Systems
An experienced search fund investor cited the following hierarchy of acquisition outcomes: 1) buy a good business, 2) don’t buy a business, 3) buy a bad business. This hierarchy is not exclusive to the search fund community. Any capital allocator should take note of the practices prescribed in the Stanford Graduate School of Business’ Primer on Search Funds.
The authors harp on the use of systems. When targeting an acquisition, it is critical for the searcher to use a structured approach designed ahead of time but adaptable midstream (e.g., industry and company scorecards). Key to this systematic approach is abiding by the criteria identified for the target business. Examples include a growing end market (83% of search funds target industries >3% growth) and a recurring revenue model (55% of target companies have recurring revenue that is >65% of total). The acquisition target should involve minimal operational complexity. If it is explainable in one sentence and does not require an advanced degree to comprehend, one is on track.
Other areas of the target company to identify include capabilities of middle management, product lifecycle, and the dynamic between the seller and key customers and suppliers.
Understanding unit economics and cash flow is crucial. Key customer data to identify early includes order history, fulfillment history, customer service records and satisfaction surveys. The new CEO should develop a fluency in cash and cash flow management. How is cash verified? Who has control of the cash? What is the billing cycle? How is cash collected? By the 100-day mark, these are all questions that should be easy to answer. Critical to cash flow management is the scrutiny of working capital accounts. This involves an understanding of daily sales, invoices, receipts and inventory. In order to develop a mastery of the business, former search fund CEOs recommend the creation of an automated operating dashboard that includes accounts receivable, accounts payable, sales pipeline and on-time delivery data, among other metrics.
It is critical that the searcher develops a Board that has complementary skills. Well-run Boards insert themselves at critical junctures, openly communicate, encourage development of performance metrics and identify key risks and risk-mitigating factors. The Board exists to exercise an incorruptible duty of care and loyalty.
The Stanford Search Fund Primer is a handbook for searchers and search fund investors focused on finding and operating businesses between $10-$30M Revenue and >$1.5M EBITDA. Yet, the best practices described can be utilized by capital allocators of any size and within any industry.