Summary

In this conversation, Jon Stoddard interviews Sean Smith about his newly established search fund, Search Fund Ventures. Sean explains the concept of self-funded searchers and independent sponsors, detailing their investment strategies and the types of businesses they target. He discusses the importance of essential products and services, the investment process, and the value they add to their portfolio companies. The conversation also covers the cost of capital, return expectations, and a recent deal they completed. Sean emphasizes the significance of due diligence, quality of earnings, and the qualifications of searchers. The discussion concludes with insights into the future goals of the fund and the importance of investor commitments.

Takeaways

Search Fund Ventures focuses on self-funded searchers and independent sponsors.
They target essential products and services for investment.
Investment involves filling equity gaps for searchers.
Sean emphasizes the importance of downside and upside return scenarios.
Recent deals are evaluated based on strong revenue bases and recurring revenue.
Searcher qualifications include financial backgrounds and industry experience.
The HVAC sector is a key focus area for their investments.
They prioritize deals with near-term distributions for investors.
The fund has a three-year deployment period for capital.
Incentive alignment between investors and entrepreneurs is crucial.

 Watch the Interview:

Transcript:

Jon Stoddard (00:01.659)
Welcome to Top &A Entrepreneurs. Today, my guest is Sean Smith. This is a little bit of a different show because I'm talking to Sean Smith, who just started a search fund. It's called searchfundventures.co. So Sean's got a partner, Nick Bryant. They're both on LinkedIn. And we're going to talk about how he started this search fund, why he did it, and what the progress is so far.

a little bit more about search ones. So welcome to the show, Sean.

Sean Smith (00:33.87)
Thanks so much, John. I'll just a quick little kind of caveat there. We invest into search funds, particularly self-funded searchers. So I wouldn't call ourselves a search fund as much as a investor into searchers.

Jon Stoddard (00:50.201)
Okay, so let's get down to the particulars of that, what that actually means. So who's your, who is your, who do you invest in and where do you find them? What's that buy box look like and the process and how much you invest?

Sean Smith (01:08.686)
Yeah. So we invest into kind of, would break it down into two different personas. There's your self-funded searcher, which a lot of people think of as, you know, an individual who's a hungry entrepreneur who is going out to find a business that's probably between 500K and, you know, $2 million in EBITDA.

And they're buying that business using a mix of SBA loan and their own capital. And then in certain cases, investors capital like ours. So that's the one persona. The second persona is kind of your independent sponsor, who's probably, you know, relatively new from an independent as an independent sponsor, not kind of the more experienced folks who have 10 deals or under their belt and they're doing, you know, $10 million EBITDA acquisitions. These are

folks who it's maybe their first or second deal and the size of the companies, you know, call it one to 3 million in EBITDA or so. So that's kind of the two groups of people we focus on. We find folks through, you know, a mix of inbound deal flow. We've been more and more vocal on, you know, communities, both digitally and going to be kind of participating in some of the upcoming conferences. So we've started to get more and more deal flow coming our way.

We have a great network of kind of referral partners that send us deals. And then we're also actively always combing through the listings on, you know, the usual suspects like search funder and main shares. You got it.

Jon Stoddard (02:39.141)
Searchfundr.com, yeah. Yeah, you also have a couple people I've had on my show, Elliot Hall and Jason Erlich as advisors.

Sean Smith (02:47.18)
Yeah, that's right. we so Jason's fruition capital who are who raising a fund as we speak, we have, you know, worked he's just been a great mentor, both to me and to Nick at the fund. And he supported us with kind of thinking through our kind of investment thesis and process. And he sent us some deals as well. And with Elliot, you know, we recently we it's a bit more fresh, we've

kind of become involved as a deal sourcing type partner. So Elliot will share compelling deals with us as he sees them.

Jon Stoddard (03:25.135)
Let's talk about that self-funded searcher because that's what I come across mostly is people just, you know, they want to own the whole thing. They don't want to be a W-2. They want to own the whole thing. So they're going to go out, look for a business doing 500K, 2 million EBITDA. Is there a specific industry you're looking for that you don't do that you love your sweet spot?

Sean Smith (03:51.116)
Yeah, so kind of the framework we that I would say most everything trickles down from is we look for essential products and services, right? So businesses that either manufacture and sell an essential product or provide an essential service. Now that can span across, you know, a litany of end markets. However, we do have some boundaries on those end markets, right? So we do want to.

