M & A Roundup: Hiring Dealmakers In the 21st Century

Most people like to get paid for their work and m&a investment bankers are no different. The initial document that sketches out what dealmakers get paid and defines other aspects of the relationship between the banker and the client in a transaction is the engagement letter. Mergers & Acquisitions decided to take a new look at this basic building block of any m&a transaction to gauge how the letter is evolving as deals proliferate. We also wanted to look at the effect of the new economy pacts as they shoulder aside some tenets of what had been engagement letter protocols among traditional, bricks-and-mortar companies. “The deal landscape has gotten more competitive, and like other firms we have had to adjust,” said Sharif Tanamli, a managing director at Niederhoffer-Henkel Century Group in New York. “Our firm grew up with the mentality that a pure success fee arrangement is the best motivator, but we have had to add other elements to match competitors’ offers.” A success fee, as referred to by Tanamli, provides that the banker gets paid only if the assignment works out. Other options for bankers and clients include monthly retainers, usually for the six-to-12-month period that firms get hired to sell or to acquire a business. There are also contingency fees in some engagement letters, which call for a partial payment for bankers if a buyer is found but the deal doesn’t succeed for some reason outside of the banker’s control, such as the potential buyer’s failure to line up financing. A fourth fee structure sometimes used is an incentive fee or performance bonus. Typically, this rewards the banker for any price he or she gets that is above a given point. “Our clients like the idea of a performance bonus because they think we’ll have an incentive to make sure we’re selling the company for the maximum value, rather than just getting a transaction,” said Frank Novak, a VP at The TransAction Group, a Cleveland-based investment bank. Another charge seen in many engagement letters is a breakup provision. This ensures that the banker gets paid something if a potential seller or buyer pulls out of a deal at the last minute. Investment bankers contacted for this article, who primarily do mid-market deals, noted that the historical model that many engagement letters are customized from is the Lehman Brothers formula of descending percentages as the deal gets larger. This template calls for a fee of 5% on the first $1 million, 4% on the second million, 3% on the third million, 2% on the fourth million, and 1% on the fifth and any subsequent millions. Lehman itself generally hasn’t used the schedule for years. As useful as this formula may be as a starting point, Oliver Cromwell, senior managing director at Bentley Associates LP in New York, said that the Lehman formula is 25 years old and, if unaltered, can result in bankers getting too low a fee. Cromwell and the other bankers also stressed that while each firm has a basic engagement letter format, each one is also customized to meet the requirements of individual transactions. Tanamli adds that, in his firm’s view, the engagement letter isn’t a contract but rather is a “simple business agreement that normally runs only three pages long with about 10 paragraphs per page.” Arrangements for exclusivity While setting a fee is perhaps the most important thing an engagement letter does, it is not the only service it performs. There are a number of other guarantees that the letter should establish. These can be seen as a series of protections for the client and for the banker. Among the protections bankers ask for is exclusivity. This means that for the period that the letter is in force – usually six to 12 months – any buyers that come to the table will be credited to the investment banker representing the company. “There should be a full fee payable for any and all names that arise during the engagement process,” Cromwell said. There is also a so-called “tail” on many engagement letters that stipulates that the emergence of a buyer, either as a result of work done by the investment banker or from anywhere else, will entitle the banker to some payment for a defined period after the expiration of the engagement letter. The tail can last from six to 24 months. Another banker protection clause commonly found in engagement letters indemnifies the banker for any legal action. Cromwell commented that his company likes to hold the standard for such a clause to a “gross negligence” level, although sometimes clients press for a simple negligence standard. At Tanamli’s firm, the preferred structure is that any disputes arising from the working relationship will be settled by binding arbitration, rather than litigation. An important consideration for clients that is often written into the engagement letter is a stipulation that the bankers working on the deal respect the confidentially of client information as they construct offering books and other deal-related documents. Clients also ask for, and sometime receive, the right to terminate the relationship for a variety of reasons before the engagement letter expires. What mid-market m&a bankers are finding in new economy deals is that engagement letters need to address the accelerated pace of the sector. “We are realizing that you may not spend as much time producing a big, thick offering book on these companies. Some-times, too, the engagement letter will speak to producing the executive summary quickly and getting it into the market,” Cromwell said. He also noted that e-commerce companies don’t have as long a history as traditional companies, so there is less to describe in offerings and other materials. Tanamli said that evaluating dot-com deals requires a different set of yardsticks. He described a recent deal in which his firm was involved in which a dot-com company bought a software company. He noted that both his firm and the target were paid a combination of stock and cash. In the wake of the late April market turbulence, the value of the stock used in the deal has declined. He said it was helpful that his firm was paid in the same way as his client. Cromwell said that his firm, as a general philosophy, writes the letter in such a way to anticipate and cover most of the eventualities a deal can create. But it is not an exact science, he added. “You want to cover all the alternatives that might come up but without getting bogged down in every conceivable direction a deal might go in.”