As I picked up the phone, I was feeling really good about my client’s transaction—it had been scheduled to close yesterday. My client’s lawyer was on the line, and I immediately assumed he wanted to tell me that the deal closed so that we might gloat a little together. We had developed a very good relationship while working together. Attorneys and investment bankers usually do. This deal had been a hard-fought deal, fraught with challenges, that took more than a year to close. I was feeling very pleased that all that was behind us now, particularly because I really liked the client, too, and had enjoyed working with him so much. “Buzz McClellan,” the client, was at least a vocationally a Montana cowboy, family man, church deacon, and more. Buzz rode and raised horses. And along the way, he had found the time, energy, and imagination to build a highly specialized government contracting business from scratch.

“Hey, Dick,” I greeted the attorney. “How did it go yesterday?”

“Well, great, but ah . . . well. Buzz received your fee invoice yesterday and he does not believe he should pay it all, for various reasons,” answered the attorney.

Phone calls like that tend to shock one. Over the course of the rest of that conversation, and several others that followed, Buzz’s lawyer proceeded to advise me—and hang tough on point—that in the wake of closing a long, hard-fought deal, Buzz suddenly believed the investment banking fees agreed to in the FSA were too high. This, in spite of the fact that Buzz had been highly complimentary of my work throughout the deal.

It is safe to say that any attorney anywhere can always find a technical issue on which to threaten litigation or withhold payment. In this case, it had to do with the application and relevance of some obscure Montana real estate law to this transaction. That was the technical issue. The actual issue was that, in retrospect, Buzz thought he was paying too much in fees.

Dick and Buzz left me with two alternatives, neither of which was particularly attractive. I could accept their counteroffer of $250,000 there and then. Or I could spend two or three years litigating to win the $310,000 fee stipulated in our FSA. I was advised confidently by my own legal counsel that I almost surely would have won. But Dick and Buzz knew as well as I did that the costs of litigation, the time value of money, and the basic distraction factor inherent in pursuing justice very likely would exceed the $60,000 they hoped to deny my firm. Buzz himself had just received a check for many millions of dollars, and it was a bet or bluff that he could easily afford.

Dick’s rationale for Buzz’s apparent belief that a lesser fee was justified made no sense at all, either in the context of the FSA or of all of the work that had been done to close the deal. Frankly, I do not even think Dick believed this was right (actually, I know so, from after-the-fact conversations), but after all, the client had the right to his services.

All Buzz really wanted was to clip me of $60,000, because he believed he could get away with it. And, of course, he did get away with it, because I knew as well as he did that winning back that $60,000 inevitably would cost me far more than it was worth. You live and you learn.

Virtually all investment bankers will face such a disappointment somewhere along the way and will forgo fees legally agreed upon and earned, even through great effort, rather than waste time in pursuit of the amount disingenuously withheld. But once burned, twice shy: most investment bankers will respond to such an experience by tightening up their financial services agreements quite substantially to ensure that they are all but bulletproof.

Washington, DC—October 2003

I was interviewing an investment banker candidate who seemed really interested in “taking the plunge.” This guy had a lot of financial services experience and some operating experience in the very hot aeronautics and space industry as well. We could really use this guy, I thought.

“Well,” he said, “700 hours . . . that really is a lot of time to spend on a single deal.”

“It sure is,” I responded.

“Anyway,” the young man said with a smile, “you get paid a lot.”

“Most of the time you do,” I answered.

“Most of the time?”

“Well, any number of things can happen that will keep a deal from closing, right up to the very last minute. I have seen it all. The seller can lose a major client, there could be heart attacks, serious business reverses, new competition, you name it. Anything can happen at any time, and that deal you have spent 700 hours on just evaporates.”

The interviewee’s interest started to wane a bit. “Well, it must really piss you off when that happens.”

I shrugged, then answered, “No, it disappoints the hell out of me, but it does not piss me off. It just goes with the territory—part of the professional risk.”

He grabbed the arms of his chair. “My God. What does piss you off, man?”

“Well, I do get pretty upset when the deal is done, all went well, and the client still tries to find an excuse to shave my fee.”

