M&A Investment Bank Engagement Letters
The investment bank engagement letter is often overlooked by companies eager to get started on the deal process. The letter memorializes the relationship between a company and an investment banker as it relates to the potential sale of that company. A well-drafted engagement letter, among other things, clarifies the scope of the transaction, the specific services provided by the investment bank and the specific circumstances in which the investment bank receives its fee.
The letter itself outlines the terms of the relationship between the company and the investment bank with key terms such as:
Banking Team
Often the senior bankers who represent the bank when pitching their team to the company are not actively participating in the transaction after the company engages their team for the deal. Although investment banks typically structure their services with a bottom-up approach, the senior bankers should be involved in the deal in some capacity, especially after they pitched their experience and knowledge to engage the company. The company should include language in the engagement letter that requires the senior bankers to have their hands on the deal or at least be supervising what is going on.
Drafting Tip: Require weekly, bi-weekly or monthly reports from the more senior bankers on the status of the deal. This will drive involvement from the key individuals who the company wants involved.
Scope of Services
Every engagement letter includes standard services, such as valuing the company and negotiating the financial aspects of a transaction. However, services can vary depending on company needs, the type of transaction and the type of investment bank. Companies should take special care in determining what services are needed from the investment bank and any related compensation to be paid for such services, if any, otherwise they risk paying for services they do not require.
Drafting Tip: Investment banks tend to define the scope of the engagement broadly, so they can charge fees for a variety of outcomes. For example, an investment bank may define a “transaction” as any transaction in which the sellers or the company receive any proceeds, including a financing as opposed to a sale. A broadly defined scope such as this leaves the client susceptible to paying intended fees. A carefully drafted engagement letter will specify exactly what the scope of the transaction is and for what the investment bank will be paid.
Fees
An investment banking engagement letter may include three forms of fees: (1) the retainer fee; (2) the transaction fee; and (3) any expense reimbursements.
The Retainer
A retainer is an upfront fee payable to the investment bank before any services have been performed as a means to retain the investment bank for its future services. Clients should resist the retainer as it may reduce the sense of urgency around a transaction and is compensation that is not tied to performance. However, if there will be a retainer, it should not increase the cost of success.
Drafting Tip: Place a cap on reimbursement and require the company’s written consent for any amount above that cap.
Tail Obligations
A “tail” obligation requires the company to pay a fee to the banker after the termination of the engagement letter if a transaction occurs within the tail period. The tail period is that period of time following termination that provides the investment bank with the right to receive its transaction fee if the client enters into a transaction with a buyer. Tail obligations aim to compensate investment banks for services performed or introductions made that provided value after the termination of the engagement letter.
Drafting Tip: Clients should narrow the tail period (1) by time; (2) by class of buyer; and (3) by closed transactions.
Draft the engagement letter to make the tail period as short as possible. Investment banks may attempt to include a tail period that lasts up to two years, but clients should push back on this. Next, only allow the tail obligation to apply where the investment bank introduced the company to the buyer through an executed non-disclosure agreement. If the tail applies to any buyer, then the investment bank could be compensated for providing no value to the transaction. Tails should also not apply if the investment bank was terminated for cause.
Term and Termination
Generally, the term of an engagement letter should be no greater than six months, with an automatic expiration at the end of the specified time frame, which is when the tail would begin.
The engagement letter should be terminable by either party upon providing 30-days written notice to the other party. If the company terminates without cause, the tail then applies, but if the banker terminates, or the company terminates for cause, then the investment bank should not be entitled to any tail fees.
Conclusion
The letter itself outlines the terms of the relationship between the company and the investment bank with key terms such as:
1. Banking Team
2. Scope of Services
3. Fees
4. Tail Obligations
5. Terms and Termination
2. Scope of Services
3. Fees
4. Tail Obligations
5. Terms and Termination
Banking Team
Often the senior bankers who represent the bank when pitching their team to the company are not actively participating in the transaction after the company engages their team for the deal. Although investment banks typically structure their services with a bottom-up approach, the senior bankers should be involved in the deal in some capacity, especially after they pitched their experience and knowledge to engage the company. The company should include language in the engagement letter that requires the senior bankers to have their hands on the deal or at least be supervising what is going on.
