Investment banking is a sophisticated and exclusive field, so it’s little wonder its innerworkings are hard to grasp. Pair the lack of clarity with the high stakes, and many business owners are tentative when engaging advisors.
While investment banking services don’t come cheap, an experienced and well-connected advisor can be a godsend when raising capital or selling your company. The value a shrewd banker adds to the outcome far eclipses the cost. That being said, it can be hard to weigh the costs and benefits without understanding how fees are calculated.
Though most fees and fee structures will be negotiated between the business owner and advisor on a deal by deal basis, there are a few terms to consider. Each can have a significant impact on the effectiveness of the advisor and potential outcomes during the deal.
Understanding Banking Fees
The fees in an M&A or capital raise process are structured to help smooth out the conflicts that can arise when a company is being advised by an investment banker. Bankers or advisors are often in a conflicted situation where, if the fees aren’t structured well, it’s better for them to sell a company for less money more quickly. That way they can move on to the next deal and make another fee. While it might be in your interest to get maximum value for your company, and waiting 6 more months for a better offer is no big deal, a bank has to keep the lights on and their advisory running.
Ensuring that a bank will push for the right outcome for your company comes down to getting the fees right. Banks, like everyone else, are driven by incentives. By ensuring the incentives in the fee structure are aligned with the your expectations will help drive the deal to the right result. Often that means that as a business, you’ll have to decide whether you want a deal closed faster or for more money. The choice can have a significant impact on which banker to use and how to structure the fees. Well structured fees facilitate successful outcomes.
Nearly every banker structures their fees as some combination of a retainer and success fees. The split between retainer and fee, along with how the success fee is structured, has the biggest impact on banker incentives. Understanding each can help you decide how to negotiate fees as you work with advisors.
The retainer is the fee paid just to have an investment bank work on your transaction. It is non-refundable and paid in monthly installments or upfront as a lump sum. They tend to be highly negotiable: Bankers might waive a retainer for a surefire deal, while riskier projects could carry a steeper charge. This ensures that the advisor isn’t left empty-handed if the deal flatlines.
The good news, though, is that money spent on retainer is usually credited against the success fee when the deal closes.
In general, retainers for larger transactions are usually north of $100,000, or range from $50,000-75,000 for a $20-$30 million deal, according to Basil Peters of Strategic Exits Corp.
Think hard about the riskiness of the company compared to the retainer being changed. Banks that charge a large upfront retainer but shrimpy success fees won’t be strongly motivated to get a deal done, while those that tout a success-only model probably do not close a greater percentage of deals, just a greater number.
Success Fees: Lehman Style
The bulk of a banker’s pay comes from the success fee. And how is the success fee calculated? Again, the percentages and terms vary on a case-by-case basis, depending on the size and complexity of the deal, the nature of the transaction (equity raises are a bigger lift) and final outcome, among other considerations.
Starting in the ’70s and ’80s, success fees were based on the Lehman Formula. Originally applied to financing engagements, formula was made famous as a template for M&A transactions. In a nutshell, Lehman is a 5-4-3-2-1 structure: 5 percent of the first million dollars, 4 on the next million, and so on, scaling down to 1 percent.
Today the formula is still a popular way of structuring success fees, though inflation has made the traditional numbers unworkable. Instead the Double Lehman scale is more prevalent: 10 percent of the first million dollars, 8 percent of the second, 6 of the third, 4 of fourth and 2 of everything thereafter. Variations on the structure have also become more common, tailored to each deal. The Modified Lehman scale takes 2 percent of the first $10 million and a lesser percentage of the balance.
Success Fees: Non-Lehman
Though variations of the Lehman Formula are still very popular, different structures are starting to be used by different firms. In particular, rather than reducing fees as a deal gets bigger, some firms actually increase their fees as they generate a higher sales price.
“Many would argue that the most sensible formula is one where the percentage of the consideration increases the higher the selling price, thereby providing a better incentive to maximize price and not recommend the easy deal,” M&A expert Edwin Miller, Jr., writes.
Escalating success fees above certain benchmarks is one way to incentivize bankers towards larger outcomes — i.e. 1.25 percent of first $100 million of value, 1.5 percent on value between $101 and $125 million, 2 percent thereafter. But regardless of the scale, the logic behind compensation is to incentivize the banker to do his or her job. That means resisting the quick solution and driving towards superior terms.
In terms of strict success fees, the biggest deals aren’t always the most expensive. Often larger deals, while somewhat risky, can be completed more easily than mid-market deals. Mid-size exit transactions often carry higher percentages because the deals are trickier to finesse, involving fewer and less experienced buyers.
Other Fees and Expenses
It may seem obvious, but it is worth noting that fees are determined by the value of the deal, not the proceeds to the seller. That is, bank debt or other liabilities may reduce the seller’s payout but not the fee base.
And timing is another issue. Bankers often want to be paid at closing, which is reasonable in connection with a cash sale. However it gets more complicated, and more negotiable, when deals involve different financing components, like deferred payments, capital adjustments and promissory notes.
Aside from retainer and success fees, targets will have to reimburse the banker for deal-related expenses, like travel, which on a large transaction can become significant.
Deal-making discourages transparency, but it never hurts to simply ask the banker how fees were structured for comparable deals. It might reveal much, especially if the transactions involved private companies, but even general outlines make the process less inscrutable.