Engaging a reputable investment bank to assist in the sale of a business is generally money well spent. A good investment bank will work diligently to maximize the seller’s enterprise value and coordinate a disciplined, organized, and successful transaction.
This article discusses the top ten negotiation issues in investment banking engagement agreements. Although the recommendations below are designed mainly to benefit the business seller, they are also intended to be reasonable to the investment bank. For the purposes of this article, I assume that the seller has an enterprise value ranging from $5,000,000-$30,000,000, which is the typical M&A transaction size among my clients.
1. Transaction Scope. The first draft of the investment bank’s form engagement agreement will often define the engagement to include every transaction imaginable, including a sale, minority investment, equity financing, debt financing, joint venture, etc. To avoid having to retain and compensate the investment bank for services the seller does not require, the agreement should specify that the banker’s services are limited to only those services the seller needs at the time of engagement (e.g., financial advisory services for a sale of all or substantially all of the company’s stock or assets). The engagement agreement should itemize the services to be provided by the investment bank in the engagement, which may include: (i) advising the seller on a target price range; (ii) preparing a confidential information memorandum (CIM) and executive summary (or “teaser”) for delivery to potential purchasers; (iii) locating, contacting, meeting with, and following-up with potential purchasers; (iv) arranging conference calls, visits, and management presentations; (v) reviewing, organizing, and managing due diligence materials in a virtual data room; (vi) obtaining (in coordination with counsel) confidentiality agreements from all potential buyers; (vii) soliciting, analyzing, and comparing competing offers; (viii) advising on transaction structure, negotiation strategies, and deal points; (ix) negotiating the acquisition term sheet and definitive purchase agreement; and (x) coordinating communication between buyer, seller, legal counsel, and other professional advisors.
2. Fees. The investment banker’s fees may be affected by the reputation and capabilities of the bank, as well as deal size, complexity and likelihood of closing. The main fees are the retainer and the success fee.
- Retainer. A non-refundable retainer or “work fee” is generally paid to the investment banker from the commencement of the engagement. The retainer demonstrates that the seller is serious about selling the company and compensates the investment bank for its initial work. Retainers generally range from $25,000-$75,000 and are payable monthly or in other increments and capped. It is reasonable for the seller to require that the retainer be paid on a monthly basis and credited dollar-for-dollar to the success fee (described below).
- Success Fee. The largest component of the investment banker’s compensation is the success fee. It is usually either (i) a simple percentage of the transaction value or (ii) an upward scaled percentage (e.g., 3% of the transaction value up to $X and 4% of the transaction value over $X or from $X to $Y, etc.). If a scaled percentage is used, the bank might set $X at the “walk-away price”, meaning the lowest favorable price at which the seller is willing to close a deal, with value tranches and percentages increasing from $X. As long as $X is satisfactory to the seller, this structure will align the parties’ interests by incentivizing the investment bank to pursue a sale at or above the $Y price to earn the enhanced fee. In transaction values from $5,000,000 to $30,000,00, success fees typically range from 3%-8% of transaction value, with the higher percentages levied on lower valued transactions. There will often be a minimum success fee of $200,000 to $600,000, with most minimums at the lower end of the spectrum. Success fees are payable on closing or possibly over time if the transaction requires contingent payments (as described below).
- Avoid Progress Fees. Some investment bankers will request a progress fee (e.g., $100,000+) payable upon the signing of a letter of intent or definitive purchase agreement. Progress fees are not standard and the seller should resist them because a transaction will not necessarily close after signing the definitive agreement, and is even less certain of to close after signing a non-binding letter of intent. If a progress fee must be included, it should be payable only on the signing of the definitive purchase agreement, not the letter of intent. Like the work fee, the progress fee should be credited against the success fee.
3. Transaction Value. The success fee is calculated on the basis of “transaction value”, which should be defined to mean the enterprise value paid to seller and its shareholders in the transaction. Transaction value will customarily include: (i) all payments to the shareholders (including cash, securities, and other property); (ii) debt that buyer assumes or pays at closing; (iii) the value of any equity that seller retains in the target post-closing; and (iv) above-market value payments on employment, non-compete, licensing and supply agreements. The transaction value should always exclude cash on hand and pre-closing cash distributions to seller’s shareholders to avoid paying the banker a fee on seller’s existing cash. Similarly, payments to specific employees that do not result in value to the shareholders (e.g., post-closing employment agreements with the buyer) should be excluded from the definition of transaction fee, as should the value of real estate owned by seller or affiliates and any post-closing real estate leases to purchaser at fair market value. It is customary for the banker to seek to have its success fee paid on the full transaction value at closing, including on the value of contingent payments such as escrow holdbacks, earn-outs, or promissory notes. However, in order to better align the banker’s interests with those of the seller, the seller should attempt to require that the banker receive its success fee on contingent amounts only if and when such amounts are actually received by the seller. This position is somewhat aggressive and may be resisted by the investment bank.
