The Role of an Investment BankerDepending on the nature of the engagement, an investment banker (sometimes called a business broker or an M&A advisor) may play a large or small role in a divestiture transaction. Regardless of the contractual expectations negotiated between an investment banker and their client, every investment banker brings value to a transaction by bringing expertise in the following key areas:
Determine Objectives of the SellersInvestment bankers, at the end of the day, are agents of their clients. A good investment banker will determine what you, as the seller of the business, wants, and use his or her expertise in the M&A industry to achieve that goal.
Determining the objectives of the sellers is arguably the most crucial step in creating a successful relationship between an investment banker and his or her client. This process involves sitting down with your investment banker and articulating your priorities and your expectations for the transaction. Your investment banker should have your best interests in mind, and what this means is balancing maximizing value and managing expectations.
Manage ExpectationsAn investment bank delivers value by managing the expectations of their clients during sales processes. An experienced investment bank will know the current M&A market and will be able to discern where seller’s expectations are unreasonably above market norms. For example, if you are looking for 10x EBITDA in the sale of your business, and recent comparable transactions in your industry have only obtained 5x EBITDA, then you will likely end up forgoing good offers in search of an unlikely higher bidder. A good investment bank strikes the right balance between getting you the most value, while maintaining realistic expectations on what can be achieved in the sales process.
Advise on Business Valuation and Deal StructureM&A deals vary greatly in nature and structure. The size of the transaction, who your target bidders are, and whether or not you want a continued interest in the business after the sale, are just a few of the many factors that go into determining the best transaction structure for any particular deal. An experienced investment bank will be knowledgeable about attainable values and deal structures for a company.
Prior to marketing a business for sale, an investment bank will advise on an achievable business valuation and deal structure based on their experience as well comparable data from the market. These are essentially predictions on how much your business could reasonably sell for in the market, but help shape the priorities and expectations of the business seller through the process.
Engage in Value-Maximizing PreparationA good investment bank should be able to assist in identifying activities which your business can engage in to maximize its value to potential buyers. Such activities will almost always differ from business to business, and seek to target and improve weak points in a business. For example, if your business has an unusual amount of working capital, an investment bank may devise a strategy to decrease working capital levels that are more in line with market norms. In general, minimizing the factors that will impede salability will also increase the pool of potential buyers and, in turn, increase your chances of obtaining the best deal.
Prepare Marketing DocumentsOne area of expertise that investment banks will provide is in preparing marketing documents. Marketing documents include crucial documents to the sales process, such as financial projections and confidential information memorandum (CIM). Preparation of these documents is often one of the most time-consuming aspects of the sales process. These documents will be the first impression a potential bidder may get of your business so the investment banker has to succinctly present the opportunity. The CIM, especially, should contain relevant information, while at the same time be organized and concise.
Find Qualified BuyersAn investment banker’s value lies largely in the connections he or she may have in the M&A industry and their ability to find qualified buyers. An investment bank, from experience, should have a broader market knowledge than any one seller. Additionally, part of an investment banker’s job is knowing the market movements. Due to their industry knowledge, investment banks can often find potential bidders for your business that you originally did not think to seek. For example, a business in a completely different industry may be looking to acquire and expand into the market that your business is in. Without an investment bank that regularly keeps abreast of M&A market news, a seller may miss the opportunity to pitch to an appropriate buyer.
Negotiate the Best DealInvestment bankers are advocates for the best transaction valuation and structure. They maintain this role through all phases of the sales process including obtaining an LOI, dealing with due diligence, and negotiating the purchase and sale agreement.
Through the due diligence process, an investment banker will gather all necessary financial, legal and organizational documents. Additionally, they will scrutinize due diligence documents and anticipate any questions that a potential buyer may have. This is an important part in achieving a smooth and success sale.
During negotiations, an investment bank will identify aspects of the deal that are if conflict with the seller’s objectives, and will negotiate accordingly. Smart negotiating, as well as knowledge of standard contractual terms in the industry can help to determine which contract terms to push hard on, and which to compromise on. An investment banker also plays the middle man, acting as the "bad cop" in the deal while the seller and the potential can continue an amicable relationship during and after the transacation.
Facilitate Interaction between Other Deal ProfessionalsAs mentioned earlier, part of an investment banker’s value lies in the people they knows. This applies not only to potential buyers, but also to other advisors on your M&A team as well. Every M&A team should have a strong lawyer, a strong accountant, and other necessary professionals with expertise in their area.