“So that 700 hours or part of that goes down the drain too? How do you avoid that?”

“Pick good clients, pray for the best,” I answered.

Incidentally, I never saw that interviewee again, but I hear he took a job as an accountant somewhere with a reasonable and dependable monthly check.

Success or Contingent Fees Formulas (The Lehman Variations)

There are many success fee variations, but most sales-side investment bankers charge fees based upon some version of “the Lehman formula” (or something reasonably approximating it), which was developed in the early 1970s for large Wall Street investment banking activities. According to the formula, as the transaction value (sales price) goes up, the fee as a percentage of transaction value goes down. As the formula was developed for transactions that would likely occur only in the Upper Markets or upper reaches of the Middle Market and is some 30 years old, Middle Market investment bankers have adopted several variations of the formula as more realistic and fair. A common contemporary variation for Middle Market transaction fees is called the Double Lehman, which charges a 6% to 8% fee for the first $2 million of transaction value, then 5%, 4%, and 3% for each successive $2 million in transaction value, respectively, and then 2% of all transaction value exceeding $8 million. Sometimes, when the transaction is large enough, a 1% fee is charged for all transaction value exceeding $20 to $100 million. All of this is usually with a minimum success fee of something like $250,000.

Some Middle Market investment banks state their fees as a flat rather than scaled percentage of transaction value, but even then, the result usually proves more or less equivalent to a Double Lehman formula calculation. For deals generating less than $5 million in transaction value (these tend to be relatively rare), the $250,000 minimum fee protects the banker. In some cases the Double Lehman formula may well charge 10% on the first $2 million. This adjustment reflects the fact that Middle Market investment bankers know all too well they are likely to invest essentially the same 700 hours on a $5 million transaction as they would on a $50 million deal.

Other fee schedules include blended rate Middle Market investment banking fees for:

• Very small deals ($3 million or less) that rarely fall below $250,000

• Small deals ($4 million to $10 million) that range from 7% to 5%

• Medium deals ($11 million to $20 million) that range from 6% to 3%

• Larger deals ($21 million to $35 million) that range from 4% to 2.5%

• Still larger deals ($35 million to $50 million) that would range from 2.5% to 1.5%

• Deals exceeding $50 million in transaction value drop fairly rapidly to just over 1% and routinely are subject to prior negotiations between the seller and the Middle Market investment banker.

Alternative Approaches to Fee Formulas

The Double Lehman formula reflects an inverse relationship between transaction value realized and the fee percentage levied, because the ultimate transaction value of a deal has less to do with the amount of work involved than one might expect.² At the same time, Middle Market sellers and investment bankers know it is in their mutual best interest to reasonably compensate investment bankers to maximize transaction value. And the Lehman formulas’ declining fee schedules ensure that investment bankers continue to realize somewhat higher fees in return for increasing transaction values, even as the fee percentage declines. Frankly, though, as a practical matter this is more about fairness to the client than motivation of the investment banker, and I will discuss that point further.

On occasion, a client will suggest a baseline transaction value, for which he proposes to pay a fee that is lower than the normal Double Lehman while agreeing to pay a fee that is much higher than the Double Lehman above the baseline. Various theories held by clients may drive such proposals, such as motivating the investment banker to get a higher price. In fact, it is highly unlikely that clients would influence the outcome of a transaction by adjusting its fee structure, except perhaps by adjusting it so low that no good banker would accept it. In the vast majority of negotiated auctions, prospective buyers drive the transaction value by competing to win the acquisition. Experienced investment bankers can and very much do influence the process, but they cannot determine the final outcome. In fact, in the heat of the deal, they do not have and should not take the time to calculate alternative fees arising from varying proposals. I can say that I am not usually at all aware of the precise fees involved when in the heat of battle, and I do not think many of my colleagues are either. Provided the basic fee agreement was fair, there is already a sufficient prize to the banker.