Drafting Tip: Require weekly, bi-weekly or monthly reports from the more senior bankers on the status of the deal. This will drive involvement from the key individuals who the company wants involved.
Scope of Services
Every engagement letter includes standard services, such as valuing the company and negotiating the financial aspects of a transaction. However, services can vary depending on company needs, the type of transaction and the type of investment bank. Companies should take special care in determining what services are needed from the investment bank and any related compensation to be paid for such services, if any, otherwise they risk paying for services they do not require.
Drafting Tip: Investment banks tend to define the scope of the engagement broadly, so they can charge fees for a variety of outcomes. For example, an investment bank may define a “transaction” as any transaction in which the sellers or the company receive any proceeds, including a financing as opposed to a sale. A broadly defined scope such as this leaves the client susceptible to paying intended fees. A carefully drafted engagement letter will specify exactly what the scope of the transaction is and for what the investment bank will be paid.
Fees
An investment banking engagement letter may include three forms of fees: (1) the retainer fee; (2) the transaction fee; and (3) any expense reimbursements.
The Retainer
A retainer is an upfront fee payable to the investment bank before any services have been performed as a means to retain the investment bank for its future services. Clients should resist the retainer as it may reduce the sense of urgency around a transaction and is compensation that is not tied to performance. However, if there will be a retainer, it should not increase the cost of success.
Drafting Tip: If the retainer is unavoidable, clients should request paying the fee over several months and require that such fee be credited against the transaction fee.
Transaction Fee
A “transaction fee” is a payment made by the client to the investment bank upon completion of a successful transaction and is usually calculated as a certain percentage of the overall transaction value. The transaction fee is the largest part of an investment bank’s compensation and may be heavily negotiated. The amount of the transaction fee will range from deal to deal, with the variability dependent on the parties involved, the deal size, and other factors.
A “transaction fee” is a payment made by the client to the investment bank upon completion of a successful transaction and is usually calculated as a certain percentage of the overall transaction value. The transaction fee is the largest part of an investment bank’s compensation and may be heavily negotiated. The amount of the transaction fee will range from deal to deal, with the variability dependent on the parties involved, the deal size, and other factors.
Drafting Tip: It is important to focus on the definition of transaction value because the total fee is generally based on that term. Be sure that the transaction value excludes any consideration attributable to cash or cash equivalents held by the company.
Minimum Fee
Sometimes an engagement letter will include a “floor” or minimum fee that must be paid regardless of the transaction. A minimum fee should be avoided if possible, but if one is unavoidable, then it should be reasonable in light of the transaction value.
Sometimes an engagement letter will include a “floor” or minimum fee that must be paid regardless of the transaction. A minimum fee should be avoided if possible, but if one is unavoidable, then it should be reasonable in light of the transaction value.
Reverse Lehman Formula
One common fee structure is a grid or scaled percentage structure (sometimes referred to as the “Reverse Lehman” formula), which applies an increasing percentage fee depending on the size of the transaction. For example, a company may agree to pay 1% of the total deal value up to $200,000, 2% of the total deal value over $200,000 but below 300,000 and 3% of the total deal value over $300,000. This makes sense because clients should be willing to pay a higher transaction fee for a superior result. Multiple tiers of increasingly higher fees may also incentivize a banker to achieve a greater fee.
Think critically about what transaction price will lead to a higher percentage fee when implementing a Reverse Lehman formula. The highest percentage should apply to a transaction price significantly above expectation to compensate and incentive the investment bank for providing above expectation services.