A good investment bank should have a roster of reputable and quality professionals from whom you can pick one that suits you. The benefit of these relationships is that, as a repeat player, investment banks hold more bargaining power with these professionals as well as more knowledge regarding their reputation within the industry.
M&A Related DesignationsIn choosing a professional advisor, business owners must be careful to pick a trustworthy professional who has their best interests in mind and can execute the strategy. One way to gauge a financial advisor’s ability is by his or her professional designations. Obtaining a professional designation requires additional education and testing in a specific field of expertise. Professional designations are an important indicator of the caliber of a financial advisor, though a diligent business owner should also consider additional criteria in evaluating individuals that will provide advice or educate on potentially the largest financial transaction of their lives.
The four most recognized financial designations are Chartered Financial Analyst (CFA), Chartered Accountants (CA) (Canada or UK), Certified Public Accountants (CPA) and Master of Business Administration (MBA). These designations are widely accepted as the highest standard for professionals with regards to the advanced financial knowledge often needed to navigate through the complexities of a mid-market transaction.
There are a number of specialized designation that complement the more recognized financial designations noted above. Obtaining a level of specialty beyond a MBA, CA, CFA, or CPA demonstrates the added commitment of the professional to his or her craft.
There are however a growing number of for-profit, weekend designation programs that have led to a dangerous level of confusion in the marketplace. It is important to evaluate the prestige of the organization offering the designation, depth of content, and rigor in obtaining the certification. The following compilation of speciality designations is not an endorsement, but merely a summary of the various organizations that provide accreditation to professionals in the areas of exit planning, business valuation and mid-market investment banking.
Exit Planning Designations
Certified Exit Planning Advisor (CEPA)CEPA is a designation obtained from the Exit Planning Institute (EPI). The EPI has offered the five-day certification program since 2007, and it is currently the most widely accepted and endorsed professional exit planning program in the world. CEPAs are trained and educated to identify and address potential exit planning issues, build a comprehensive exit strategy, and educate business owners on important exit planning topics. Graduates of EPI’s CEPA Program also benefit from continuing education and access to industry forms and templates.
Certified Business Exit Consultant (CBEC) CBEC is a professional designation offered by Pinnacle Equity Solutions. Pinnacle’s program consists of a five-day learning program followed by a four-week marketing and sales program designed to get newly certified members hands-on exit planning experience. Graduates of Pinnacle’s program continue receiving monthly training sessions on practice management and technical exit planning training.
A Certified Exit Planner (CExP) The CExP designation is provided by Business Enterprise Institute (BEI). BEI’s program consists of a two-day training session, 10 online courses, and a two-part exit planning exam. A CExP is also required to hold another accepted professional designation or equivalent professional experience. Graduates of BEI’s program are required to complete 30 continuing education hours per year to maintain their CExP designation. BEI program standards are also backed by an independent, non-profit, Board of Standards Corporation.
Business Valuation Designations
Chartered Business Valuator (CBV) CBV is a professional valuator who has received their designation from the Canadian Institute of Chartered Business Valuators (CICBV), an accrediting body in the field of business valuation in Canada. CBVs specialize in quantifying the worth of a business, including its intangible assets, brand and intellectual property. To earn the designation, candidate must have a degree from a post-secondary academic institution or university, gain valuation experience at place of employment, complete a number of required courses and pass the Membership Qualification Entrance exam.
Certified Valuation Analyst (CVA) CVA is a professional accredited in the field of business valuation. CVAs members receive their designation from the National Association of Certified Valuators and Analysts (NACVA). NACVA is a professional association of over 31,000 CPAs and other valuation experts. This designation is obtained after completing a sample Case Study or Fair Market Value report, an optional five-day training program and submission of two personal and two business references.
Certified Business Appraiser (CBA) CBA is a professional accredited in business appraisal and has received a designation from the Institute of Business Appraisers (IBA). The IBA was established in 1978, and is the oldest professional association devoted solely to the appraisal of closely-held businesses. Prerequisites to obtain the CBA include possession of a 4-year college degree or equivalent, completion of a comprehensive workshop, passing a 5 hour written exam, and submission of two appraisal reports.
