Client & Investment Banker Alignment is Critical
As a boutique investment bank, we expend a lot of effort providing high quality advice and acting as a staunch advocate for our sell-side merger and acquisition (M&A) clients. Why? Because we want our clients to receive the highest price and best terms for their business. Since completing transactions is difficult; we need to be pulling together. To do this, clients understand the importance of establishing a strong partnership that properly motivates us to work hard to achieve excellent results. Therefore, our clients' interests and our investment banking fees need to align. To address questions related to investment banking fees, the following is a brief primer.
Formal Engagement Agreement
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 agreement 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.
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 fee is a minor portion of the overall fee and represents a fraction of the true costs to mobilize the investment banking effort. Retainers are often compared to a deposit, or a slotting fee, so that the investment banker is assured the client is serious about pursuing the transaction. Sometimes retainers or portions of retainers are credited toward the success fee.
The majority of the investment banker’s fee is tied to successful completion of a transaction. For sell-side mergers and acquisitions, the success fee is structured as a percentage of the deal size; generally, the larger the deal the smaller the percentage, and vice versa. 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 progressive incentive fee.
A straight fee is a single percentage applied regardless of deal size. For example, a success fee of 3% is calculated whether the deal size is $25 million or $50 million. With this structure, the investment banker is incentivized to generate the highest price for his client since his fee in absolute dollars increases with deal size.
With a progressive incentive fee, client and investment banker agree to a certain pre-determined valuation target for the business and the fee percentage incrementally increases or “ratchets up” based on achieving value above the target. This structure incentives the investment banker to achieve the highest price and gives a special bonus for surpassing a pre-determined valuation. The higher the company’s valuation (the more dollars the client puts in his pocket), the higher the investment banker’s fee percentage and absolute dollars. This structure provides a strong incentive for the investment banker while aligning the parties' interests in maximizing the value of the transaction.
General Success Fee Guidelines
Regardless of success fee structure, here are general guidelines for success fee percentages based on deal size. Note that sometimes investment banking success fees may be subject to a minimum. For example, there may be a quoted success fee of 3%, subject to a minimum fee of $500,000 regardless of deal size:
- Transactions up to $10 million, fee range of 5-8%;
- Between $10 million and $20 million, fee range of 3-5%;
- Between $20 million and $50 million, fee range of 2-4%;
- Between $50 million and $100 million, fee range of 2-3%; and
- Between $100 million and $250 million, fee range of 1-2%
As with most things in life, keep the fee arrangement simple. Haggling over unique, low probability circumstances, maintaining special carve-outs or withholdings, 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.
Ensure the investment banking fee aligns well with the client’s interests. 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.
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.
Last, assuming your investment banker has a solid track record, the value he contributes will be far greater than any fees paid.