The lowest percentage should apply to a transaction price at or slightly above expectation, especially in a frothy market where finding buyers is much easier. When considering the lower end of the Reverse Lehman formula, be sure to compare the minimum fee, if any, so that the investment banker is not disincentivized from achieving a higher transaction price due to a comparitively high minimum fee.
One common fee structure is a grid or scaled percentage structure (sometimes referred to as the “Reverse Lehman” formula), which applies an increasing percentage fee depending on the size of the transaction. For example, a company may agree to pay 1% of the total deal value up to $200,000, 2% of the total deal value over $200,000 but below 300,000 and 3% of the total deal value over $300,000. This makes sense because clients should be willing to pay a higher transaction fee for a superior result. Multiple tiers of increasingly higher fees may also incentivize a banker to achieve a greater fee.
Think critically about what transaction price will lead to a higher percentage fee when implementing a Reverse Lehman formula. The highest percentage should apply to a transaction price significantly above expectation to compensate and incentive the investment bank for providing above expectation services.
The lowest percentage should apply to a transaction price at or slightly above expectation, especially in a frothy market where finding buyers is much easier. When considering the lower end of the Reverse Lehman formula, be sure to compare the minimum fee, if any, so that the investment banker is not disincentivized from achieving a higher transaction price due to a comparitively high minimum fee.
Drafting Tip: Two general concepts to implement are: (1) the lower the transaction value, the smaller the percentage fee should be and (2) the fee should be lower if the banker did not procure the buyer. The company should list potential buyers that it has begun discussions with prior to engaging the investment bank as carved out of the transaction fee or qualify for a reduced fee.
Expenses Reimbursement
Engagement letters typically require clients to reimburse investment banks for their expenses. Careful drafting can save a client from paying for an investment banker’s expenses that should be excluded. The engagement letter should limit any reimbursement for expenses to reasonable and necessary expenses incurred by the banker. It should require the banker to document all expenses with third-party receipts and apply any discounts, or volume purchases available, to the investment bank. No payment should be made in connection with legal fees incurred by the banker when negotiating the engagement letter.
Engagement letters typically require clients to reimburse investment banks for their expenses. Careful drafting can save a client from paying for an investment banker’s expenses that should be excluded. The engagement letter should limit any reimbursement for expenses to reasonable and necessary expenses incurred by the banker. It should require the banker to document all expenses with third-party receipts and apply any discounts, or volume purchases available, to the investment bank. No payment should be made in connection with legal fees incurred by the banker when negotiating the engagement letter.
Drafting Tip: Place a cap on reimbursement and require the company’s written consent for any amount above that cap.
Tail Obligations
A “tail” obligation requires the company to pay a fee to the banker after the termination of the engagement letter if a transaction occurs within the tail period. The tail period is that period of time following termination that provides the investment bank with the right to receive its transaction fee if the client enters into a transaction with a buyer. Tail obligations aim to compensate investment banks for services performed or introductions made that provided value after the termination of the engagement letter.
Drafting Tip: Clients should narrow the tail period (1) by time; (2) by class of buyer; and (3) by closed transactions.
Draft the engagement letter to make the tail period as short as possible. Investment banks may attempt to include a tail period that lasts up to two years, but clients should push back on this. Next, only allow the tail obligation to apply where the investment bank introduced the company to the buyer through an executed non-disclosure agreement. If the tail applies to any buyer, then the investment bank could be compensated for providing no value to the transaction. Tails should also not apply if the investment bank was terminated for cause.
Generally, the term of an engagement letter should be no greater than six months, with an automatic expiration at the end of the specified time frame, which is when the tail would begin.
The engagement letter should be terminable by either party upon providing 30-days written notice to the other party. If the company terminates without cause, the tail then applies, but if the banker terminates, or the company terminates for cause, then the investment bank should not be entitled to any tail fees.
Conclusion
With these concepts you can directly provide value to your client even before the deal has started.
Kit Ryan is an associate located in Pillsbury's San Diego office.