Accredited Senior Appraiser (ASA) ASA is a professional appraiser who has received a designation from the American Society of Appraisers (ASA) and has five years of full-time appraisal experience. The American Society of Appraisers is a non-profit international organization dedicated to appraisal professionals. To receive a designation, ASAs must pass the ASA Online Ethics Exam, a 15-hour National Uniform Standards of Professional Appraisal Practice, and submit three letters of reference.
Accredited in Business Valuation (ABV) ABV professional appraisers earn this designation from the American Institute of CPAs, the recognized national professional organization for certified accountants. All ABV credential holders are CPAs and additionally have passed an ABC Examination, fulfilled required business experience requirements and completed 75 hours of valuation-related education credits.
Master Certified Business Appraiser (MCBA) MCBA is a professional who has received this professional designation from the Institute of Business Appraisers (IBA). IBAs possess post-graduate degrees and a minimum of fifteen years full-time experience as a business appraiser. IBAs additionally must provide three letters of reference attesting to the appraiser’s analytical skills and work product, professional and ethical character and contribution to the appraisal profession.
Mid-Market Investment Banking Designations
Corporate Finance (CF) QualificationCF professionals receive this designation from the Institute of Chartered Accountants in England and Wales (ICAEW), a world leading professional organization for accountancy, finance and business professionals. CF professionals are certified ICAEW Chartered Accountants or Certificate in Corporate Finance holders who have obtained their Diploma in Corporate Finance from ICAEW and additionally have a minimum of three years of experience in corporate finance.
Certified Merger and Acquisition Advisor (CM&AA) CM&AA is a professional who specializes in middle market corporate financial advisory and transaction services and who has obtained a designation from the Alliance of Merger Acquisition Advisors (AMAA), a professional group of more than 800 professional services firms that focuses on middle market mergers acquisitions. CMAAs are required to complete a 5-day course covering various in-depth M&A topics.
Chartered Merger and Acquisition Professional (CMAP) CMAP is a professional specializing in middle market mergers acquisitions who has received a designation from the Middle Market Investment Banking Association (MMIBA). As a prerequisite criteria to obtain CMAP credentials, candidates must be accomplished in business, finance, account, economics or business management demonstrated by either a college or university degree, another acceptable designation or M&A related experience. MMIBA’s CMAP Certification program consists of a five-day Mergers Acquisitions workshop and a four-hour CMAP Certification Exam.
Merger & Acquisition Master Intermediary (M&AMI)M&AMI is a professional specializing in middle-market mergers acquisitions and received a designation from M&A Source, a professional organization specializing in lower middle market M&A transactions. M&AMIs represent clients in mergers acquisitions, advice clients in valuation and facilitate necessary financing for mergers acquisitions. Successful M&AMI candidates require both educational credits and the successful completion of multiple middle-market transactions.
In Summary Designations are not a litmus test to base the ultimate decision of selecting an advisor. They can be useful though in the initial evaluation of professional competency. It is also important to remember that not all designations are equal. Business owners should maintain a level of scrutiny in determining if an individual, regardless of credentials, will help them achieve their desired objectives.
The Investment Banking Landscape - Different Types of FirmsThere are different types of firms that a business owner can engage with for the sale of their businesses. Each of these firms can provide a different set of services to the business owner. They are differentiated based on the size of the transactions that they work on, their geographic reach, and the services provided. The different types of firms include boutique investment banks, regional investment banks, bulge bracket investment banks, M&A advisory firms, and business brokerages. For each of these firms, it is important to analyze which is the most likely to be used as an advisor for your business.
Boutique Investment BanksOver the past decade, several 'boutique’, investment banks have entered the financial landscape. Boutique investments banks are non-full service that specialize in some particular aspects of investment banking such as capital raising or mergers and acquisitions (buy and sell side engagements). These firms will typically range in size between 1 to 100 employees and will have a few locations in a relatively small geographic region. There are however some larger firms that are specialized by industry that would be considered boutique.
Most boutique investment banks work with middle-market firms on deals sizes with enterprise value between $5 and $100 million. I-banks with more specific industry expertise can work on larger sized deals.
Many boutique investments banks are founded or led by former partners of large banks where they were eager to get more involved in the process. Also, boutique investment banks filled in the gaps left by most big banks which would not look at smaller deals unless there was some exceptional value attached to it. At boutique investment banks there tends to be more intimate interaction between the firm and the business owner.
