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.
Things To Lookout For In The Scope Of Engagement
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.
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.
What is a 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.
What is a 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.
What does the engagement agreement address?
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.