By Tom Matlack – Investor, Mentor and Board Member
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Eight years after creating my original formula, (a new idea on how to calculate Search Fund performance equity) which attempted to address what I perceived as misaligned incentives in standard search performance equity economics, it seems time for a refresh.
This need arises from two factors: the increasing complexity of cash flows in many search deals and a heightened focus on MOIC rather than IRR as the measure of success.
My original formulation works when there is one investment and one return date. It becomes more challenging to apply when the cash flows involve more than one of each, muddling the duration.
Furthermore, my original idea was that any exit within the first five years would be subject to the MOIC produced by calculating compounding at a 35% IRR for those five years, disincentivizing early sales since the original search economics incentivized by accident (since achieving a 35% IRR for short periods on small amounts is much easier than for long periods on larger sums). This part of my formula has not been utilized as often as the second half of my idea, i.e., reducing the IRR to 20% after the five-year mark. This was always intended to be a trade-off between searchers and investors, which included a stricter standard in the first five years, followed by a slightly easier one after the five-year mark.
There is a better framework that addresses the above complexities and updates my original idea to fit the current situation.
When discussing the outcomes of search deals, neither investors nor CEOs ever mention the internal rate of return (IRR). They only focus on MOIC. Any outcome exceeding 5 times is regarded as excellent, while anything above 3 times is considered a good result. The 2024 Stanford Study reports that the average MOIC return to investors (net) is 4.5 times overall and 3.2 times when excluding the top 5 observations.
Thus, I propose to codify the way we discuss outcomes in the performance equity component of Search Entrepreneurs’ compensation as follows: 3.0x MOIC would receive 20% of the performance equity, 3.5x MOIC would receive 40%, 4.0x MOIC would receive 60%, 4.5x MOIC would receive 80%, and 5.0x or over would receive all the performance equity available—linear interpolation between these points.
In addition to the above MOIC measure, to receive any performance equity, the Search Entrepreneur would need to achieve a minimum of 20% IRR through the final exit of the investment.
Of course, the absolute levels of the MOIC goals and minimum IRR can be negotiated on a case-by-case basis if my proposed levels are not acceptable. Still, the framework remains intact to simplify my original formulation for the current landscape.
My intention in adopting this new formulation is to simplify the calculation of performance equity, to focus on the consensus measure of success, and to shift everyone’s focus to a hold period of five years or more, as this allows sufficient compounding to reach the goal. I am posting the MOIC returns required under my prior formulation below just for comparison purposes:
Thanks to Frank van Lint for bringing the issues in my original formulation to my attention. Credit for originating the idea of a double-trigger MOIC and IRR approach goes to my friends and partners Juan de Dios Aguilar and Ramiro Alfaro.
Finally, other formulations have been developed for truly long-term hold scenarios to create appropriate incentives for time horizons of 15 to 20 years. The above is my attempt to modify my original formula for those entering into a more traditional search fund deal with an expected time horizon of 5 to 10 years.