The pros of engaging with a boutique investment bank: Boutique investment banks specialize in a particular industry or a specific transaction or they may specialize in certain geographical areas and hence, are well known in their niche. Their fees are lower than bulge bracket investment banks but these smaller firms can offer unwavering attention to the clients resulting in long term relationships as opposed to transaction based one. Also in the boutique firm, the dealmaker may be more directly involved in completing the transaction as opposed to larger investment banks where analysts and associated would do a bulk of the work in a deal.
Cons: Boutique investment bank may not have the network of contacts that a larger firm will have to find the best prospective buyers. Online social network and deal sourcing platforms are narrowing that gap. Smaller firms might allow lack the necessary resources of professionals to properly execute large and complete transactions. Another downside of the boutique investment bank is that there is limited scope on the suite of services to offer growing companies such as ability to take public. Often times the services are limited to the expertise of the deal-makers within the firm.
Regional Investment BanksAs the name implies, regional investment banks typically focus on a certain area or region. These firm will have multiple offices with a national presence. Some banks may even have operation in many different countries. Deal for regional investment banks can be comparable in size to the bulge bracket i-banks but often they will be less than $1 billion. Typical deal size will be higher than the boutiques and range between $100 million to $1 billion in enterprise value. Most regional investment will focus on capital raising or mergers and acquisitions (buy and sell side engagements) but the large regional i-banks will provide a full suite of services including equity and debt capital markets, leverage finance and restructuring services.
Examples of larger well know regional investment banks would be Lazard, Rothschild, Houlihan Lokey, Jefferies & Co..
Pros of engaging a regional investment bank: Regional investment banks provide similar service of a boutique firm, but can also offer comparable resources and deep industry knowledge of a bulge bracket investment bank.
Cons: Fees charged by regional investment banks will typically be higher than boutique investment banks due to higher overhead costs in these firms. In some instance, deals that are smaller or lesser in profile may receive a lower level of attention as lead dealmakers are occupied with larger transactions.
Bulge Bracket Investment BanksBulge bracket investment banks are the largest entities and corporations in the financial world. The bulge bracket is comprised of top banks that include Bank of America, Merrill Lynch, Morgan Stanley, Citigroup, Deutsche Bank, UBS, Goldman Sachs, Credit Suisse, Barclays Capital, and JP Morgan Chase. These banks are massive, multinational firms that have tens of thousands employees worldwide.
The average bulge bracket deals are over $1 billion but they may execute high profile deals in the upper mid-market. Similar to regional banks, the bulge bracket banks provide both advisory and financing services - and also provide asset management, trading, commercial banking, and insurance.
Pros: Bulge bracket investment banks will garner the higher attention and exposure for sell-side mandates.
Cons: If your company is one of the select few high profile mid-market deals suitable for bulge bracket investment banks, you will pay a significant fee premium for their expertise and brand power
M&A Advisory FirmsAn M&A Advisory firm is a corporation dedicated to providing guidance on corporate mergers and acquisitions. These firm provide sell-side and buy-side services similar to investment banks but also provide more consultative ancillary services to the M&A transactions such as advice on exit strategies, business valuation, preparation of pitchbooks, assisting with due diligence, and taking part in the negotiations of sales.
M&A advisory firms advise on transaction in the lower mid-market, typically on deals from $5 million to $150 million of enterprise value. Fees for sell-side or buy-side assigned follow industry standard success fee structures but fees for ancillary services can be charged on an hourly basis. In comparison, investment banks work exclusively on transactional assignments and have minimum success fee expectations which tend to create a floor for the size deals that these firms work on.
Pros: M&A advisory firm can provide valuable advice on piecemeal sections of the M&A process, be it valuation, due diligence or exit strategies. These firms also may provide a more cost effective approach if fees are structured on an hourly basis for a specific deliverable.
Cons: M&A advisory firms tend to hire professionals that have a broad understanding of the M&A process whereas investment banks tend to hire dealmakers. When engaging a firm to sell your business, ensure that you are hiring a dealmaker that can get the deal done.
Business BrokerageLastly, it is important to look at a business brokerage in relation to the other firms. Business brokerages assist in the sales of businesses typically valued at less than $5 million or that fall in the Main Street category. Business brokerages assist the seller in setting a selling price, preparing marketing materials, conducting buyer searches, and coordinating the negotiations.
