Navigating Your Way Through An Investment Bank Engagement Letter
Navidar | May 25, 2022
Congratulations! You have done everything right. You have grown your company successfully. You have decided to sell the business that you and your team have built over the years. You formed a good working relationship with your investment banker long before deciding to sell your company. (See more about forming a banker relationship here.) You have selected the investment banker whom you want to work with on your transaction.
Now that these steps are behind you, the next step in the process is to formalize your working relationship with your investment banker. This is done using an engagement letter, which is the contract between your company and the investment banking firm that specifies, among other things, the services to be provided, fees to be paid, and various other responsibilities and commitments. Because this contract is important and because we have seen a far broader range of comments on major issues in the engagement letter working with middle market technology clients at Navidar than we did earlier in our careers at Goldman Sachs and Morgan Stanley, we thought that a discussion of several main issues would be useful.
Our Main Messages About Negotiating Engagement Letters
If we were to distill our main message into a few words, it would be that companies should use the engagement letter to align incentives with their banker and think carefully about their overarching goals for the transaction, which virtually always include selling your company at a strong valuation, getting good deal terms, and having the opportunity to evaluate numerous competing offers from prospective acquirers. It is key to remember that your deal is unique and special to you, so we do not recommend delegating the engagement letter process exclusively to your lawyers, in large part because there are many non-legal “business” terms and issues in these contracts that must be considered carefully in the context of your individual goals. Finally, we recommend resisting the temptation to extensively mark-up your banker’s engagement letter with extensive comments.
“Exclusive Financial Advisor” Language
Most engagement letters begin with language stating that the investment bank will be your company’s “exclusive financial advisor” in connection with the sale of the company. This language is quite common and may raise the question in your mind of whether it would ever be a good idea to have a non-exclusive financial advisor relationship in which more than one investment bank would be working for your company at the same time. The short answer is no. Investment banking engagement letters are written this way because there are many serious drawbacks to a multi-bank arrangement, not least of which is that this arrangement is not in the client’s interest as it would severely hamper each bank’s ability to meet your goals.
Specific drawbacks would include potential marketplace confusion (who is representing the company?), deal coordination and timing problems (how would I get the banks to work at the same pace and under the same timetable to synchronize bids for the company?), communication issues (how would the banks communicate effectively with the client and each other?) and a host of other negatives. Parenthetically, we would note that—absent truly exceptional circumstances—virtually any investment bank worth their salt would insist upon an exclusive relationship as your “exclusive financial advisor”.
Scope Of The Engagement & Services To Be Provided
This section of the engagement letter defines the engagement (Are you hiring the bank to sell your company? Are you raising capital? Are you doing both?) and specifies what services your bank will provide. In analyzing this section, it is wise to think very carefully about how the deal process might evolve and to consider that it may evolve in ways that you had not anticipated and may not be able to anticipate at the time the engagement letter is signed.
For example, Navidar worked with a CEO who was certain that the best course of action was to sell his company. During the course of the sale process, however, a number of strategic acquirers with which he wanted to partner said that the company needed to become larger before they would be interested in buying it. Simultaneously, the company also received feedback during the process that it could raise additional growth capital on extremely attractive terms, which is what the company ultimately decided to do. The CEO and Board were very happy that Navidar encouraged them to pursue both the sale and the capital raise options simultaneously and to include both the sale and the capital raising services in the engagement letter. Because deal processes and market conditions can change rapidly, it is often wise to build flexibility regarding the services mentioned in the engagement letter. To be clear, specifying these additional services does not cost the company extra money as it ultimately only pays the fee for the type of transaction that it ultimately completes.
Compensation and Fees
In this part of the engagement letter, the client and the investment bank agree to the fees to be paid for the services to be provided. Often, compensation involves several components, including a retainer fee (often paid monthly), a minimum transaction fee, and a success fee, the latter of which is usually expressed as a percentage of the overall value—referred to frequently as aggregate value—of the transaction.
