When hiring an investment bank, either for growth capital needs or an M&A transaction, a company owner should pay special attention to the scope, team and fees in the engagement letter.
If the company has an accomplished deal professional in its camp — be it a seasoned M&A lawyer or a similarly seasoned financial advisor — this due diligence can be carried out effectively and efficiently.
However, sellers or those seeking growth capital will sometimes execute an engagement letter with little or no negotiation, creating a situation that the owner could regret.
Instead, owners should be aware of the following key points in an engagement letter and seek expert advice to get the letter positioned appropriately for their situation. (For more insight from James Hill on private equity, see "The Zero Hour." For video, click here.)
1. Scope of the Engagement
These provisions specify what the investment banker will do for the owners: help them coordinate the process; help them write the teaser that goes out to potential interested parties; work with their attorney on the nondisclosure agreements (NDAs) sent to parties that have expressed an interest after reading the teaser; and work with their owners and the attorneys and accountants to prepare the confidential information memorandum (CIM). A key to the scope of the engagement wording is to ensure that the engagement does not go beyond what the owner is hiring the investment banker to do.
Owners need to be clear that the letter only articulates exactly why they are hiring the investment banker and that it is the only engagement.
2. Team and Termination
It is important to articulate in the engagement letter who will be on the team, because you do not want to work with only junior investment bankers after being sold by a senior investment banker. No investment bank can promise that a particular person will always be involved — as he or she might leave the firm — but get a best-efforts type of arrangement.
As to termination, most engagement letters should allow either party to terminate on 30-days’ written notice.
Some investment banks will ask for at least six months before this termination can occur, which may be reasonable.
3. Fees and Reimbursement
Most investment banks require an up-front fee to show good faith on the part of the owners. This will vary depending on the size of the investment bank, but a fee of $25,000 to $50,000 that is credited against the success fee is not unusual. The fee on the enterprise value of the transaction — what is known in most investment banking agreements as consideration — will typically be a certain percent up to a certain enterprise value that is agreed on between owner and bankers as likely to be achieved. Thereafter, the fees are structured in increments above the initial enterprise value to encourage the banker to seek a higher valuation.
Reimbursement of costs incurred by the investment banker are usually in the $25,000 to $50,000 range, with any overage requiring prior approval by the owners.
This is a key element in any engagement letter. The total consideration is how the banker gets his or her fee.
Points worthy of negotiation are: seller notes that are not contingent, often based on a present-value discount; seller notes or earnouts that are contingent, with the banker to get its percentage of that payment only when it is received by the owners; escrow amounts (sometimes not considered contingent but sometimes one can negotiate to pay the banker when the escrow is released in whole or in part); and any other contingent consideration deemed worthy of discussion.
Rollover equity from the seller is always considered part of the consideration.
5. Termination and Tail
Termination of the investment banker upon 30-days’ notice, if not a minimum term that might be negotiated, requires: the owners to remain responsible for indemnifying the investment bank; the non-refundable fee to remain non-refundable; the confidentiality agreement executed up front by the investment bank to remain in effect—it should for two years after either completing a deal or having a termination; all reimbursements be paid as previously noted; and the investment banking institution to have what is known as a tail period.
When it comes to the time of the tail, the investment banker will often suggest 12 to 24 months. This varies with each investment bank, but the owner should try negotiate the tail down to 12 months after the official termination.
Another termination-related item that should be included is the parties introduced. This is usually based on anyone that the investment banker or the owners suggest might be the buyer or the growth capital provider.
It is not unusual for the investment bank to suggest that after the termination it prepare a list of parties that would qualify for the 12-month period. It is more desirable to have a list as an exhibit to the engagement letter, where both the owners and the investment bankers have agreed that these parties were discussed.
The tail discussion is a sensitive one for the investment banker, and it requires significant experience to iron out the details. It is important to be fair to both the owners and the investment banker.
6. Other Banker Duties and Competitors
The investment banking firm is obligated to communicate with the owners about all parties with whom it has discussed the potential transaction. In addition, the owners will often negotiate a provision that will not allow the investment bank to represent a competitor in a transaction while it is representing the company. This is a carefully negotiated provision where a seasoned deal professional can be of great help.
This is the provision most sacred to investment banking firms and little negotiation can occur. Basically, the company is required to indemnify the investment bank for any and all claims arising out of the transaction, or the process if the transaction does not occur. Unless it can be shown that the investment bank created liability due to its wanton misconduct or gross negligence, then the indemnification stands.
The other part of this indemnification that annoys owners is that in all cases, even if the investment bank is found to have fully creating the liability, its total indemnification cap is the amount it received for the transaction.
You can achieve a few concessions with good, experienced deal counsel, but most of these provisions will remain in place.