Given the size of the business for sale, the most typical buyer is a private individual rather than a strategic buyer or private equity group. Business brokerages typically marketing the business to a broad base of potential buyers whereas other types of firms will employ a more targeted approach. Brokerages will use standard templates and forms to engage multiple listing and also speed up the sale process. Success fees for the listing usually range from 10% - 12% with no upfront of monthly work fees. Business brokerages tend to take on many simultaneous assignment knowing that some listing will never successful sell.
Pros: Business brokerages are experienced at advertising Main Street business for sale. They provide guidance to expedite the sale of smaller businesses.
Cons: For mid-market businesses, the transactions tend to be somewhat more complex and require a deep level of understanding in corporate finance. The typical standardized process engaged by business brokerage are usually not suitable for businesses in the middle market.
Criteria for Choosing the Right Investment BankerSelling your business can sometimes seem like a daunting task, and choosing an investment banker - the right one - can help ease the process. Investment bankers add value to a sales process in many ways. First, a good investment banker will be able to use his past experiences to recognize when demands of the sales process are unfavorable or out-of-the-norm. Usually, just identifying and addressing these issues will indicate to potential buyers that you’re serious about securing a good deal. Beyond just recognizing these signs, a top notch investment banker will have the toolbox to overcome issues that arise. Second, the mere presence of an investment banker in the sales process can boost your business’s credibility. Investment bankers can play the role of a middle man and shoulder the burden from the business owner of having the tough conversation with the buyer that are needed to drive the best terms and price. Great investment bankers will also drive competitive bidding tensions between buyers by publicize an auction process or subtlety hinting that there are other pending offer.
In order to evaluate and choose the right investment banker, a business owner should first reflect on their own objectives that they want to achieve through the process. An investment banker will help further articulate these objectives but having a basic understanding of key considerations during the process will help you decide what you are looking for out of the sale. It will also help you decide which investment banker is best suited to help you achieve your goals.
Evaluation Criteria to ConsiderA business owner should consider the five key factors in their search in selecting the right investment banker for the sales process.
1) Accessibility - The M&A process requires constant communication between members of the deal team. Technology has made it easier for information sharing and dialogue but nothing will replace the necessity for face to face interaction during the process.
For most sales processes involving companies with an enterprise value below $100 million, having your advisor in close proximity will improve the chances of a successful transaction. The reason is twofold. First and most obvious, is that the investment banking team will be able to quickly attend meetings and address issues that arise in person. It is less likely that an investment banking firm with office half way across the country will attend every meeting when issue come. During the M&A process, issues come up often. The second less obvious reason, is that investment banks with a local presence will, in most cases, work harder to maintain their reputation in the local community and therefore give more attention to deals in their own backyard.
For mid market businesses, a local presence is an important factor in selecting an investment banker, but there are some exceptions. In the case where it is believed that the selling company will garner the attention of many international buyers in a highly competitive auction or is in a very niche industry, the qualification of the investment banking firm may trump the close proximity of the advisor.
2) Deal-makers Experience and Reputation - An investment bank’s reputation is important, but even more important are the reputations of the individuals who will execute the company’s transactions. Look at all of the past deals that the investment banker and their firm has worked on, and review how many of those have successfully closed. Three specific areas to consider when assessing a deal maker’s experience is deal sizes, industry expertise and role played in past transaction.
Choosing an investment banker who has worked on deals of a similar size is important because the size of the deal often implicates different concerns and demands. For example, a $100 million deal will likely have more complexities and challenges than a $5 million deal. A large part of the value an investment banker brings is familiarity with the sales process that your business will be going through.
An investment banker that has industry expertise relevant to your business is also important. The knowledge of industry standards and norms, business contacts and industry-specific valuation will be an advantage in a sales process. An investment banker with connections to logical strategic buyers will obviously help your business must more than someone who doesn’t.
Make sure to understand the role that the investment banker of choice has specifically played in previous deals. Were they the person leading the transaction or were they just part of the supporting cast? A professional who has worked on multiple deals as the leading sell-side investment banker will have a much better understanding of the process than one who has worked on the deal in a supporting role. Also, get information on the commitment of the investment bank with other mandates. If they are working on five other deals that are much larger than yours, it is unlikely your deal will receive the attention it deserves.
3) Chemistry and Trust - Personal chemistry is an important consideration when hiring an investment banker or firm to sell your business. The M&A process is a time consuming and intimate activity. You will spend countless hours with your I-bankers as they prepare your business for sale. You should be comfortable listening to their advice and guidance. If the chemistry is not there from the start, an already stressful process, will just get worse over time.
