Articles & Insights

Aligning Investment Banking Fees with Client Interests

September 27, 2019

As a boutique investment bank, we expend a lot of effort providing high quality advice and delivering for our clients. We are very cognizant of the need to align our investment banking fees with ourcclients’ interest because ultimately we act as our client’s advocate.Completing transactions is difficult; we need to be pulling together. Before executing a transaction, we enter into a fee arrangement with our client as documented by an engagement letter. Since we will be working together with our client intensely over the course of several months, the engagement terms and fee arrangement are generally the start of the relationship. These matters must be handled delicately as it sets the tone for the relationship and lays the foundation for cooperation. To address questions related to investment banking fees, the following is a brief primer.

Retainer

A credible investment banker will charge a non-refundable retainer upon engagement. There are two primary reasons for the retainer: (1) it covers the time and expense the investment banker incurs in preparing the client to go to market and (2) it serves as a screening mechanism to ensure that the client is committed to the transaction. This retainer may be paid as a lump sum, over time or based on achievement of certain activities associated with the transaction process. This retainer should represent a minor portion of the overall fee. Sometimes retainers or portion of retainers are credited toward the success fee.

Success Fee

The majority of the investment banker’s fee is tied to successful completion of a transaction. The success fee is structured as a percentage of the deal size.For capital raises, the fee percentage is applied to the amount of capital raised. The fee percentage increases as one moves from raising senior debt (perceived as less risky and ranges from 1%-2%) to junior debt (more risky) to equity (perceived as most risky and ranges from 5%-10%).Some fee arrangements include an “equity kicker” in the form of warrants, so the investment banker shares in the growth of the equity value of the company.The size of the deal may also influence the fee percentage; the larger the deal the smaller the percentage.For mergers and acquisitions, the fee percentage is applied to the overall size of the transaction. Although many business brokers refer to the Lehman formula, few investment bankers use this structure.Instead, they may quote a straight fee percentage or a performance based progressive fee.

Progressive Fee

With a progressive fee, client and investment banker agree to a certain valuation target for the business and the fee percentage increases or “ratchets up” based on achieving the target. The higher the company’s valuation (the more dollars the seller puts in his pocket), the higher the investment banker’s fee percentage. Progressive fee arrangements provide a strong incentive for the investment banker while aligning the parties’ interests in maximizing the value of the transaction to the client’s owners.

Final Comments

As with most things in life, keep the fee arrangement simple. Haggling over unique, low probability circumstances, maintaining special carve-outs or with-holdings, or creating complex fee structures generally backfires and often causes difficult situations for client,investment banker and the counterparties. Complex arrangements tend to cause anxiety, uncertainty and sometimes result in lack of motivation and focus from the investment banker, not what the client desires. You get what you pay for, most of the time. Expect to pay a reasonable, market fee. Receiving an engagement letter from an investment banker containing a low fee (potentially with no retainer), indicates a low level of sophistication – not someone you want handling your important deal.Conversely, an engagement letter quoting an out-of-market high fee indicates someone wanting to take advantage of a client – again, not someone you want handling your important deal. Fee structures come in many different flavors, including those that align the investment banker’s interests with the client’s interests or those that can create conflicting incentives. Ensure the investment banking fee aligns well with client interests.

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