How to Write the Investment Banking Engagement Letter

Kateri Zhu | June 25, 2014

The engagement letter is without contest the most important agreement between your company and the investment banker.

It sets the stage for sellside processes, acquisitions, mergers, debt financings, and equity financings. It has an overwhelming effect on the quality and depth of the investment banker’s duties to the client. It outlines the terms and scope of the advisory services provided. It rigorously details the economic points that go to the heart of the relationship.

When negotiated and structured properly, this contract can be remarkably powerful in aligning the investment banker’s interests with yours. High degrees of alignment will productively incentivize the banker to close a deal for you, with the optimal valuation and terms.

However, to successfully negotiate this agreement, it’s imperative that executives understand the perspective of the investment banker and the specific motives that will encourage a top notch transaction outcome.

Here are the seven most decisive points to cover in your agreement.

1.  Fee Structure

Investment bankers will typically divide your advisory charges into two functionally divergent groups: a (1) non-refundable deposit or retainer, and a (2) success fee.

The retainer is usually a flat fee. While it’s sometimes paid out at the beginning of the engagement, it’s usually paid on a regular basis over the length of the mandate. The most common schedule is payout on a monthly basis.

While it’s not directly linked to the completion of your transaction, paying a mutually agreed upon retainer is pretty standard and it demonstrates your level of commitment to the sale process. Similarly, the investment banker should be putting a significant amount of work into preparing your company for sale and should correspondingly be compensated for his efforts as the work is completed.

However, the success fee — and not the retainer — should always be the most significant component of the total compensation. This gives both parties the best motives for an optimal outcome.

The success fee is usually paid out at deal close. It’s based primarily on three things: (a) deal type (e.g., buyside acquisition, sellside process, financing, etc.), (b) the type of ownership sold (e.g., equity, senior debt, mezzanine debt, etc.) and (c) transaction value. It’s often expressed as a percentage of the total transaction value and can also include a progressive pricing schedule. In other words, above a certain agreed-upon price threshold, the success fee percentage calculated off the transaction value will rise incrementally with price.

A progressive schedule is an effective way to design a strong incentive for the banker to help you realize a valuation that exceeds your goals.

2.  Exclusivity

Giving exclusivity to an investment banker can be a daunting proposition.

Naturally when you mandate an advisor and his or her team fails to meet expectations, it’s a tremendous setback with respect to time and financial resources. Moreover, reaching your goal of a closed deal has been likewise delayed. And finally, when or if you go back to market — presumably with a different banker — the fact you were already out in the market and could not get a deal done could negatively impact investors’ views of your company.

However, nearly all qualified investment bankers will require exclusivity. Why? Because a good banker is going to be putting a significant amount of thought, time, and effort into preparing your team and your offering materials to go to market. The sale process will span several months and can result in a number of divergent outcomes. The retainer, as discussed, should be a small portion of their compensation and unfortunately, is also rarely sufficient to cover the amount of time a solid banker will invest in your deal process. High quality and trusted investment bankers take each mandate seriously and dedicate themselves to closing a successful transaction. How much of their time and energy would they be willing to risk if they’re not your exclusive advisor?

Moreover, deal processes generally run better with one lead person or firm handling all buyer communication and negotiations. Fewer cooks in the dealmaking-kitchen typically correlates with smoother, more focused, more expedient, and ultimately more effective transaction processes.

Nonetheless, during your banker selection and negotiation process you’ll certainly have the option to deny exclusivity to a banker. Simply note that the choice against giving exclusivity may limit your ability to get a top investment banker in your corner.

3.  Length

The term length specifies how long the engagement — and therefore the accompanying exclusivity — lasts.

A six to a twelve month term is pretty standard. This allows time for your banker to position the company, send out teasers to potential buyers, prepare the confidential information memorandum, solicit interest, get disclosure agreements signed, coordinate with buyers during their due diligence processes, receive offers, and negotiate a deal.

However standard length aside, the engagement term you negotiate should be driven by two things: (a) how much time your advisor needs to close your specific deal and (b) how long you can be reasonably bound to an exclusive relationship with that advisory team.

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4.  Termination

Moreover, your letter should explicitly outline the rights of termination after the term of mandate. Generally speaking, most agreements are drafted to automatically renew on a monthly basis until canceled, in writing, by either you or the banker.

5.  Tail Period

The tail period is also a standard feature of engagement letters.

A tail is a length of time after the official term during which a transaction close would still result in advisor compensation. Typically, the tail period will be twenty four months. It’s in the interest of the client to seek a shorter rather than longer tail period.

Tail periods are overwhelmingly common. This is primarily because deal processes are (a) frequently delayed for a variety of reasons and (b) dependent on a number of players. It would be reasonable to compensate your banker, subject to some time constraint, should the ultimate buyer be someone who was introduced by his or her team. For example, if a seller and investor are connected by the intermediary and begin negotiations, undertake diligence, but fail to finalize a purchase agreement during the official term, the intermediary should nonetheless be given credit when they close a deal nine months later.

Therefore, the fundamental purpose of the tail is to make sure that the advisory team is compensated for their work when a deal is started, but not consummated, within the mandate term. Moreover, the tail also precludes a client from terminating an engagement immediately prior to deal close in order to dodge the majority of the advisory fee.

All this said, there are a number of reasons why a deal unrelated to your advisor’s efforts can likewise close after the official term. For example, if a buyer emerges two years later as a direct result of your efforts or the efforts of another intermediary, it would be unreasonable to pay the original investment banker. As a result, clients will add safeguards to the tail provision in order to limit it to its intended purpose.

The most common safeguard is a requirement that the tail apply only to deals with an investor or buyer that was connected by the intermediary to the client during the official mandate term. Definitions of “connected” can differ across mandates, but you should minimally negotiate to restrict the pool of buyers triggering payment during the tail to those counterparties who received information from your advisor, expressed an interest, and signed a confidentiality agreement.

6.  Expenses

Your banker will always incur reimbursable out-of-pocket expenses such as travel, research and material preparation during the sale process. Most engagement letters will explicitly dictate that the client will cover any expenses incurred by the advisor in the performance of its services.

Nonetheless, it’s in your interest to draft the letter such that you maintain the ability to exercise some reasonable control over these expenses.

For example, clients frequently request that the banker provide a monthly report outlining the expenses incurred by his or her team. Additionally, its standard to place a ceiling on the dollar sum of reimbursable expenses, barring pre-approved exceptions in excess of said ceiling. Moreover, it’s not uncommon to limit reimbursable expenses to external, third-party, out-of-pocket costs. And finally, the agreement should explicitly indicate that violations of these provisions will result in the expenses not being reimbursable.

7.  Coverage

A sale process can result in a wide range of outcomes, from selling only a portion of the company for a minority equity position, to raising mezzanine debt, to launching a strategic joint venture. Consequently, it’s important that the scope of services provided and covered transactions are well defined.

This provision will mitigate the probability that certain deals are not unintentionally roped into the confines of your contract or subject to inappropriate fee structures. For example, ultimately raising mezzanine capital may be a great outcome for you. However, the fees due to a banker for raising mezzanine capital are usually significantly lower than raising a comparable quantity of equity capital.

Your primary goal in negotiating the engagement coverage should be to (a) balance a well defined scope of engagement while (b) concurrently maximizing the services of the investment banker to explore all possible outcomes that will satisfy your goals.

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