But insisting on a lower floor fee in return for higher fees paid at the upper end of the valuation range can prove very costly. This may emanate from the client’s own human tendency to bluff from insecurity. When a client bluffs from insecurity, it usually reflects a certain defensiveness, given his unfamiliarity with a process he nonetheless feels he is supposed to control. He thinks if he bluffs by building a higher fee into a higher value, he will produce it. Sorry, but it does not and cannot happen that way.

This approach can have unintended and, from the client’s point of view, unfortunate consequences. In an engagement I worked on a number of years ago, it happened, for reasons unique to the marketplace at that time, that a buyer on the verge of its own initial public offering wanted a company so badly that he paid almost 300% of the figure initially considered to represent the high-end of preliminary range of value. None of the other prospective buyers even came close to this extraordinarily motivated buyer’s offer. Remembering that I had strongly advised him against the higher fee percentage on a higher transaction value approach, the client proved quite willing to pay me six times the fee that the Double Lehman equivalent would have allowed, for which I myself was much obliged. In short, though, this approach can backfire like crazy.

How Transaction Value Is Measured

Transaction value—what the company is sold for—is never quite so simple a concept as it might first appear. Determining transaction value often is very complicated, requiring enormous care. In financial services agreements, the language used to define transaction value tends to be very specific, complex, and extensive, in the interests of both client and investment banker. If proper care is not taken at the outset (and even sometimes when it is), it may prove all but impossible to calculate investment banking fees at closing that the client and investment banker alike find equitable and in line with their prior agreement. Should the client and the investment banker interpret contractual definitions of transaction value differently, they very likely will disagree as to fees due and payable. At all costs, all parties should avoid ruining the triumph of the successful sale of a company by allowing confusion to lead to differences over the investment banker’s bill.

The complexities of transaction value definition arise from the painstaking care required to define all of the potentially discrete categories of value to be realized upon closing:

• Contingent versus noncontingent transaction value—transaction value that may or may not be realized following the closing of the deal, often in the form of an earnout

• Escrow set-asides—whether a closing fee should be paid on these, even though the client will not receive them until sometime in the future

• Noncash, but noncontingent elements of transaction value—such as stock and notes

• Obscure or disguised transaction value—arising from unique terms agreed to within the deal negotiations to accomplish certain tax advantages (e.g., special consulting fees)

• Consideration included within the transaction whose value is difficult to measure—such as stock in a privately held company or in a PEG recapitalized company

• Transaction value to the client derived by an investment banker’s intense negotiation—to take certain assets out of the deal for the client, such as balance sheet cash or excess working capital.

Contingent versus Noncontingent Transaction Value

This one is easy. Because contingent consideration—often called earnouts—in transaction value (see Chapter 13) tends to be based on future business performance, it cannot be measured precisely in the present. As a rule, most investment bankers do not expect to be paid success fees based on earnouts until their clients actually collect the contingent portion of the consideration.

Escrow Set-Asides

This is a tough one, and I have seen it done both ways (attributable fees paid at closing, or fees paid later when the escrow is released). The two arguments, each favoring a different approach, go something like this:

• Escrow set-asides are for adjusting claims that are asserted later for events that often occur or become known postsettlement, and therefore investment banking success fees attributable to escrow set-asides should be paid at closing. Furthermore, the investment banker did his job and now has no control over these subsequent events and or claims, which is not entirely true of the client.

• Any postclosing adjustment charged against escrow set-asides is a purchase price adjustment in effect, and therefore no investment banking success fee should be paid on escrowed amounts until the escrow is released.

There may be elements of truth on the side of either argument, depending on what the escrow is intended to cover. In the final analysis, each case should be evaluated on its own merits. One reasonable compromise is to pay fees currently on some portion of the escrow set-aside and defer fees on the balance until the escrow is released. In my experience, very few escrow set-asides are not eventually paid if appropriate due diligence was performed by both sides of the transaction before closing. A good compromise, then, is probably a formula that provides that 75% to 851 of the escrow set aside will result in an immediately attributable fee payable to the investment banker, with the balance of fees paid when the escrow is finally released. This constitutes a kind of escrow agreement within the escrow agreement.

