A company looking to sell its business will often
engage an investment banker to assist in the process. Such a firm can be an
invaluable asset to a prospective seller, assisting the company in preparing
for sale, providing a rolodex of suitable buyers, helping negotiate the terms
of the deal and facilitating the transaction all the way to a close. The right
investment banking firm can help a company sell its business for substantially
more than it otherwise would have.

Before an investment banker will engage with a selling
company, however, it will require a written agreement setting forth material
terms such as the scope of the investment banker’s engagement, the term of the
engagement and the compensation it will receive. Negotiating the key terms of
this engagement agreement is important for the selling company, as it will
dictate the range of services the investment banker will provide and be
compensated for, how and when it will be paid, and the types of transactions
for which the investment banker will be paid even after the engagement has
terminated. We discuss each of these issues below.

With regard to the scope of engagement, it is
important not only to mutually determine what the investment banker will do for
the company, but also what the investment banker will not do. The “Transaction”
for which the investment banker will be entitled to fees must be precisely
defined so that the investment banker cannot claim a fee for a transaction
where it did not provide services. For example, if the engagement is for the
sale of the company’s equity or assets, then the investment banker should not
be able to claim any fees for a debt financing the company arranges itself in
the interim. But a broad definition of “Transaction” could lead to such result.

The term of the engagement will also be addressed in
the agreement. The investment banker will require exclusivity in just about all
cases, as it will not want to compete with other firms to sell the company. A
term of one year is fairly standard, with investment bankers preferring to have
sufficient time to locate a buyer and process the transaction. And we will
discuss later in this post the protections in the engagement agreement for the
investment banker in the event a deal it has brough to the table does not close
by the end of the term.

Next, the compensation owing to the investment banker
will also be addressed. Two main components of this compensation are a retainer
and an overall success or transaction fee. Many investment bankers require a
retainer for the engagement, which is a non-refundable fee paid at the outset
of the engagement. The selling company should try to negotiate the retainer out
of the engagement completely if it can, and if that can’t be done, the retainer
should be a minimal part of the overall contemplated compensation, as well as
being creditable against the success fee.

The success fee is generally a percentage of the
purchase price of the company. The range of percentage charged for a success
fee can vary greatly based on deal size, so it is important to confer with an
attorney or other adviser with knowledge of the industry to ensure the fee
listed in the engagement agreement is commercially reasonable. The investment
banker may also seek to impose a minimum success or transaction fee, which
guarantees a floor on payment to the investment banker at close of sale
regardless of the sale price. Any minimum fee is obviously not desirable for a
seller, as it imposes an obligation to potentially pay significantly more to
the investment banker than the purchase price would otherwise dictate. The
company can push back on this with a logical argument the investment banker’s
sales pitch will lend some support to, namely, “If we’re such a great company,
as you’ve been telling us, and you’re so good at your job, why do you need to
charge a minimum fee?” The investment banker’s rebuttal is likely, among other
things, that they cannot control what happens to the company between time of
engagement and time of sale, and the minimum serves as downside protection in
the event due diligence or other matters result in sale at a lower price than
the parties anticipated. If the company is to agree to any such fee, it should
have a high degree of confidence about the purchase price it can obtain. The seller
should also use language giving it broad discretion to choose not to do a deal
in the event the only offer obtained is prohibitively low.

Another important component of the investment banker’s
compensation is its fee on any contingent compensation owing on a deal. If
there is money to be paid after the closing, which can include a return of
money escrowed for indemnity claims, an earnout to be paid, or payments
pursuant to a seller note, the investment banker will want to include that in
its fee. Although doing so makes some logical sense, as post-closing payments
are part of the overall compensation to the selling shareholders, a seller will
want to ensure it has no obligation to make payment until actual receipt of any
contingent monies.

Some investment bankers will use language in their
engagement agreements imposing an obligation on the sellers to pay at closing a
fee on all contingent compensation that may be owing after closing. But doing
so imposes obligations on the sellers to pay: (1) before they ever receive the
money, and (2) the full amount of the contingent compensation, which may never be
realized. As to the last point, say a buyer makes an indemnity claim, and the
escrow amount is reduced by $2,000,000 as a result. If the investment banker
fee is 3%, the seller will have paid $60,000 in investment banking fees on
money it never actually received. For this reason, negotiating terms that
contingent payments will be paid promptly after the money is received, and only
to the extent that contingent payments are actually received, can prevent a
seller from having to make premature and excessive payments.

Finally, the engagement agreement will address what
fees may be owing to the investment banker for a transaction that closes after
the engagement agreement is terminated. This is often referred to as a “tail
period” for the engagement. Here, the investment banker is seeking to ensure
the seller does not attempt to either stall a transaction until after the term,
or pretend not to be interested in a prospective purchaser introduced by the
investment banker, only to contact that prospective purchaser after termination
to consummate a deal.

In general, a one-year tail period is acceptable to cover
the consummation of a deal with a prospective purchaser the firm has introduced
to the seller. Careful attention will have to be paid to this clause, however,
to preclude the investment banker from casting too wide a net here – for
instance, by defining a sale giving rise to its fee to include a deal with any
buyer during the tail period, even if that buyer was never introduced to the
seller by the investment banker.

The investment banking relationship can definitely be
a beneficial one for a selling company, but given that the sale of a business
is the single most important transaction the company will ever have, it makes
sense to review all agreements material to that sale carefully to ensure appropriate
safeguards are in place.

Jeffrey Petersen

This post is for informational purposes
only and does not constitute legal advice.