Avoid end markets that are highly cyclical or highly sensitive to discretionary spend. So for example

you know, a taken an easy example, right? A plumbing contractor might be seen as a an essential service. But if that plumbing contractor only services, you know, luxury retail stores, for whatever reason, all of a sudden we're inherently exposed to luxury retail, which is not a sector we would typically invest in. So that that's, know, I would say kind of the way we think about it, right? It's the product and service that the business provides, but also the end markets that it's exposed to.

Jon Stoddard (04:50.779)
All right, so let's say they find a essential services business. It's an HVAC company. My recent podcast was a guy that bought three HVAC companies. It's doing 750K in EBITDA. It's been around for 20 years. Perfect scenario where the owner is retiring, wants to keep the legacy, and has a reasonable price on that. So he brings you the deal and

Where do you come in? mean, he's going to, let's say it's a $5 million business and he's got to raise, you know, it's 10 % down with the SBA, 90 % loan. Interest rates are going down a little bit. Depends on where you go. I've seen like TD Bank, if it's local, you can get 8.5. So he's got the deal kind of ready, baked in, it's ready.

Where do you come in and what are you looking for that he doesn't have?

Sean Smith (05:54.808)
Yeah, so the owner doesn't come to us generally. It's the searcher themselves, right? They'll have the LOI fully baked. Some folks have come to us while they're kind of going through the LOI process and asked us, Sean, this viable? Do you think we can raise on this? So in certain cases, it's earlier than that, but most cases people will come to us with a baked deal and they're in that process where they need to raise equity to close a gap.

to fund the deal, right? They've got indicative terms from lenders. They know the purchase price. They know kind of what the deal structure is going to look like. Q of E draft one or two has been done. So they're reasonably confident in the EBITDA figures and the working capital and all that. So we help fill that gap. then what I do think is,

sort of differentiated that has been an interesting way for us to get deal flow and where we do add value above and beyond, you know, plain vanilla capital provider is we sort of have two value added angles. One, we support with deal sourcing and inorganic growth from an acquisition target perspective. So we do have kind of a proprietary deal sourcing engine that's always on and we can point it in thematic directions. And it's

a way for us to support, searchers who have kind of an inorganic growth strategy. We can help them find leads. And actually, for the deal we closed recently, we've already sent them three proprietary leads that are well-aligned with their criteria for a roll-up. So that's one really neat way and one reason people come to us outside of just closing an equity gap. The other one is, as you mentioned, my business partner, Nick Bryant.

He's a serial entrepreneur, know, multiple exits. He's on the software kind of more technical side of things. And he's building out a tech enablement playbook, which is so key for a lot of people, right? That searchers kind of go into these businesses, look for new economy ways to kind of level up operations, whether it's installing a CRM or, you know, an ERP or just kind of new tech stack, you know, automation in general.

Sean Smith (08:13.397)
building out a way and we've already began kind of supporting folks with those initiatives as sort of a call it a center of excellence or value creation center.

Jon Stoddard (08:22.939)
Yeah, optimization with old technology. Let me go back to that gap that you helped fill. So the guy finds a great business. It's under LOI, reasonable multiple, can handle the debt cash flow. Let's say it's a 2.1 debt service coverage ratio, but he needs, you know, it's $500,000 down. He's got $100,000. He needs $400,000. This is where you come in.

right? You can provide the $400,000. But what is that cost of capital to him and to the business? What does that look like?

Sean Smith (09:00.91)
Yeah, yeah, it's a great question. So I think the common metrics that people throw around are kind of the 30 % IRR target, right? And that's coming from the Stanford.

Jon Stoddard (09:13.435)
That's the PE stuff, which I think I always push back. go, look, I understand that you want 30 % IRR, but the HVAC businesses has only been growing at 5 to 7 % a year for the last 10 years. So that's a little bit of conflict or friction where that's going to look like at the end of five years when you want your money back.

Sean Smith (09:38.39)
Yeah, yeah, especially if you're not, you know, pursuing an exit path, if you're doing more of a long-term hold, you know, kickoff cash flows sort of, yeah. So, I think, you know, we do have a cost of capital that sort of, I would say,

Jon Stoddard (09:45.367)
One and done. Let's say one and done. Yeah.

Sean Smith (09:57.93)
triangulates towards that range. But really the way we think about things is from a downside standpoint and then an upside standpoint. And that, course, averages out, in a sense, to your base case. But we want to see a downside scenario using realistic assumptions that are based on historical financials, historical performance, and improve credibility through qualitative factors that we see on a forward-looking standpoint.

When we build that downside case, we want to see a return that is kind of in the range of or a bit north of the average S &P 500 return over the past 30 years. Right. So exactly. Yeah. So something nice that.