Noncash, but Noncontingent Elements of Transaction Value and Their Effect on Fees

Noncash, noncontingent transaction value may include promissory notes, stock, etc. The consideration is fixed, having a stated and therefore knowable value upon closing, even though that value may change over subsequent time. Most investment bankers will want to be paid according to the stated or face value of such consideration at settlement. This should not usually unduly burden a client, given that Middle Market investment banking fees tend to average only 3% to 4% of transaction value. The client invariably receives more than enough cash (many multiples of that amount, in fact) in a transaction to pay investment banking fees in cash, based on the value of noncash consideration. Furthermore, the acceptance of noncash, noncontingent consideration is ultimately always a client’s decision, not the investment banker’s, and the total transaction value to a client is a much larger sum of money than the professional fee received by the investment banker. Sometimes, it is in the best interests of the client to take some of this type of consideration to get the deal done, or as frosting on the cake, but it should not be in turn imposed upon the investment banker’s fees, which are merely for professional services. I have never seen, for example, a lawyer or an accountant paid in like-kind consideration for the services rendered in support of an M&A transaction.

When Mechanics of the Deal Obscure or Disguise Transaction Value

This kind of transaction value can take many forms. It often arises when the investment banker recommends using a mechanical device—often addressing tax, financing, or other imperatives of the seller or the buyer—in the course of a transaction negotiation to get the deal done for his client. For example:

• A lease agreement may be substituted for a promissory note as part of the consideration to be paid the seller.

• Substituting a very lucrative consulting contract for the seller in return for some reduction in the purchase price also might be acceptable (assuming all the rights and remedies remain identical, the seller may find 60 monthly installments of $10,000 equivalent whether they paid as a lease, a note, or a consulting contract). It may have been just this touch that allowed the deal to get done.

Transaction Value That Arises after the Deal Was Completed

Transaction value may be realized years after the deal has closed. This involves such post-transaction events as the buyer’s acquisition of an asset that had been leased but not included in transaction value. It may involve equipment which the buyer had an option to buy, or a lease that was treated as an operating lease as opposed to a capital lease (in which the “lease” in effect is a financing device that was negotiated by the investment banker to facilitate the deal for his client, and the buyer subsequently decided to purchase the underlying assets). Should the banker be paid for the additional value or opportunity negotiated on behalf of his client? This is a fair question, and one that needs to be addressed in every financial services agreement, but there is no one-size-fits-all answer. It will depend on a number of factors, such as the passage of time between exercise of these options or events and the original deal closing. Then there is the double counting of transaction value that can sometimes come about in these cases and of course should be avoided and can be with good contract language.

Consideration Included in the Transaction with a Value That Is Difficult to Measure

What happens when a transaction involves the merger of two private Middle Market public companies? Such merger deals often involve relative rather than absolute transaction values. The seller may agree that the buyer’s business is worth 133% of his own, while both parties decline to place an absolute value on either company. The relative value approach is not uncommon, because it sometimes is much easier for two Middle Market merger partners to agree on than absolute value. Establishing relative values requires a great deal of work, despite the fact that the results often remain more obscure in terms of actual values. Relative values may well be more intuitively apparent. For example, a review of revenues and net earnings may help establish the relative values of two companies operating in the same industries. So what is the transaction value in this type of situation? It will prove elusive, and may require independent appraisals or negotiations between the investment banker and his client. By closing, hopefully, the investment banker and his client should have established the kind of relationship that keeps such negotiations from becoming contentious. This has usually been my experience.

Extra Transaction Value Derived by the Investment Banker

A substantial part of most Middle Market transaction value negotiations will typically surround negotiating balance sheet targets (i.e., working capital and cash). The negotiations around these issues can be just as intense as those around basic transaction value and in fact can significantly alter the outcome of the aggregate transaction value for his client, sometimes by as much as 5% to 15% or more.

In general, investment bankers will want to include in transaction value those concessions won in a negotiation resulting in assets or cash retained by, or distributed to, a client that otherwise would not have been retained and/or be removable by the client in the normal course of events. The problem with this is measuring those extra concessions against what is otherwise normal. For example, one might safely assume that, since enterprise value is conventionally defined as cash free, any transaction value attributable to the cash retained by the client is not subject to an additional investment banking fee, and that would be correct.

