Before beginning their search process, buyers should have a clear understanding of the funding sources they’re going to use to buy a small business. This includes debt financing, which we’ve covered in past articles, as well as equity financing, which is the topic of this article. Entrepreneurs can raise equity from a variety of places, each tailored to different strategies and financial landscapes. In this article, we will discuss equity sources for three principal acquisition strategies: the Self-Funded Model, the Traditional Search Model, and the Independent Sponsor Model. Understanding how different equity sources could fit within these different search models can help prospective buyers make informed decisions in securing the funding needed to realize their entrepreneurial aspirations.
The Self-Funded Model
This approach primarily relies on personal funds, seller financing, and debt to finance to buy a small business, necessitating equity contributions that represent a smaller portion of the overall purchase price. The model is a good fit for those aiming to maintain significant control over their venture while managing a tighter capital structure. For self funded searchers looking to raise investor funding for their portion of the downpayment on an acquisition loan, these capital sources can be useful targets:
- Angel Investors
An effective strategy for self-funded searchers can be engaging with angel investors. These individuals can be professionals who invest in search funds as part of their portfolio strategy or possibly personal contacts who believe in the entrepreneur’s vision and capability. The most influential among this group are often former searchers, who bring not only their capital but also invaluable experience and a network of contacts.
- Specialized Organizations and Accelerators
In addition to individual investors, there are organizations specifically structured to support self-funded searchers. These entities offer a blend of equity contribution and comprehensive support services, including M&A advisory, capital raising, due diligence, and operational guidance. Some of them also work to create a more inclusive ecosystem for business ownership, partnering with various stakeholders to facilitate the acquisition process. For example, Search-Invest Group positions itself as a partner for entrepreneurs, aiming for them to retain up to 80% equity ownership, thereby ensuring that searchers have significant control over their acquisitions. Similarly, New Majority Capital focuses on bridging the racial and gender wealth gap by supporting BIPOC and women entrepreneurs in their quest to own and grow small businesses.
Both angel investors and specialized organizations can become a source of equity for self-funded searchers. By leveraging these resources, entrepreneurs can secure the necessary capital and advice to complete their acquisition while preserving the autonomy and control essential to the self-funded model.
The Traditional Search Model
The Traditional Search Model consists of entrepreneurs raising capital to buy a small business through a collaborative effort with investors in a structured manner. This model is characterized by its ability to pool funds from a diverse array of sources, which can be used for financing the acquisition of a business, while also providing searchers with a stipend during the search phase.
- Individual Investors (including Angel Investors and Family Offices)
In the context of Traditional Search, angel investors are an essential source of equity, where investors who prefer to write checks into larger deals participate alongside other equity providers. Angel investors in this space often manifest a deep interest in the search fund model, and can include family offices along with former searchers and personal connections.
- Private Equity Firms (including Companies and Accelerators designed for Traditional Search)
Raising equity in the Traditional Search model often involves partnering with specialized firms dedicated to search fund investments. Firms like The Brydon Group, NextGen Growth Partners, Anacapa Partners, and Relay are specifically designed to support traditional searches, providing significant capital injections from Limited Partners (LPs) dedicated to this investment model. These firms not only contribute financially but also offer strategic guidance and operational support, playing a pivotal role in the selection and acquisition of target companies.
The process of raising equity in a Traditional Search begins with gathering initial capital, typically ranging from $400k-$720k, to fund the search phase. This is followed by securing a second round of funding, usually between $5M-$15M, for the acquisition of the target company. Investors in the Traditional Search model are often actively involved in the strategic oversight of the search process as well as after the acquisition is complete, where they monitor performance and support the searcher, often with a goal of a mutually-beneficial exit. This collaborative approach ensures that there is a strong alignment of interests between searchers and investors, with equity contributions carefully structured to balance risk and reward.
The Independent Sponsor model presents a unique approach to acquiring small businesses, focusing primarily on identifying and negotiating acquisition opportunities before raising the necessary funds. This model attracts individuals capable of independently securing deals, an approach that diverges from traditional search fund methods. Independent Sponsors need a strong network and the ability to convincingly present the value of each deal to potential investors. They also must demonstrate a deep understanding of the targeted industry and the specific acquisition opportunity, highlighting the strategic and financial benefits to attract the necessary equity and debt financing.
- Institutional Investors and Private Equity Funds
Central to the Independent Sponsor model is the engagement with Institutional Investors and Private Equity (PE) funds, who play a key role in providing the financial backing for people to buy a small business. Unlike the traditional search model, which relies on a pre-established pool of investors, Independent Sponsors tailor their fundraising efforts to specific deals, presenting a unique value proposition to potential investors based on the merits of each acquisition opportunity.
- Strategic Investors
In addition to PE funds, strategic investors become increasingly relevant in the Independent Sponsor model. These investors, often companies or individuals with interests aligned with the target acquisition, offer not only capital but also industry insights, operational expertise, and potential synergies. The involvement of strategic investors can enhance the value proposition of a deal, making it more attractive to other financiers and contributing to the overall success of the acquisition.
The Independent Sponsor model affords a higher degree of autonomy in deal selection, allowing sponsors to pursue opportunities that closely align with their expertise and investment thesis. This flexibility, however, comes with the challenge of convincing investors of the viability and attractiveness of each deal without the assurance of pre-raised funds. Many Independent Sponsors and interested investors find each other through conferences, as events geared towards dealmaking have risen in popularity.
Whether you’re leaning towards a self-funded approach, traditional search, or the independent sponsor route, there are equity options available to you to buy a small business, even if you don’t have a traditional private equity background. Clarity in your business vision and the ability to articulate this vision compellingly to potential investors cannot be overstated. Investors are not just investing in a business; they are investing in you. Your passion, expertise, and commitment to the business’s success are fundamental in securing their trust and capital.