Jon Stoddard (10:37.723)
All right, 11%, 11, 15%, yeah.

Sean Smith (10:44.33)
even if the business just stagnates, declines a bit, margins compress, but it pays down the debt, that's the key piece here, right? If it can still pay down the debt and equity holders can increase their position towards the end of a life, then we still see that sort of nominally attractive return on it for a downside.

On the upside, we want to see a credible path to a return that is north of 30%. So that's where you get that 30 % kind of outcome that's very exciting for everyone. Now we know that that's the upside case. It's not every single one is going to knock it out of the park, but we look at every deal with that asymmetric return profile to say, hey, if this one does not get out of the park, it's a 40 % or it's a 45%.

Right and that might mean the choir has to roll up, you know two or three more add-ons or they have to Execute flawlessly on a sales strategy, right? So that when you when you take those two's gun

Jon Stoddard (11:44.399)
Yeah. So what does that look like? Is it participating preferred? Is there a step up? Is they're looking for a coupon? If you total that up, is that how you're to try to get to 30 %?

Sean Smith (12:02.67)
Yeah, it's a mix of all those. And it also depends on, I kind of mentioned the two personas that we invest in, right? There's the self-funded searcher, there's the independent sponsor. For the self-funded searcher, when there's an SBA loan that they're personally guaranteeing, that's when you see that step up deal structure, right? Because the searcher is being compensated for personally guaranteeing the loan and taking a substantial amount of personal risk. So yes, we look to see a step up in the range of two times on those deals.

We look for a preferred dividend in the range of 10 to 15%. And when you kind of put all that together and mix that with the cashflow scenarios I just talked about earlier, that's how you get that kind of downside and upside dynamic.

Jon Stoddard (12:49.669)
So when we first connected, you just started the fun. I mean, it just started in 2024. But since we connected and scheduled a podcast, you've actually done a deal. if you can talk about that deal, animize it, but just tell me a little bit more exactly what that looked like and why you chose it.

Sean Smith (13:10.956)
Yeah, absolutely. So the deal came in, you know, across our desk originally from a co-investors in our network who we've now, you know, looked at multiple deals with. So that was a nice show of faith, right, that this individual is investing in the deal. We know they're credible and that kind of helped kick off the process, right? So we looked at the business. It's a commercial HVAC business based in Toronto. So it's kind of

Jon Stoddard (13:39.437)
Uh-huh. So you're not concerned about cross-border investing.

Sean Smith (13:40.972)
you know, a real.

Sean Smith (13:45.356)
No, not in Canada. No, we've gotten comfortable with, you know, North America in general. So, yeah, commercial HVAC business in Canada, very classic kind of search deal, right? Very much a necessity business, good end markets. All the kind of things we talked about. In fact, a lot of the details you went through earlier were almost like a premonition of some of what I'm going to say now, down to the specific bank you mentioned. But actually...

Jon Stoddard (13:46.905)
Not in Canada. Okay.

Obviously,

Jon Stoddard (14:12.027)
TD Bank, 8.5 % if you're within 200 miles of a retail location. Yes.

Sean Smith (14:17.019)
Can't comment on the specific cost of debt. But what I will say is, attractive purchase multiple, strong acquirer, healthy EBITDA to the tune of, in a range that provides plenty of kind of cushion and a downside. our.

Jon Stoddard (14:35.003)
20 to 20, a good HVACB business process is 20 to 25%. Would you say it's in there?

Sean Smith (14:40.878)
On commercial, at least from what we've seen in commercial, it's a bit lower. The 25 % range would be a bit high from what we've seen in commercial. But I have also seen, at least in the search space, have also seen reports that have kind of indicated that figure. I've yet to see it. So maybe I'm a little naive in the space. yeah, that could be. I guess I should say I've yet to see it and see it in a credible format that you know.

Jon Stoddard (14:48.891)
Hmm.

Jon Stoddard (15:00.901)
Well, they probably won't sell, but if they do sell, it's going to be a premium.

Sean Smith (15:10.958)
this business is going to sustain a 25 % EBITDA margin. I've seen a lot of residential HVAC businesses, at least on the deal reports and the BVR and other kind of sources that are doing substantially higher margins, but commercial seems to be a bit lower from what I've seen.

Jon Stoddard (15:15.824)
Yeah.

Jon Stoddard (15:26.852)
Interesting. Yeah.

Sean Smith (15:28.61)
But anyway, just to round it out. So we had lots of conversations with the searchers, got really comfortable that they're qualified to pursue their strategy. They do have financial backgrounds. They're pursuing an inorganic growth strategy. And like I alluded to, that's an area where we can add value. So that was exciting as well. So.