But there is also working capital (which incidentally, and as discussed in Chapter 27, must also be conventionally determined on a cash-free basis, since to do otherwise would simply cancel out the effect of the basic cash-free enterprise value convention itself by adding cash back in when it comes time to establish the working capital target). There is no convention associated with working capital, beyond the fact that it ordinarily should be cash free and should in some way represent adequate ³ working capital to which the buyer is entitled. “Adequate” is usually determined by reference to the company’s recent history of actual cash-free working capital, provided that the company has had positive cash free working capital. An experienced investment banker will do all that he can on behalf of his sales-side client to leave as little working capital on the balance sheet as could fairly meet the definition of adequate. To the extent he is successful, his client benefits, sometimes handsomely. But there is no standard way for the banker to be compensated for these negotiations unless working capital targets are established upfront between him and his client and then used as a basis to determine additional transaction value based on the banker’s negotiating skills. In point of fact, it is not usually done this way, and some bankers may just throw this in as an additional benefit to their clients—which I suspect is rarely appreciated,⁴ simply because it is not that well understood by them.

There is one clear instance, though, where such increments in value can be readily measured and the banker compensated for his efforts; that is when the banker is engaged after a Letter of Intent (LOI) has already been received. One way or the other, either by omission or commission, working capital and cash targets have been established implicitly or explicitly and therefore can be used as a basis for measuring additional transaction value on which the banker can and should be paid, since in this case he clearly, visibly, and measurably increased the net amount of transaction value received by his client.

Retainers (Commitment Fees)

Retainers, more appropriately called commitment fees, usually barely cover the start-up costs of an investment banking engagement, including the first month’s work. Thus, they tend to be relatively inconsequential in financial terms to the investment banker. But commitment fees are important to investment bankers, as they tend to distinguish the serious sales-side client from those who always have a “for sale” sign out but are not interested in selling until the price is not only right but extraordinary beyond any reasonable expectation. In fact, they are often more curious about their value than serious about a transaction. Without retainers or commitment fees, most investment bankers could spend entire careers representing clients who turn out not to have been serious when a buyer makes an offer. There are plenty of these pseudo-clients around. Why not? They have little to lose. Investment bankers cannot afford to represent this type of client by any means, although novice or dilettante intermediaries will sometimes agree to do so. They soon learn, too late. With a commitment fee of from $35,000 to $50,000 in hand, most investment bankers can proceed on the assumption that their new client is committed to closing a deal under the right circumstances.

Finally, commitment fees may or may not be credited against the success fees, depending on the size of the deal and other concessions or special arrangements that have been negotiated between the investment banker and his or her client.

Basic Contract Period

Sellers typically engage an investment banker for a basic term of from six months to one year, usually automatically renewable thereafter for serial extensions of 60 to 90 days. Most investment bankers should find six-month basic terms sufficient to prove themselves to the client. The longer, 12-month basic term reflects the average time required in the United States to fully complete a Middle Market deal.

Richmond, VA—October 1995

Early one morning, Benjamin, a lawyer, asked me to review, as an expert consultant, a case involving a Middle Market investment bank in the southern United States that was claiming a $1 million (wow!) fee from a client, on whose behalf the investment bank had seemingly done little or nothing.

It seemed the investment bank had a clause in its financial services agreement stating that a fee would result in the event the client closed a deal within 18 months (of the termination of their agreement) with any buyer to whom the investment bank had introduced the seller. Allegedly, the investment bank, understanding the client was going to fire it in a couple of days, launched a massive mailer to all potential buyers it could imagine existed. A substantial number of buyers were undertaking roll-up acquisitions in the client’s industry at the time.

After firing its investment bank, the client eventually closed a transaction with a buyer who, not coincidentally, had received a letter from the investment bank via its final mass mailing.

