As we represent individuals who are selling businesses for the first time, we are often asked about what is involved in creating an investment vehicle so that these exiting founders/operators can build on their momentum and attract investors in order to take their knowledge and leverage it to run larger businesses that will produce even more profits. This is the first part of a multi-article series where we will describe the legal requirements for making that happen. This article provides some considerations regarding the first choice you will need to make—which structure should I use?
Think of this as the Berkshire Hathaway model of building a business empire. At its most basic, this involves creating a company (which can be either a corporation or a limited liability company) that will act as the parent holding company. This parent company will not actually operate any businesses directly, but will only hold the ownership interests of portfolio companies. Whenever you decide to make an acquisition, you will form a subsidiary company owned by the parent holding company to run that portfolio company. The process of creating subsidiaries is repeated each time a new business is purchased or started.
The holding company structure provides much greater flexibility to you as the manager. Unless you sign agreements with investors that allow them to force a distribution or a liquidation event, you can hold onto your portfolio companies for an indefinite period of time. This will give you the freedom to buy businesses when you wish and to sell businesses when it is most advantageous. You will also own a larger percentage of the assets as the manager than you would under a fund structure.
If you utilize the services of different employees or contractors in day-to-day operations of the different subsidiaries, the holding company structure also allows for incentive-based compensation to be tied more easily to the specific subsidiary. These working arrangements can also be created under a fund structure, but the mechanics can be more complicated.
Holding company structures are also easier to establish. There will be a great deal of negotiation around creating the parent company, but if you opt for the most basic structure for portfolio companies then they can be single-member LLCs that can be up and running in a few days. You also only need to establish entities as new portfolio companies are acquired, unlike a fund where everything must be set up from the outset. The trade-off for this is that separate books and records will need to be maintained for each subsidiary and for the parent holding company in order to protect the different corporate structures and maintain separation between them, but if you work with a reputable accountant who has familiarity with online businesses this should not prove too much of a difficulty.
The holding company structure also allows investors to invest in individual subsidiaries. This means that a potential investor does not have to commit to all of your portfolio companies and can select only certain ones. This has the potential to keep even more equity for you in the parent company. Having different investors in different subsidiaries can create other complexities, though, including with taxes, so you may not decide to pursue this possibility.
The biggest disadvantage of the holding company model is that it is the most difficult model with which to attract investors. Because you will be entitled to a greater percentage of the financial upside, investors may scoff and tell you that they are only interested in investing on terms or in structures friendlier to them.
A second option is to create a private equity fund. A fund will have a management company, a general partnership entity, and a limited partnership entity. The limited partnership entity will be the entity into which you will pool funds from investors and the entity that will make acquisitions or investments into other businesses. Structurally and operationally, it will be a private equity fund.
One advantage of a fund structure is investors’ greater familiarity with investing in funds. The 2-and-20 model may not be as common anymore, but depending on the level of involvement with your portfolio companies and your ability to source off-market deals you may be able to find limited partners willing to compensate you as a fund manager on even more generous terms. The structure of funds can also make it easier to acquire portfolio companies in different verticals so long as your limited partners consented to this from the outset. The reason for this is that investors in funds expect a diversified strategy so that if a single company doesn’t take off it won’t cause the whole fund to fail as an investment.
The mechanics of obtaining money from investors once there is committed capital is also an advantage of the fund structure. In a holding company structure, if you obtain outside investment then that money will just be sitting in the company’s bank account drawing a tiny amount of interest. In a fund, investors keep their money until you as the fund manager find a suitable investment. Once a suitable investment is found, you issue a capital call and your investors wire you funds within a set period of time and the fund is able to make the investment.
The main disadvantage of a fund is that a fund will have a set end date (with limited flexibility added in). This means that no matter what, there will be a time when the fund’s assets will have to be liquidated so that investors can receive distributions. The startup costs of a fund are also higher as there will be the legal fees of setting up the multiple entities involved in a fund, a number of fees to be paid to state governments, and potentially lengthy negotiations with investors over the fund structure.
A second disadvantage is that investors will receive more of the upside than with a holding company model under most circumstances. This is the reality, but if your track record doesn’t allow you to raise money on more favorable terms then you will just have to accept this. It will also still be difficult to attract investors for a fund without a track record of successful exits. This difficulty will be less than if you attempt to create a holding company structure, but you should still be aware that raising money won’t be automatic.
A third option for structuring an investment vehicle to allow outside investors to help you as an operator is a search fund. In this structure, an individual entrepreneur or a small group of entrepreneurs finds a group of investors (high net-worth individuals, family, friends, family offices, etc.) who commit to fund the entrepreneur’s (or small group’s) purchase of a business that the entrepreneur will then operate as the CEO. The latest craze that is similar to search funds is SPACs, which on a much larger scale pool money to search for and purchase companies in order to list those companies on public exchanges. The search funds we are talking about here are much smaller and the end goal is different (likely an exit event on the private market rather than taking the company public), but the mechanics of organizing a search for a single target company with a particular profile is not fundamentally different.
The biggest advantage of a search fund is that they are the easiest vehicles with which to attract investors. It is still not easy, but it is an easier process than your other options in most situations. You will present your credentials and your thesis to potential investors and those investors will make their decision based on their evaluation of that combination. There are fewer complicated structures and it is more about how much faith the investors have in you as an operator.
Another advantage is that your investors are more likely to take on active advisory roles as you operate the purchased business (if you invite them to do so). It is in their interests to do so as they are equity holders, but since the investment is only in one company instead of a portfolio the attention of your investors will be narrowed to just the one company. If you are able to attract investors with expertise that compliments your own, this can create tremendous synergies.
There are two main downsides to choosing a search fund. The first is that you as the operator/manager are likely to receive less of the equity upside than under a holding company structure; the total upside can, though, be comparable to that of running a private equity fund. The second disadvantage is that a search fund is created to facilitate a single investment. It is not a portfolio of companies but is instead more of a one-shot deal. This means that the risk of overall failure is higher since the risk is not distributed over several companies but is instead concentrated in a single one. It also means that if you want to acquire another company, that may necessitate creating another search fund or other investment vehicle and that can slow things down.
Deciding on what investment structure to create can be a confusing process, and what is best for one person may not be what is best for another. If you want to talk through the specifics of your situation, contact us at firstname.lastname@example.org and we’d be happy to guide you through the decision-making process.