You know, when we thought about it from that concept of the asymmetric bet, the downside to the business, it's got a really healthy revenue base, strong end markets, lots of recurring revenue. We felt confident that the downside scenario, even in a challenging market, would return above that, you know, that market return. But.

the upside, if these folks hit their goals on the on the inorganic side, especially if we can help them do that and de-risk things a bit, that's a return that's much higher than I think the cost of capital would justify.

Jon Stoddard (16:22.159)
Yeah, let me ask you about the people qualified. You said they had financial backgrounds. Do they have any HVAC running a HVA business and or managing people? Because managing trades. You know what? They call them in Australia, they call them tradies.

Sean Smith (16:37.452)
Yeah, that.

Yeah. So I'd say from, they'd spent a good deal of time in the sector and in kind of the search process and learning about the space. So that's what kind of got us comfortable. certainly had managerial experience in their kind of roles, but I think, you know, it's always a gap and you've got to make that decision. I was just speaking with someone earlier today about, you know, the balance between a group who's, who's skill set and background is really well fit for.

the strategy they're pursuing versus an individual or a partnership whose background is squarely aligned with the industry and the cultural dynamics in the firm they're taking over. I think it's a balance and much like building a diversified portfolio, you may think about it as some opportunities you focus on the one skill set and others you focus on a more generalist, strategic, big picture skill set.

Jon Stoddard (17:41.283)
Let me ask you about the commercial versus residential. Now, I'm not an expert at this. So I have seen some HVAC businesses in Arizona. Their commercial is, you know, they could own the contracts to a fries grocery store or a fast food restaurant with like three or four locations in here. And what happens is they do have reoccurring revenue, but it's

It's not a large number. It's a nominal month to month fee to be available because if a freezer goes out or HVAC goes out in Arizona, you got to replace that product real quick. And maybe you hire, buy the entire unit, which is there a spike in revenue than a drop down, the reoccurring. Why is that a good business for you?

Sean Smith (18:37.432)
So I think you're commenting on kind of the seasonality of the business or just specifically more on the breakdown type repairs.

Jon Stoddard (18:44.025)
Well, it's the revenue of valleys, peaks and valleys of a commercial business. There is reoccurring revenue, but it's because they want you on site and staff if something goes down.

Sean Smith (18:56.3)
Yeah, so you're kind of distinguishing between the preventative maintenance contracts versus the actual repair work that gets built and called in. That's what you're talking about? Yeah, I think from what we've seen, the preventative contracts are kind of the foot in the door to then get more of this recurring work that is generally recurring in nature because these systems, and again, and I'm not an expert in this either, right? I want to preface that in that.

Jon Stoddard (19:05.529)
Right, yeah. Yeah.

Sean Smith (19:24.834)
you know, just like you said. you know, the systems, from my understanding, do have a fairly typical kind of repair cycle. And there's certain, you know, things like filter replacements or, you know, other types of, you know, boiler repairs or what have you that are kind of more frequent in nature. So you can start to rely on those along with the preventative maintenance kind of floor.

as recurring revenue. What we're not focusing on here is a commercial business that is heavily anchored towards install revenue. So when there's new construction, they are the ones installing the HVAC systems. That is not what we're talking about. It's a service business model.

Jon Stoddard (20:04.665)
Yeah.

Jon Stoddard (20:12.111)
They already have the contracts with large, yeah, yeah. Whether it's buildings or it's grocery stores or it's food franchises, whatever.

Sean Smith (20:15.405)
You got it.

Sean Smith (20:21.974)
Yeah, industrial facilities, big warehouses, things like that.

Jon Stoddard (20:26.105)
Yeah, great. So what this independent sponsor, was their goal to say, we're going to start rolling up. We understand the difference between the one and done. It's hard to look at something and get a 30 % IRR for a one and done, that it is a person that says, well, we're going to roll it up. And as soon as we get past 10, 15 million EBITDA, we're going to get a bump.

in multiple, it's going to be a multiple expansion. Is that what they come to you with? Said, this is who we are and what we're trying to do.