You, and your team if appropriate, must also have full trust in the person you select. This person will mostly be handling the single largest financial transaction of your life, so pick an investment banker that can properly get the job done. Having confidence in your banker’s negotiating skills and ability to protect your interests throughout the sales process is a must. The last thing you want is to be half way into the process, and questioning the actions taken by your selected investment banker.
4) Adequate Resources - You will need to assess the resources that a prospective investment bank will allocate to your deal. Firms with larger teams may be better able to handle several larger and more complex financial transactions simultaneously. It is still prudent to make sure that that your transaction is not just one of many being executed by the firm. On the other end of the spectrum, an experienced M&A professional at a boutique investment bank can do a lot by themselves and provide a more personal experience. However, you must make sure that they have the resources available to create a dynamic marketing program that maximizes the value of your company and delivers world-class results.
5) Network of Contacts - M&A is still a game of 'who you know’ in addition to 'what you know’. Finding the right buyer is a key piece of the puzzle and therefore it is important to assess how well connected the firm or individual investment banker is to capital source or strategic buyers. Online social networks have closed the gap between connectivity of large international investment banks versus smaller local boutique firms. It is necessary to assess the firm’s ability to source prospective buyers in appropriate industries or regions.
In the instance where logical prospective buyers are in foreign jurisdictions, a regional boutique investment banks with an affiliation in an international alliance of investment banks may be beneficial. In any event, be certain to understand how the investment bank firm intends to find the best prospective buyer for your business and the depth of their networks.
Process for Engaging an Investment BankerHow does a seller find an investment banker in the first place? Just like any other critical purchase for your business, a formal procurement process should be followed. Here is a process to find, evaluate and engage qualified investment banking firms.
Finding Qualified Investment BanksWhen looking for an investment bank to include in the selection process, sellers should use the following sources:
- Research of investment banking firms that have sold companies in their industry.
- Discussion with former owners and CEOs of other companies who sold their businesses.
- Referral from trusted advisors such as lawyers, bankers or accountant.
Initial MeetingThe next step will be an informal meeting with the investment banker. This might be over lunch or at his or her office. Be sure to insist that the meeting is with the individuals who will be directly working on the deal, not assistants or interns. Before discussing details of your business, consider having a confidentiality agreement executed first.
In this initial meeting, evaluate if the investment banker is a fit for you and your business. You will want to find an investment banker you have chemistry with - one who you feel will listen to what you want, and has the experience to deliver on your goals and objectives.
Formal PresentationsAfter the initial meeting with candidates, two or three firms are chosen to give formal presentations to the seller on how they would handle the sale process. In the investment banking industry, this is called a 'beauty contest’.
The presentation detailing the sales approach must include discussions on:
- An estimated range of value of the company to be sold;
- The experience of deal team that will execute the transaction and their roles in the process;
- The firm’s qualifications and details of other similar transactions that they have conducted;
- How they would position the company, including their perception of the seller’s competitive advantages;
- How they would go about marketing the company and sourcing prospective buyers;
- Who they believe the best prospective buyers would be;
- What possible obstacles they see in the sale process; and
- A summary of their fees structure for engagement.
Engagement LetterFinally, the last step in securing an investment banker is to sign an engagement letter. The engagement letter will be the official contract between your business and your newly picked investment banker.
Provisions to pay particular attention to in an engagement letter include:
- Fee structure - how much you will be paying your investment banker;
- Exclusivity - in what situation would your business be allowed to break exclusivity; and
- Contractual "outs" - in what situation can you terminate the relationship.
Investment Banking 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 interests 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.
Retainer FeesInvestment 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. 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. Retainer 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 lesser 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 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 investments bank will not forego the opportunity cost (measured by a success fee) of working on a deal that is unlikely to close. For that reason, on riskier assigned 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 bank 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 FeesSuccess 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 on the completion of the deal. However, the success fees 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 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 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 PercentageA flat percentage may be an appropriate fee structure where negotiating the highest prices is not the primary objective of the seller or in cases where it is 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 on businesses with enterprise value 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 large 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 FeeA scaled fee can be employed to incentivize a banker, as to maximize value in a sales 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 FeeA reverse scaled 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 to give incentive to 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 "reasonable" success fees should be as they varies by industry and region. The most important point for any seller is that success fees are negotiable.
