A Summary of M&A Fees for Sell-Side Transactions
An overview of M&A fees for sell-side transactions.
Investment banks offer expertise and know-how that can add significant value to any transaction, but complicated fee structures can be daunting and confusing in picking an investment banker.
In negotiating fee structures, a business owner should consider the goal he or she seeks to achieve in hiring an investment banker. An owner looking to sell a business as soon as possible and an owner willing to wait longer for the highest bidder will likely have different fee structures. In other words, a fee structure is intended to incentivize investment bankers and to align their interests with your own as a business owner looking to sell. In order to negotiate an appropriate fee structure that will achieve your goals, you should first understand the factors that go into a fee structure.
Below are common components of a standard fee structure.
Investment banks often require a non-refundable retainer fee, sometimes called an upfront fee, work fee or an engagement fee. For transactions larger than $100 million, retainer fees can be in the hundreds of thousands of dollars in total over the entire sale process period. For transactions below $100 million, these fees may range between $50,000 and $150,000. Retainer fees exist mainly to ensure that the selling firm is committed to the sales process. Retainers are usually paid on a monthly basis over a reasonable time frame (usually not longer than 12 months). They are also usually capped at an agreed-upon level.
The retainer should not be so larger that it reduces the motivation of the investment bank to earn their success fee on closing the transaction. In general terms, the upfront fee should not be greater than 15% of the overall fee (upfront fee plus success fee). Some less reputable firms charge a large upfront fee to prepare a confidential information memorandum and then put minimal effort to close a transaction because they have already earned reasonable profit on payment of the retainer for the work performed.
The amount of the work fee will first depend on the likelihood of a closing. Bankers often require higher initial retainer fees if they believe that there is a higher risk of not closing. Riskiness may be assessed by many different factors, including how the business owner’s value expectation compares to current market conditions. Good investment banks will not forego the opportunity cost (measured by a success fee) of working on a deal that is unlikely to close. For that reason, they will propose a higher work fee component to compensate for that risk.
The amount of retainer fees will also depend on the costs that the banker anticipates will be incurred in the initial stages of the project. If the banker will be working exclusively on your deal, the banker will likely charge higher retainer fees in order to cover costs and keep the business running. Regional or bulge bracket investment banks typically charge higher work fees than boutique banks, given their higher overhead costs.
Work fees are sometimes, but not always, deducted against success fees once a deal closes. Be sure to negotiate for these fees to be credited back if the investment bank terminates the engagement or if they otherwise fail to do reasonable work to effectuate a closing.
Success fees are paid upon a successful closing. The success fee (not the retainer) should always be the most significant component of the total compensation. The success fee is usually calculated as a percentage of the company’s enterprise value, and is contingent upon completion of the deal. However, the success fee structure could vary depending on the goals of the business owner looking to sell.
The following are common methods of calculating success fees:
Fixed Success FeeFixed success fees are appropriate in situations where the banker has minimal work to do on the engagement, including a negotiated sale where a buyer has already been identified prior to the engagement with the banker. When a buyer has been identified, the investment banker can more easily estimate the amount of hours he or she will have to invest into the transaction. Additionally, when a buyer has already been identified, the business owner may be unconcerned with finding a higher bidder and, therefore, need not employ scaled fees to incentivize the banker to stimulate more bids.
In a negotiated sale scenario, minimum hourly fees can also be structured in lieu of work fees in order to cover the overhead cost incurred by investment banks. An upside fixed success fee would then be payment on successful completion of the transaction. Fees paid on a negotiated sale are typically lower than fees charged in a competitive auction process, given that the investment bank would not need to seek and approach multiple prospective buyers.
Flat Percentage Success Fee
A flat percentage success fee may be an appropriate fee structure where negotiating the highest price is not the primary objective of the seller or in cases where it will be difficult to garner competitive bids. A flat percentage is calculated as a percentage of the company’s enterprise value and is more common for businesses with enterprise values under $10 million.
Bankers usually require a higher flat percentage for smaller businesses to ensure that they are adequately compensated for the amount of work they put into the engagement. Often times, a banker has to invest more time and effort to successfully sell a smaller business than to sell a larger business. This is because larger businesses have a broader appeal, whereas smaller business may need to look harder for a suitable buyer.
A business owner should be aware that in a scenario where there is a flat success fee percentage, the investment banker may try to close a deal quickly to collect the success fee without seeking the highest price or the best purchaser. To avoid this misalignment of interests, the seller should structure a compensation mechanism that pays a higher success fee percentage if different purchase price thresholds are reached.
Scaled Success Fee
A scaled success fee can be employed to incentivize a banker as to maximize value in a sale process. It is more commonly used when a banker will be responsible for finding multiple prospective buyers, as those situations generally require an investment banker to take additional time and effort to position and market the business favorably.
While a scaled fee can vary based on negotiations between the business owner and the banker, two generally accepted scaled fee structures are the Lehman Scale and the Double Lehman Scale. The Lehman Scale is calculated based on a percentage of enterprise value as follows:
- 5% of the first $1,000,000;
- 4% of the second $1,000,000;
- 3% of the third $1,000,000;
- 2% of the fourth $1,000,000; and
- 1% of the remaining total.
Reverse Scaled Success FeeA reverse scaled success fee is similar to a scaled fee, except that the percentages increase (rather than decrease) as the enterprise value of a business increases. A reverse scaled fee creates even stronger incentives for the banker to find the highest possible bidder, as a higher enterprise value threshold would mean an even higher success fee.
There is a tremendous amount of subjectivity in setting the threshold ranges on the reverse scale accurately. In negotiating a reverse scaled fee, a business owner should be careful not to set the scale too low. Doing so would mean unusually large success fees for minimal work. A reverse scaled fee should reward additional percentage payouts for additional work in order to incentivize the banker to go "above and beyond" rather than merely reward the banker for obtaining an easily negotiable, or even low, offer.
As an example, if the seller receives a $50 million offer that meets the minimum value expectation, the investment banker would get a modest success fee of 2%. However, if a much higher offer of $65 million is received, the investment banker could receive an additional 10% on the difference between your minimum value expectation and the premium offer. Total success fees in this transaction at $65 million would be $2,500,000 (or 3.85% of the total deal).
General Rule of Thumb on Success FeesIt's tough to know exactly what a "reasonable" success fee should be as they vary by industry and region. The most important point for any seller is that success fees are negotiable.
Here are some rule of thumb ranges based on a company's enterprise value:
- Less than $1 million: 8%;
- Between $1 - 5 million: 6 - 8%;
- Between $5 - 10 million: 4 - 6%;
- Between $10 - 25 million: 4 - 5%;
- Between $25 - 50 million: 2.5 - 4%;
- Between $50 - 100 million: 2 - 3%;
- Between $100 - 250 million: 1.5 - 2.5%;
- Between $250 - 500 million: 1 - 2%; and
- Above $500 million: 0.50% - 1.5%.