Sean Smith (21:05.472)
Yeah, so you see lots of kind of roll up plays in the space and there's always some assumption around multiple expansion and how extreme the amount of multiple expansion will be. And of course,

I think for virtually anyone in the space, one of the prevailing strategies is to take a business that's kind of below the radar of middle market private equity, grow it in one way, or form from an EBITDA standpoint, whether that's organic growth, whether it's inorganic growth, or just improving margin.

and then make that business marketable to lower middle market PE, which the assumption then is there's a lot more capital, it's a more efficient market, and that will drive multiples higher. And of course, when EBIT does higher, it's a less risky business and maybe operations are better as well, so it's higher multiple. So yes, I'd say virtually every single investment memo we've reviewed has some degree of multiple expansion assumed.

we'll always look at scenarios that assume no multiple expansion. And frankly, most credible approach, at least in our mind, is to go through the BVR data, the tremendous data that also Search Fund allows access to, which is pretty phenomenal. And you can pull up tons of transactions that are pretty close in size and margin profile. can really get in the weeds and look at deals and figure out, what is the

the average purchase multiple, median purchase multiple, and are we in line with that even if we hit in our forecast year seven, we assume this thing gets to 4 million, 5 million, and even okay, let's look at the 4 million, 5 million dollar deals. Where are those multiples? And frankly, a lot of times they're not too far north of where...

Sean Smith (23:00.319)
the deals we're looking at in the 2 million, 3 million. So we generally won't assume much multiple expansion, if any, but in the upside case, like I talked to you about our framework, the upside and the downside, we'll certainly give credit for maybe a turn, turn and a half, two turns if it's a big swing.

Jon Stoddard (23:02.073)
Yeah.

Jon Stoddard (23:17.455)
Yeah, I have to tell you about a little story about the BVR and the multiples. I had a conversation with a guest of mine, Adam Coffey. He's been in private equity. An individual reached out to me. He was buying some businesses in the medical field. And he's done well. He's done about 10 acquisitions so far. And he was seeking, Adam Coffey's kind of

interest level as far as investing or provide guidance for future acquisitions to maybe sell.

basically set up at I'm passing because they showed me some screenshots of business valuation resources multiples on this guy's particular list. It was too broad. It wasn't mentioned enough. He said you're not going to get the multiple expansion you think you are in five years even if you get the even up. So which was pretty illuminating for me. And then when I shared the story with him is like I was difficult.

Sean Smith (24:24.364)
Yeah, no.

Jon Stoddard (24:24.431)
to understand like, he's doing a great job. You're increasing your wealth. You're doing everything great. But it wasn't in his buy box because, you know, just not going to get that multiple expansion.

Sean Smith (24:37.452)
Yeah, no, it's the debate over, you know, whether or not to give credit for multiple expansion is always ongoing, right? But I mean, I think the BVR data is pretty incredible and for people to have virtually free access to that, it's amazing.

Jon Stoddard (24:46.703)
Yeah.

Jon Stoddard (24:51.033)
Yeah. So let's talk about where this money comes from that you invest in. Is it from, is it your own money or is it outside investors, high-native worth individuals, institutional? And, and, and do they actually, a lot of people think that never raised money before they're going to get somebody's going to write you a check, put it in your account and you kind of spend it like, that's not really how it is. It's more of commitments. Yeah. So tell us about that. Yeah.

Sean Smith (25:18.573)
Right.

Yeah, so the largest commitment, we have an anchor commitment from Nick, which is very sizable and a great show of faith from Nick as a GP, who's a co-GP in the fund. I've contributed some capital as well. And then we have a few additional commitments that we've added in. So like you noted, held our initial close about six weeks, four to six weeks ago. We have opened the fund for a second close.

we are taking additional commitments. And I think the main kind of focus there is twofold. It's folks who are sophisticated investors, PE backgrounds, hedge fund backgrounds, and kind of just broader kind of investing experience that are interested in the sector, want to get involved in a diversified format. And then it's also folks that are really strategic and can add strategic value, as I kind of mentioned, our whole.

know, mantra around being a value-ad investor. If we can bring in LPs that have great sales backgrounds and are interested in kind of taking, you know, a portfolio company or two under their wing and providing that mentorship, that's sort of the sweet spot for the, you know, groups that we're talking to and that we have commitments from.

Jon Stoddard (26:34.511)
Yeah, so these LPs, are they familiar with this asset class of investing in down payments for SMB or is it a completely new conversation?

Sean Smith (26:46.318)
So everyone we've talked to, I'd say 90 % of people we've talked to are familiar with it and kind of understand the dynamics. More so on the traditional search side of things, which as we all know has been around and more.

Jon Stoddard (27:05.081)
Yeah, our partners from Harvard, those guys, that's bigger, in numbers, yes.

Sean Smith (27:09.1)
Right. And much more formalized, you know, there's structure around that asset class. There's a lot less structure around the self-funded search and kind of this lower end of, you know, blending with the independent sponsor market. So there's definitely some coaching and we're doing work to kind of educate and, you know, teach people more about how the...

the kind of dynamics of deals look, where we come in, just like the questions you were asking, right? Like, what are we actually doing? So certainly folks do ask us those questions.