Here are some rules 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%;
- Above $500 million: 0.50% - 1.5%
Critical Terms of Agreement in Investment Banking Engagement LettersFoundational to an engagement agreement are terms setting the scope of the working relationship between an investment banker and the selling company. Here are number of provisions within the engagement letter that need particular attention.
ExclusivityExclusivity is a common in most investment banking sell-side engagements. Without exclusivity, investment bankers are not incentivizes to spend significant time and effort to close transactions, especially on a success fee basis. Also, one lead deal maker overseeing and controlling the process increases the chance of a successful close.
Definition of Transaction ValueSuccess fees are based on some percentage of total transaction value but the definition of the term "total transaction value" should be clearly defined in an engagement letter. All forms of consideration received by the vendor can be included the "transaction value" and applicable to the success fee percentage. The sale of real estate concurrent with the sale of the business is another common inclusion in total transaction value.
Forms of considerations receive that can be subject to a success fee include:
- Excess cash removed from the company prior to a transaction
- Stock of purchaser
- Working capital adjustment
- Assets retained
- "Rolled Over" equity
- Purchaser notes
- Proceeds on the sale of real estate included in the sale of the business
- Earn outs
- Assumption or payment of debt by the purchaser
- The best advice is to have prospective investment bankers walk through a detailed examples of how their fees are calculated based on different scenarios.
Definition of TransactionWhat constitutes a successful transaction where a success fee would be owning? This sounds like a straightforward question but in many instances the initial intended outcome of a sales process can change drastically from the actual achieved result. An example of this might be starting a sales process with the intention of selling 100% of the equity to a strategic buyer and ultimately only selling a portion of the equity to a private equity group.
Or, initially considering a private equity recapitalization and ending up obtaining financing from a bank for a debt recapitalization. The implication is that fees would be significantly lower for debt refinancing than raising equity capital. It is important to define the initial intend transaction and to structure appropriate fee based on the actual final outcome.
Define Engagement ScopeThe engagement letter should clearly define the scope of the engagement. This would include a summary outline significant milestones, deliverables and timelines for completion. A defined scope allows a selling firm to measure if the sales process is on track.
Minimum Fee LevelsRegardless of the success fee structure or percentage most investment banks will have a minimum fee payable if a transaction is consummated. This provision is in place to compensate the banker for their effort in completing a deal that is agreed to and accepted by the selling company. Again, in determining the minimum fee it is important to define what constituted a transaction and it should be a fair compensation for the actual result. This minimum level is often times difficult to determine at the onset of a sales, so all like and unlikely scenario should be considered when negotiating this point.
Break FeesA break fees may be owning to an investment banker were a selling company for any reason elects not to proceed with a transaction they have received and accepted a bona fide offer. The level of the break fee is an arbitrary number but can be as high as 50% of the fee to be earned under bona fide offer.
Tail PeriodA tail period is the time period during which an investment banker working on a company's sale is entitled to payment, even after termination of services, if the deal closes within a specified period (usually 12 to 24 months) with an approved buyer. This prevents potential unfairness to the bankers, who expend time, effort and resources to identify potential buyers, even if they don't seal the final deal.
Some investment bankers will define "approved buyers" as any potential buyers who displays an interest, and is provided with the confidential information memorandum. It would be prudent to restrict tail period payouts to only those cases where the buyers have actually started negotiations for the sale.
The scope of payment and time frame under tail period provisions must be carefully considered. Take an example where an investment banker contacts over 100 parties, and the fee tail period is for three years. If the investment banker is ineffective in selling the business and terminated from the engagement, it is unlikely that another banker will market the business while that fee tail provision is still in effect. So you will be stuck for many years without being able to sell your company.
Termination ProvisionsThe engagement letter should explicitly outline the rights of termination of the investment bank. It is typical for the investment bank or the client to be able to terminate the engagement with advance notice, with or without cause. Some engagement letters will provide for automatic termination at end of specified period (usually a year) unless the parties agree to extend the mandate. If termination is due to breaches by the investment bank, withdrawal of a specified banker from the engagement team or unilateral termination by the investment bank, then the tail period provision should be nullified.
Payment TermsInvestment banks typically seek to have success fees paid in cash at the time the transaction is consummated. Regarding contingent payments such as earn-outs, the value and timing of this type of consideration is in uncertain, so determining an applicable success fee is difficult.
Selling companies on the other hand generally seek to pay the investment bank with respect to deferred or contingent payments only if and when the company actually receive the related consideration.