the segment booms, more ETA programs are being created at business schools around the world. The programs teach students exactly how to go about searching for a good business to buy, how to raise debt and equity capital, how to transition into ownership, and ultimately grow the company into something bigger and stronger than before.

One such program was founded by Royce Yudkoff, professor of management practice at Harvard Business School (HBS) along with Richard Ruback, professor of corporate finance at HBS, a decade ago. The two have since co-authored the book, HBR Guide to Buying a Small Business.

Yudkoff says the program, which is very practical in nature, has grown enormously over the last five years. While students don’t normally enter business school with intentions to graduate and immediately buy a business, he says there are many who encounter the program and find it’s for them.

There are a few characteristics in those students that they see again and again. “One, they really want to exercise leadership early in their careers; they don’t want to wait 10 or 15 years before they get general management responsibility in a large company – they want that experience sooner. Two, they want a direct link between their work and their reward. Three, they want the professional independence of not having a boss. Certainly, they answer to their customers, their employees, their regulators, their investors – but it’s all different from having a boss,” Yudkoff says.

These students also see this path as less risky. ‘We hear a lot from students who do this that they don’t perceive it as particularly risky, and in this I agree. At first, when you think about entrepreneurship, it seems like – wow, that’s a really risky thing. But what these students are doing – and this is a world of difference from startups – is they’re buying from a retiring founder of some business that has been around for 15,25, 35 years. It’s demonstrated that it is enduringly profitable,; it has a clear business model.

You buy it at an attractive price, there’s overlap with the founder as they train you, and then you’re taking it over and running it. And really—how risky is that? It’s nothing remotely like a startup. Frankly, it’s not clear to these students that it’s riskier than working in some big company where something out of your contr could happen, and you could find yourself in a bad place.  The risk in the minds of these students is very, very measured.”

He says it takes a special person to buy these businesses. “The person needs to be capable of doing two things. One is they have to have the training and skills to run a small firm, but they also have to know how to raise capital and organize an acquisition transaction. Having those two skills together is pretty rare.”

Yudkoff attributes the growing interest in the program to increased awareness, as well as larger forces in the economy—including the number of small companies coming up for sale along with the fact that careers in large companies seem less secure or predictable than they were 20 years ago.

All Types

The bulk of the searchers on the market today are MBA students or recent graduates—those who graduated in the past two or three years, says Spencer.

There are typically two types of searchers, Spencer says—one who is geographically-focused and one who is more portable. The geographically-focused searcher is looking for a business in one area, regardless of what that business is. “Say the person lives in the Dallas area, and for family reasons, can’t move from Dallas or is reluctant to do that. That searcher will be pretty open about what industry they’re looking at. Then you might know somebody who is more portable, so they can look all over the U.S.—that person might be more focused on a specific set of industries. They might want an ambulance company, and they’re willing to look all over the U.S. for that company.”

In addition to these young grads, there are other searchers flocking to the funds, and Slenzak predicts that will increase. “An interesting trend to talk about is that the interest in search funds has expanded significantly, but the number of fund-less sponsors has even outpaced that, and I think that’s a huge, meaningful trend.”

That is a result of the boom in the private equity asset class. “What you see in fund-less sponsors are a lot of younger private equity fund managers that are leaving funds and doing it on their own, or investment banker types that are leaving and doing it on their own. I think a couple of factors drive that. One, as the private equity asset class increased, these expats have also increased. And as capital availability has increased, the likelihood of executing that strategy has gone up, and a lot of people are able to leave private equity funds and investment banks and do it on their own,” says Slenzak.

He believes that not only will this upward trend continue but will surpass the frowth of the other two types of search funds. “I think that it’s going to increase and probably outstrip the increase in search funds.” There are just more people in that category. “If you have each bucket increasing at say, 30% in a year, that big bucket is going to increase faster,” he says.

“One other reason for that is the capital availability is so prevalent, and raising a fund has so many regulatory constraints, that people just find it in some ways more attractive to just become a fund-less sponsor than to raise a private equity fund,” Slenzak says.

In general, searcher is going after all types of industries, though there are some areas of interest.  Yuan say, “Software and healthcare are the hottest right now in the U.S.  Manufacturing and other business services are a staple for search funds around the world. Searchers tend to focus on businesses services rather than consumer and retail.”

While the phenomenon is global, some areas are seeing especially high growth. “The biggest growth regions are U.S., Brazil, Spain and England,” Yuan says. “Asia remains relatively untapped.”

Onward and Upward

Many in the industry agree that this is a trend that will continue to boom.

“I believe the timing is right. We have more schools building awareness about it, and I think that the model gets easier as more baby boomers retire out of their businesses. I think the trend will continue,” says Spencer.

Yudkoff agrees that it will continue, though he says what’s driving it now is probably different from what’s driven it to here. “What’s driven it to here is greater awareness and availability of information through these courses, and second, the forces in the economy which make this path attractive relative to the alternatives,” he says. Moving forward, “I think the biggest force is that business school students are seeing their predecessors doing this in large numbers, and it’s working out for them on average. And so it’s becoming a sensible alternative.”

He adds, “Sometimes it just takes a certain number of people to do this for other people to accept it as a valid path, so I think that’s a big influencer—that there are now enough people who have done this.”

Globally, there is certainly room to grow. “There are huge untapped geographies such as Asia and Australia,” says Yuan. “Also, searchers currently make up a tiny portion of total available deals. The bottleneck is on mentor-ship and people who are CEO material. As more mentors and business school programs mature to train the next generation of searchers, it may very well become a career of choice for MBAs.”

There is also money out there to support the growth. Slenzak says, “I think this model is just showing up on the radar of a lot of big money sources, and I think over the next two to five years, we’ll see a lot of money trying to get into this space. There’s a lot of capital out there, and people will be looking for a model to put capital to work in this sort of micro-cap asset class. I think that people will look to this model to put money to work at this asset class and generate returns that have been so successful in years past.”

He adds, “As private equity returns diminish, they’re going to look to try to get higher returns in this micro-cap space, and they’ll look to this model to try to capture that.”

Heather Endresen
Senior Loan Officer
Live Oak Bank
714.404.3648
heather.enderesen@liveoakbank.com

 

If you know of a business owner who’s thinking of selling or buying a business and who might benefit from a complimentary consultation with us, have them contact me in strictest confidence at mertel@transworldma.com

Mike Ertel, CBI, M&AMI, CM&AA
Transworld M&A Advisors
813.299.7862 Direct

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