Search funds represent a unique investment vehicle designed to facilitate entrepreneurship through acquisitions.
The structure of a search fund’s capitalization table (cap table) is a critical strategic decision that influences its governance, fundraising capabilities, and overall success. The cap table outlines the equity ownership of the company, including search fund investors, founders, and other stakeholders.
Two prevalent models emerge in the search fund landscape:
- A distributed cap table with numerous search fund investors holding relatively equal stakes; and
- A concentrated cap table where a few search fund investors hold larger shares
This essay delves into the pros and cons of each model, examining their implications for governance, investor relations, decision-making efficiency, and the fund’s ability to navigate the complexities of acquiring and managing a business.
Distributed Cap Table: A Closer Look
Advantages of Distributed Cap Tables
Diversification of Expertise and Resources: A distributed cap table brings together a wide array of search fund investors, each contributing different skills, industry knowledge, and networks. This diversity can be a boon during the search and due diligence phases, offering a rich pool of expertise to draw upon. Moreover, it creates a more robust support system for operational challenges post-acquisition.
Risk Distribution: With more search fund investors sharing the financial burden, individual risk exposure is minimized. This can make it easier to raise capital, as search fund investors might be more willing to participate under lower risk conditions.
Enhanced Networking Opportunities: A broader search fund investor base can open doors to valuable connections, potential customers, and partnerships, facilitating smoother business operations and growth opportunities.
Disadvantages of Distributed Cap Tables
Governance and Decision-Making: A larger group of stakeholders can complicate governance structures and slow down decision-making processes. Achieving consensus among a diverse group of search fund investors can be challenging, potentially leading to delays in critical decisions.
Dilution and Value Alignment: With more search fund investors on board, the potential for dilution of equity increases, which might affect long-term value alignment. Ensuring that all search fund investors remain committed to the fund’s vision and strategy becomes more complex.
Communication Overhead: Regular updates and effective communication become more burdensome as the number of search fund investors increases. This can divert time and resources away from the fund’s core operational focus.
Concentrated Cap Table: A Closer Look
Advantages of Concentrated Cap Tables
Streamlined Decision-Making: A concentrated cap table enables quicker decision-making processes. With fewer search fund investors holding larger stakes, it’s easier to align on strategic decisions and act swiftly, an essential advantage in the dynamic process of acquiring and managing a company.
Stronger Investor Commitment: Search fund investors with significant stakes are likely to be more deeply involved in the fund’s operations, offering substantial support, guidance, and resources. This can lead to a more hands-on approach, benefiting the search fund’s strategic direction and execution.
Simplified Governance and Communication: A smaller group of search fund investors simplifies governance structures and facilitates easier communication. This can enhance operational efficiency and ensure that search fund investors are closely aligned with the fund’s goals and strategies.
Disadvantages of Concentrated Cap Tables
Concentrated Risk: Search fund investors in a concentrated cap table face higher individual risk exposure. This can make it challenging to attract investors unless they have a high risk tolerance and confidence in the search fund’s strategy.
Limited Perspective Diversity: With fewer search fund investors, the fund might lack the broad spectrum of expertise and resources available in a more distributed model. This could potentially limit the fund’s ability to evaluate and pursue the most advantageous acquisition targets.
Dependency on Key Investors: The fund’s success becomes closely tied to a few key search fund investors. If any of these investors withdraws or reduces their level of support, it could significantly impact the fund’s operations and stability.
Strategic Considerations and Best Practices
The choice between a distributed and concentrated cap table should be guided by the search fund’s specific needs, strategy, and the characteristics of its potential search fund investors. Here are some strategic considerations and best practices for search fund entrepreneurs:
Define Clear Objectives: Start by outlining the fund’s strategic goals, preferred management style, and the level of search fund investor involvement desired. This will help in determining the most suitable cap table structure.
Assess Investor Profiles: Consider the expertise, industry background, and networks of potential search fund investors. A diverse investor base might be more beneficial for funds targeting complex industries or those in need of broad strategic support.
Consider Fundraising Dynamics: Understand the implications of each structure on fundraising efforts. A distributed cap table may facilitate easier capital raising from a wider search fund investor base, while a concentrated table may appeal to search fund investors seeking significant influence and direct involvement.
Plan for Governance and Decision-Making: Develop a governance framework that aligns with the chosen cap table structure.
ETA Equity can assist searchers in thinking through the various cap table considerations and related pros and cons. Contact us at eta@etaequity.com to learn more.