There are a variety of fee structures that the client and the bank can consider. One simple but effective structure involves specifying a straight percentage of the transaction value. For example, the two parties may agree that the fee will equal 2.5% of the aggregate value of the transaction, regardless of the overall deal value. Alternatively, the parties may consider a tiered fee structure in which a different fee percentage applies at different aggregate value levels. For example, the parties may agree that the fee up to $20 million in aggregate value will be 4%, then 5% on the additional $10 million up to $30 million, and then 6% on any amount above the $30 million level.
The best fee structure depends on a number of factors, but one word of caution here. It may seem ideal to use a tiered fee structure but doing so can at times introduce an undesired degree of complexity into the situation. How can this occur? Well, in our example above, the deal value ranges (up to $20 million, then up to $30 million, and finally above $30 million) were based on the company’s financial projections at the time of the signing of the engagement letter, which occurred before these projections had been fully vetted and scrutinized. If it later turns out that the revenue or profit projections used at the time of signing the engagement letter were too high or that the company’s growth rate will be lower than initially projected, would it then be fair to adjust downward the initial valuation ranges that form the basis of the banker’s fee? Our key take-away here is two-fold regarding compensation. First, try to resist the temptation to introduce a lot of complexity into the fee calculation and, second, realize that most high-quality investment bankers do not need to be “incented” through a tiered fee structure to achieve the highest value and will do their utmost to find, structure, and negotiate the best deal for their clients.
The Termination section addresses how and under what circumstances the client and the investment bank can terminate their commercial relationship. Again, we argue for simplicity and recommend language that essentially says that either party may terminate the relationship at any time and for any reason subject to some short period of advanced notice, typically 30 days or so. In a prior post, we described how to form a relationship with an investment banker well before you are contemplating a deal (see more about forming a banker relationship here) and believe that this is one of the best ways a CEO can get comfortable with the quality of the banker and the level of service his company is likely to receive after they hire that banker. In addition, we recommend asking your banker if they have ever had an acrimonious parting of the ways with a client or whether a client has ever terminated a relationship due to unsatisfactory work product. Truthful answers to these questions will give you comfort that you have picked the right banker and are unlikely to want to terminate the relationship before a successful transaction has been achieved.
The “Tail” & The Survival Period
The Survival section often follows directly after the Termination section of the engagement letter and addresses the issue of the banker’s fee in the situation where a transaction of the type specified in the engagement letter occurs within a specified period of time after the relationship with the banker has been terminated. In this section, banks usually ask to be compensated if a deal happens during a period of typically 12-18 months after the engagement has been terminated. This term is standard throughout the industry and is designed to protect the bank if a transaction of the type specified in the engagement letter, for example, a sale transaction, occurs after the relationship is terminated.
One topic that occasionally comes up in regard to this section is whether the client ought to use a “named names” clause and thus have the tail period apply only to the specific potential acquirers that were directly contacted by the bank during the deal process. Though perhaps intuitively appealing at first, we do not think that this is a good idea and do not recommend it to clients.
The reasoning comes down to the reality that a company wants alignment with its banker and wants to incent them to always act in the company’s best interest. This “named names” approach creates a fundamental misalignment of incentives that is not beneficial. How so? If the banker is going to be compensated if a deal happens during the tail period only with a party that the banker has contacted, then this encourages the banker to contact a wide variety of parties to ensure that they will be paid for all their prior time and effort if in fact any deal occurs during the tail period. Going very wide to potential purchasers may be a waste of the company’s time and, perhaps worse, may make it more difficult to maintain the confidentiality of the deal process, neither of which benefits the company.
We hope this discussion has proven useful. As we say at Navidar, it is important to keep your eyes on the prize, which is to achieve a successful sale of your company at a strong valuation, with excellent terms, after having evaluated numerous competing options. Keeping the focus on the big picture and situating the engagement letter in its proper place within the broader transaction will position you for success in one of the most important undertakings of your company’s life.
If you are interested in speaking to us about ways to start preparing your company now for a future M&A, or if you are currently seeking advice on a potential transaction, please contact Stephen Day at [email protected] or (512)765-6973.