Jon Stoddard (27:40.879)
Yeah, this is tough. I think if you go to them, it goes, well, it is a new asset class for SMB. a couple things go through their mind. Who else is doing it? What's their success? And what's your deal flow look like? And why are you different? I mean, if I was an investor, I'd be asking some of those questions.

Sean Smith (28:04.332)
Yeah, no, I think those are kind of the three key points. on the deal flow side, I'd say we're well covered. We see 20 to 30 deals a month and have been able to be, I'd say, pretty selective. lot of that's more and more that's coming inbound as we're kind of more vocal about the fund and getting more involved in the community. On the kind of differentiation side, know, I

Jon Stoddard (28:15.738)
Yeah.

Sean Smith (28:27.276)
I feel we've built a really differentiated approach and bringing in kind of some value add angles that are unique to mine and Nick's skill sets are pretty important to our mission and kind of our investing style. But then kind of the middle question, right? What's the track record? How have you guys kind of done this in the past? I mean, the reality is we're emerging managers in this space, right? We can't lean on track records from different investment classes, right? Nick's done.

tons of angel investments. He's had some big successes there. You know, I've spent time in venture capital and in leverage finance, but the reality is this is a different asset class. It combines aspects of all that. So we believe we have a really strong approach and a great view to it. But the reality is we don't have a track record yet in space, right?

Jon Stoddard (29:13.093)
Yeah. Well, the hard thing is, let me give you two connections here. One is I did an interview with a guy that just got out of Harvard and he was a traditional searcher. my first question was, I don't understand how they're allowing you to buy a $20 million business with absolutely zero.

experience running a business and he goes that's funny my mother asked me the same question but the key is is like buying an enduringly profitable business the did stop our breed partners model is enduringly profitable like what a monkey can manage right you're still a w-2 you're at risk of losing the business if you don't manage it correctly but

It's just putting somebody into that spot that doesn't screw it up and then continues the five to 10 percent.

Right? I mean, is that the key of finding the right people of looking for the right, you know, well, what we would say is like in the Silicon Valley world is like, you know, you got, you're on the right train track, right? Just get in front of the train.

Sean Smith (30:28.152)
So certainly that is a big component of our thesis, right? And it's when you talk about the train tracks, it's the company, you we're betting on a really good horse, right? We want to see that the horses can run and it's strong.

We want good tailwinds behind it, right? So that's the industry and that's your local market that are growing really nicely. We want risk to be well mitigated through both the acquisition terms and the investment terms that we're investing into. And part of it in the acquisition side, a lot of that comes from the purchase multiple, right? Is this truly a value investment? Are we paying a price for this that's below its intrinsic value? And then the entrepreneur needs, we need to have confidence that that individual can keep the lights on.

Jon Stoddard (30:49.455)
Yeah.

Sean Smith (31:12.436)
they are driven and dedicated to what they're doing and qualified. Those are kind of three characteristics, but underpinning all that is incentive alignment. Because you need to have really well aligned incentives between investors and the entrepreneur so that everyone's working in the same direction. And when things go bad, everyone does bad. Entrepreneur probably does even worse.

And when things go well, the entrepreneur does substantially better and investors walk away really happy. So that's kind of a key piece there. It all needs to be underpinned by incentive alignment.

Jon Stoddard (31:46.899)
Let me ask you about the intrinsic value. Really, the searcher, the entrepreneur, has values in it something. The SBA is going to value it at something. Do you run your own value? BBR does it. You can look for cops, and then you do your own valuation. What are you looking for as a reasonable delta between all of those four?

that you'll work with and say, I'm going to go, you know, happy to invest in at this price, whatever it trades at.

Sean Smith (32:18.039)
Yeah.

Sean Smith (32:22.861)
Yeah.

So, know, underwriting something from a lender standpoint, right, hinges a lot around ability to hit interest payments and amortization payments and really service the debt, right? So it's very much a cashflow based kind of focus. We also take a cashflow based focus and we're very...

You know, I would say disciplined about those kinds of cashflow scenarios I mentioned to you, especially the upside, the downside and what kind of shakes out in the middle. So, you know, we value things based on what our target IRR is. And if the output value is substantial, you know, has a good margin of safety over what the buyer's paying, that's one way we look at it. We look at it using the cost of capital that we expect in the market, which is to the tune of 25, 30%.

for equity and then whatever kind of the cost of debt looks like. And we average that out and run kind of an intrinsic calculation based on discounted cash flows. And then of course, the relative stuff using BVR and kind of other market metrics, both in kind of the current year and then in the terminal year is critical, right?

