The investment banking engagement letter is the official representation of your company’s relationship with your M&A advisor or investment bank, and as such should be carefully considered. The process of negotiating the letter can also provide helpful insight into a prospective bank’s priorities and operations, and reveal how well your interests are aligned. Even if your company’s legal counsel is handling negotiations, it’s important to understand the key points of the agreement and how they do (or do not) represent the interests of your business.
Here are six of the most important aspects of the investment banking engagement letter to keep in mind as you begin negotiations.
1. Scope of Services
What role is the investment banker serving, and what’s the end goal of the engagement? A financing transaction? A purchase? Both? Stating this in the engagement letter ensures that each sides’ goals are aligned both with one another and with the proposed fee structure.
The investment bank will typically detail a list of included services in this section of the engagement letter. Some of these might be obvious and apply across almost every engagement (e.g., reviewing financials, soliciting financial partners and/or acquirers), while others will vary depending on the bank and the company’s needs (e.g., developing marketing materials, providing valuation services).
It’s not uncommon for owners to balk at the exclusivity clauses in the investment banking engagement letter. Even if you do all the research in the world, it’s hard to commit to entrusting one advisory firm with your business. However, the truth is that it can be very hard to find a high-quality M&A advisor or investment banker without agreeing to exclusivity. From the advisor’s perspective, a retainer isn’t enough to justify the many hours of work they’ll spend preparing your business for a sale or financing. Consider, too, that managing multiple investment banks would be an onerous undertaking for you as the business owner, and could result in a lot of confusion and uncertainty.
When negotiating engagement letters, then, the question is often not whether to grant exclusivity to a bank, but rather for how long. Typically, the bank will advocate for longer exclusivity periods and the seller will want shorter periods. Six months to a year is fairly standard in most cases, but the period can vary depending on the complexity of the transaction, how much preparation the business needs before going to market, and other factors.
3. Tail Period
The tail period is one very important aspect of the exclusivity period to keep in mind during negotiations. Even if a transaction is not completed during the terms of the engagement, the investment bank will still be entitled to its fees if the transaction happens during this tail period. Twenty-four months is a fairly standard tail period, though in general clients will look to establish a shorter tail period while investment banks advocate for a longer one.
The purpose of the tail period is to protect an investment bank from losing out on fees if they begin a transaction process during the engagement period, but the transaction is closed after the end date. Deal processes rarely run without delays and factors outside of the banker’s control can frequently impact the timing.
It is important to keep in mind, however, that there are also a number of potential circumstances in which a deal might close during this tail period not as a result of an investment bank’s efforts. When negotiating the investment banking engagement letter, it’s important to add safeguards to the tail provision to make sure you don’t owe the bank fees for transactions that did not originate from their efforts. One common safeguard is that the tail will only apply to deals with buyers or investors whom the investment banker contacted during the exclusivity period. Another is that no fees will be due if the client terminates the agreement for cause prior to the transaction.
In most investment banking engagements, there are two main types of fees: a retainer and a success fee. The retainer fee is a flat amount, often paid out monthly during the term of the engagement (though the structure varies — some clients may pay it out in full at the beginning). Retainers “typically start at $50,000 and go up depending on the size of a potential transaction,” notes Brent Beshore in his book, The Messy Marketplace: Selling Your Business in a World of Imperfect Buyers.
The success fee, as the name indicates, is directly tied to the success of your transaction — providing an incentive for both sides to work together to achieve a positive outcome. This fee usually comes as a percentage of a completed transaction. The amount depends on a number of factors, including the deal type, type of ownership, and transaction value. “On smaller deals, the success fee may be a flat percentage — usually 6 to 12 percent — of the transaction,” notes Beshore. “On large deals (over $50 million), that flat percentage can drop to as low as 1.5%. The workload required by an intermediary to close a deal does not differ tremendously based on the size of the transaction, and can actually be less work for larger companies considering the increased access to resources.”
In some cases, there will be other fees involved — e.g., a fee triggered upon the signing of a term sheet or announcement of a transaction. In general, companies should try to avoid any fees triggered by agreements like LOIs or any other non-binding term sheets, as deals can and will fall apart after these stages.
Typically, the client will cover reasonable expenses an advisor incurs while representing a company — e.g., travel, research, and more. During negotiations, however, companies should be sure that there are no undue expectations. Clients will typically place a cap on the amount of expenses that will be reimbursed and require pre-approval for any expenses above that limit. Limiting expenses to third-party costs is also common — meaning that, for example, an investment bank can’t charge you for the cost of secretarial staff at their firm.
Indemnification, or compensation for damage or losses, is another factor to consider in the investment banking engagement letter. In general, “the engagement letter will provide for very broad indemnification of the banker,” notes Forbes. A common caveat is that no indemnification is required “if the damage primarily resulted from the bad faith, gross negligence, willful misconduct, or material breach of the engagement letter by the banker.” When negotiating indemnification claims, the client should make sure that the investment bank is required to notify them in a timely manner of any indemnification claims.