4. Expense Reimbursement. The engagement agreement will invariably require seller to reimburse the investment banker’s expenses relating to the engagement, including travel, data room charges, and printing and materials costs. It is usually not controversial for the seller to mandate that reimbursable expenses: (i) include only out-of-pocket payments to third parties (as opposed to the investment banker’s ordinary overhead expenses); (ii) be capped at a certain dollar amount; (iii) be pre-approved by the seller if in excess of a certain individual dollar amount; and (iv) and be subject to reasonableness standard. Expense reimbursements of $25,000 to $50,000 should be expected.
5. Term, Termination and Tail. The customary term of the investment bank’s engagement is between six months and one year, whatever is sufficient to market and sell the business. The seller should generally have the right to terminate the engagement without cause by giving 30 days’ written notice. In addition, the seller should be able to terminate the engagement immediately for cause upon the investment banker’s material breach of the agreement or willful misconduct, gross negligence, or bad faith. Unless the investment bank is terminated for cause, it will have the right to receive its success fee if the seller consummates a transaction during a “tail period” of between 6 and 24 months after termination with any purchaser that the investment bank introduced to the seller during the term. To avoid a dispute regarding whether a success fee is payable during the tail, the agreement should require the investment bank to provide seller with a list of introduced purchasers within 10 days after termination. If the investment bank fails to provide the list, the seller should be excused from the obligation to pay a success fee during the tail period. It is reasonable for the seller to require that the tail period not exceed 12 months after termination. Upon termination, the work fee will typically be non-refundable and seller will be obligated to reimburse the banker for expenses incurred through the termination date. The seller should confirm that the investment bank’s confidentiality obligations (described below) remain in effect for at least 1-2 years after termination of the engagement.
6. Indemnification. It is customary that the seller agree to indemnify the investment bank for all claims and expenses arising from the sale process (whether or not a sale occurs) other than claims and expenses arising from the investment bank’s fraud, gross negligence, or willful misconduct as determined by a final non-appealable court decision. If the investment bank’s acts or omissions give rise to the claim, its liability is generally limited to the amount of fees it received under the engagement agreement. Reputable investment banks will not engage in any substantive negotiation of the indemnification provisions. However, the seller should confirm that the investment bank is obligated to promptly notify the seller of any claims subject to indemnification and that the seller has the right to control the defense of such claims. Since any claims that arise are likely to be attributable to the seller’s disclosures, acts, or omissions (on which the investment bank relies to market the seller’s business), the investment bank generally has a reasonable basis for defending its indemnification rights.
7. Key Persons. The seller should specify in the engagement agreement whether any members of the investment banker’s team must lead the project. If there is key person that is essential to the transaction, the seller should obtain the right to terminate the engagement if he or she disassociates from the investment bank. The investment bank may resist this effort since it has little or no control over the employment decisions of its personnel. In that case, the seller could require that if a key person leaves investment bank, his or her replacement must be acceptable to the seller; and if not, the seller should then have the right to terminate the engagement, perhaps coupled with a reduction in the duration of the tail period.
8. Confidentiality. The seller and the investment bank should enter into a stand-alone confidentiality agreement or include a comprehensive confidentiality provision in the engagement agreement. If the seller discloses confidential information to the investment bank before the engagement, a stand-alone confidentiality agreement should be signed before the disclosure. The seller’s confidential information should not be used by the investment bank for any purpose other than to serve the seller’s interests in the engagement. The seller should confirm that the duration of the confidentiality obligation continues for at least 1-2 years after termination of the engagement, with trade secrets being subject to confidentiality obligations as long as they are trade secrets under applicable law. Finally, the seller should prohibit the investment bank’s disclosure of confidential information to departments of the investment bank that are not involved in the project. If a stand-alone confidentiality agreement is used, the engagement agreement should incorporate its provisions by reference.
9. Conflicts of Interest. To avoid conflicts of interest, the investment bank should generally be prohibited from representing a potential buyer in the same transaction and from engaging any other advisors or sub-agents to participate in the transaction. However, the seller may consent to the investment bank’s request to be allowed to assist a potential buyer with financing the transaction.
10. Exclusivity. It is reasonable for the investment bank to request that it be designated as the seller’s exclusive advisor for the transaction, which avoids having competing advisors working at odds. But if the seller has previously engaged or wishes to engage additional financial advisors for different purposes, the seller should confirm that the other advisory agreements do not conflict with the investment bank’s engagement.
If you have any questions regarding this article, please feel free to contact me at john@jmdorsey.com.