Jon Stoddard (33:33.787)
When you find somebody that kind of meets your profile, the other buy box, and you're going to go back to your investor and ask for a call for capital, is that another level of like, I got to get approved from them? Or is it, it's green lighted already because you already signed them up, committed on this thesis.

Sean Smith (33:57.474)
So Nick and I are on the investment committee and we have full bandwidth to choose what investments we make. We have a process where we'll go through kind of this valuation, the quantitative stuff we just talked about, as well as more of a qualitative kind of checklist or scorecard type analysis. And we'll talk through that together and say, you know,

Jon Stoddard (34:19.781)
Yeah.

Sean Smith (34:25.026)
This kind of passes all the red flags. This passes these qualitative checks, but there's kind of a yellow flag here. Can we get comfortable with that and we'll debate it then we'll make the decision on whether or not we want to pursue a soft commitment and ultimately a commitment to the deal.

Jon Stoddard (34:39.962)
Give me an example of some yellow flags that you look at.

Sean Smith (34:45.314)
Yeah, so there's some pretty common risks in the space, right? Like customer concentration, small businesses often have an outsized portion of revenue.

Jon Stoddard (34:54.905)
Especially with commercial, right? Residential, you don't have that. Commercial, you do. Yeah.

Sean Smith (34:58.22)
Yeah, yeah, that's right. But on the residential side, then you have discretionary concerns, right? If it's a less necessary business, people will tighten the belt, right?

Jon Stoddard (35:07.907)
Yeah, Not in Arizona, I will remind you. It doesn't happen in Arizona. Yeah.

Sean Smith (35:14.247)
That's an A plus market. yeah, so yellow flag and customer concentration, right? We looked at a deal where there was roughly 60 % of revenue concentrated between a couple of customers, which was very concerning. However, there were...

Jon Stoddard (35:32.709)
Yeah.

Sean Smith (35:36.626)
for owners in place who would be kind of, you know, all really well incentivized based on a, on a great deal structure to maintain those relationships. The customers had, you know, 30 plus year tenures with the company. and, you know, because of those kind of surrounding factors, risk mitigants baked into the acquisition as well as long tenures and incentive alignment again with the owners.

We were able to get comfortable that that was a yellow, something we got to pay attention to, and that could substantially impact performance. But it's not a red because it's been well mitigated from our perspective.

Jon Stoddard (36:17.324)
Yeah, let's say, me present that. Would it go to red if you had these four individuals, they ran it for 30 years, they were still going to service it, but it was a year to year contract versus a five year contract with commercial.

Sean Smith (36:34.762)
It would be closer. think what would really drive it to red is if there wasn't substantial risk mitigation baked into the acquisition itself, as well as really long-term relationships. If neither of those two things existed, it would probably be cause to pass, right? Because we couldn't be certain that, for example, if this customer came in last year, contributed 30 % of revenue, all of a sudden we're buying into a company where EBIT does inflated by, you know,

whatever that 30 % of revenue trickles to the bottom line at, that's now a huge risk because we don't know if that customer is going to stick around. There's a one-year contract, maybe that's all it is. They needed something for that year and they're running away. Of course, you can diligence that and whatnot, but it's different when you say, hey, this is a customer that has relied on this business for 30 years. There's no indication they're going to stop relying on it. There's no foreseeable disruptions. So it makes it a lot more easy to get comfortable.

Jon Stoddard (37:27.855)
Yeah.

Jon Stoddard (37:33.583)
Let me ask you about the quality of earnings. Now I know you have Elliott Holland on staff, but how deep are these Q of E's? mean, Q of E for a mid-market or bigger company, you're having conversations with customers and asking how long they going to stay with this customer? know, down lower, it's a little bit less. What are you looking for?

Sean Smith (37:59.266)
Sorry, I think I misunderstood the question.

Jon Stoddard (38:00.507)
Well, I'm what level of light DD or DD due diligence you do on these quality earnings? I mean, I'm contrasting if you do quality earnings in a larger company, they go to the customers and ask them, you know, how long are you going to be with this customer? How long you going to keep buying? Because that's a partnership, right? But lower end, it's a little less of what do you suffice so happy with?

Sean Smith (38:20.269)
Yeah.

Sean Smith (38:31.692)
Yeah, so that's certainly, I think, key piece of this ecosystem that may be challenging for some folks. But we rely on the acquirer's due diligence process for a lot of this. we, of course, we run our own.

Jon Stoddard (38:46.223)
huh.

