How to Structure the Right Investment Banking Engagement Letter
What provisions do you need to be wary of when doing up an engagement letter with your investment bank?
Whether you're looking raise capital or to divest your present business, chances are you are going to be working with investment bankers to make this a reality. They are more connected and better trained than the average business owner for just this purpose. But do you know what you should be including in your engagement letters to ensure you're getting exactly what you want out of the deal?
Foundational to an engagement agreement are terms setting the scope of the working relationship between an investment banker and the selling company. Here are a number of provisions within the engagement letter that need particular attention.
Exclusivity is common in most investment banking sell-side engagements. Without exclusivity, investment bankers are not incentivized 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 Value
Success fees are based on some percentage of total transaction value, but the term "total transaction value" should be clearly defined in an engagement letter. All forms of consideration received by the vendor can be included in 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 received 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 detailed examples of how their fees are calculated based on different scenarios.
Definition of Transaction
What 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 sale process changes drastically from the actual achieved result. An example of this might be starting a sale 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, as another example, 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 intended transaction and to structure appropriate fees based on the actual final outcome.
Define Engagement Scope
The engagement letter should clearly define the scope of the engagement. This would include a summary outline of significant milestones, deliverables and timelines for completion. A defined scope allows a selling firm to measure if the sale process is on track.
Minimum Fee Levels
Regardless 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 difficult to determine at the onset of a sale, so all likely and unlikely scenarios should be considered when negotiating this point.
A break fee may be owing to an investment banker where a selling company, for any reason, elects not to proceed with a transaction, even if 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 a bona fide offer.
A 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 buyer who displays an interest and who 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 is 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 hire another investment banker to sell your company.
The 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 the end of a 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.
Investment 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 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 receives the related consideration.
Disbursement and Expenses
Investment banks may sometimes request that their clients reimburse for reasonable expenses related to the engagement. Such expenses can cover items varying from dinners with potential bidders to marketing expenses, all of which could help increase the enterprise value of your business. In agreeing to this, a business owner should make sure to set limitations on the kinds of expenses that can be reimbursed. For example, a business owner can place a cap on expenses, limit airfare to economy class or require pre-approval on larger-item reimbursements.
Negotiating a Fee Structure
At the end of the day, your fee structure is between you and your banker. How you allocate the costs between upfront costs, success fees and expenses could signal to the investment banker what is important to you in selling your business. Creating the right incentives through the fee structure is oftentimes the most straightforward way to ensure your investment banker’s interests are aligned with yours.
You may already know why you should hire an investment banker, but perhaps you hadn't thought about the exact wording of the agreement. You should now have a far better idea of the types of terms you need to nail down before engaging an investment banker to handle your business dealings.