Sean Smith (38:50.162)
of their processes and of the quality of earnings that they're getting done. And we want to see it being done in an unbiased way by a third party, you know, that's reputable, right? But assuming they have all that in place and I'm talking about quality of earnings, but this applies for other diligence work streams as well, right? That are necessary. They have all that in place, then, you know, we'll review the quality of earnings and determine whether or not.

It's up to par with our expectations, but we will rely on that, right? So that's, think, a really critical differentiator. It's a really critical difference in sort of market than in, to your point, if you're a PE fund running the, or in my

doing buy side &A advisory, right, like you would be retaining PWC for quality of earnings and they would be doing a 200k quality of earnings and going, you know, turning over every stone on a hundred million dollar company.

Jon Stoddard (39:43.6)
Yeah, yeah.

Jon Stoddard (39:47.835)
Yeah.

Jon Stoddard (39:51.291)
every stone and they still miss stuff. Yeah. So where you're at right now, you've got one investment. What is it? What do you need to be kind of happy with what's in your basket? I mean, do need five of these companies? 10, 20? What does that look like?

Sean Smith (39:54.424)
Yeah.

Sean Smith (40:12.908)
Yeah, so we've got two more soft commitments out there. So we do have kind of rolling closes probably in the next couple of weeks and then a month or so after that. And we've got three to five more in front of us right now that are kind of I'm confident one, maybe two of them will probably get to that soft commitment stage and then close months after that.

So we're doing, call it one deal every six weeks or so. And we have a three-year deployment period. So call it one deal. Yeah, we do. it's fairly, it's some good flexibility. 36 months starting in August. So we're cutting into it a bit, but we've got...

Jon Stoddard (40:47.587)
A three year. I was at, okay.

Sean Smith (40:59.596)
You know, we will have three deals under our belt doing about a deal a month every six weeks or so. And looking to get to ideally 25 to 30 companies, we want to have a well diversified portfolio in the space. And, you know, I'd say a big part of that is because this is a mix between kind of concentrated, you know, LBO style investing and entrepreneurial investing where having kind of a much broader diversification of videosyncratic risks is critical.

Jon Stoddard (41:28.889)
Yeah. What does it look like at that third year when there is a, you it's time to exit and you're asking the entrepreneur, the buyer to do what? Like he's going to look at his balance sheet and go, you know what? I owe search fund investors this amount of money. They want it back. Plus investment. Yeah.

Sean Smith (41:55.406)
Yeah, so we're not creditors, so we're not going to come breaking your knees with the collectors. the point of clarification, we have a three-year deployment period, which means we have three years to invest the capital that's been committed. But we'll hold our investments for 10 years. The life of the fund is 10 years plus a 12-month extension. So it could be an 11-year fund, hypothetically.

Jon Stoddard (42:11.511)
OK, I got that wrong. Yeah.

Jon Stoddard (42:23.637)
so they're not looking for return on, the investors not looking for a return on investor return on equity. They're looking for like cashflow or some kind of dividend.

Sean Smith (42:35.896)
So it's mixed. A lot of people ask, we going to see cash flow? And I think we do prioritize deals, I would say, that have near term distributions. But it's really about compounding capital. And of course, we're levered to an IRR metric. So the sooner capital comes back, the better. But at the same time, the more we can compound that capital, that's also something we're incentivized to do. So most of the deals we're looking at have, call it,

periods between four to seven years, which gives some good comfort within the fun life. Now, you know, no plan survives first contact with the enemy. So we're very well aware that I think a substantial portion of those may trickle longer than seven years. But that's that's sort of the profile, right? And would expect most of the distributions to come in that kind of, you know, liquidation event scenario versus

dividends and cash flow distributions, though we do have dividends in every deal we've committed to so far.

Jon Stoddard (43:40.313)
Gotcha. So you're looking for self-funded searchers, independent sponsors, and investors. Anything else that you need?

Sean Smith (43:52.248)
Just great collaborators in the space, John.

Jon Stoddard (43:54.927)
Yeah. And exposure really helps. Do 100 more of these and have a couple of books and you'll have unlimited deal flow. Well, Sean, appreciate the time you spent with me explaining your model, the search fund investor model. I appreciate the time.

Sean Smith (44:04.646)
All right. Well, appreciate it.

Sean Smith (44:15.832)
Yeah, thank you so much for having me.

Jon Stoddard (44:18.725)
me stop.

I ask these questions. You gotta let it upload. It takes a few minutes here.

Sean Smith (44:26.574)
Are we still on or are we?

Jon Stoddard (44:28.471)
We are not recording.