As despicable as it seemed that the former client would be obligated to pay $1 million dollars to an investment bank that had provided nothing of substance in support of the deal, the clause had been agreed to and might well have proved enforceable. I suggested a solution to the problem by advising the attorney that, under the circumstances, the investment bank in question probably had to be registered as a broker dealer with the National Association of Securities Dealers (NASD, now known as the Financial Industry Regulatory Authority or FINRA; see Chapter 30) to close such a transaction. In fact, the investment bank was not an NASD broker dealer. When confronted on this point, the investment bank backed off its claim, thereby avoiding significant issues with NASD and, quite possibly, the Securities and Exchange Commission (SEC) as well. I understand that the case was settled with only a nominal amount paid to the bankers.

Trailer Periods

Virtually all financial services agreements include a “trailer” that provides that if an investment banker “had contact (with a buyer) in connection with the engagement” and that buyer eventually closes a deal with the client—even after the expiration of initial and follow-on terms of the engagement—the investment banker will be entitled to a fee, as provided in the FSA. Most investment bankers and clients consider, and most agreements will provide, that 18 months is a fair term for the trailer, beginning with the termination of the base agreement (plus extensions) between the client and the investment banker. The investment banker very likely performed hundreds of hours of work on behalf of his client without a payday. Should a prospective buyer identified by the investment banker to his client eventually close the deal, it is reasonable to assume that the investment banker’s own efforts played a role in the deal eventually consummated.

Problems nonetheless arise when the phrase “had contact with the buyer in connection with the engagement” is vaguely defined. What exactly constitutes contact? Simply identifying the buyer on a list of potential prospects certainly would not seem fair to the client, or to anyone else for that matter. Any number of databases would allow an investment banker to create a laundry list of prospects in the hundreds. Completing a mailing to 1,000 prospects at a cost of $1.50 or so per piece (or less, in the case of email) in order to “stake a claim” on the possibility that the eventual buyer is included among them would epitomize bad faith on the banker’s part.

The best way to avoid such problems is by requiring substantial contact and by defining substantial contact in a manner agreeable to both client and investment banker. For example, substantial contact might be defined as having been achieved when a prospective buyer has executed a confidentiality agreement and received the confidential information memorandum. Such a buyer may be considered a serious prospect, one whom the investment banker not only identified, but also brought into the pool of likely participants in a negotiated auction. With the confidential information memorandum in hand, the prospective buyer essentially has in hand the basic information he needs to determine whether to buy the seller’s company immediately or up to 18 or more months hence. He has been exposed to the target in a serious way.

Breakup Fees

Some FSAs also include a clause entitling the investment banker to a breakup fee if he is fired before the contracted engagement expires. In the Middle Market, breakup fees typically range from $100,000 to $200,000. Like retainers, breakup fees protect the investment banker under circumstances in which the seller gets cold feet. At the same time, investment bankers and clients alike may find breakup clauses both offensive and essentially unenforceable. A client who is disappointed in his investment banker need only wait the investment banker out through the expiration of their engagement. This may inconvenience the client, but most investment bankers, were they to stand in their clients’ shoes, would reject breakup clauses in their own FSAs. Similarly, most Middle Market investment bankers worth their salt (and integrity) would not insist that the client agree to such a clause. In no way does it serve an investment banker’s interests to penalize a client that has grown unhappy with him.

Carve-Outs and Approaches to Carve-Outs

What is fair when a client already has entered into a dialogue with a prospective buyer before hiring his investment banker? Under such circumstances, should the investment banker expect to receive his full fee? Most investment bankers will want to know how much dialogue or “traction” has been realized with the prospective buyer. A simple phone call inquiry from a prospective buyer should not count for much, but early negotiations extending over the course of weeks can hardly be ignored. However, simply introducing or mentioning a prospective buyer to the investment banker should not entitle the seller to automatically expect a carve-out or even a reduction in fees. It has been estimated that the client at least identifies if not introduces the final buyer to the investment banker in one out of three U.S. Middle Market deals.

If carve-outs were justified solely by naming names, sellers, too, could conduct a database search to create their own list of prospective buyers to carve out or expect to receive a fee reduction from their investment bankers. In the final analysis, simply naming names, or even a very uncomplicated meeting with prospective buyers, hardly qualifies as sufficiently “heavy lifting” in a Middle Market sales-side transaction to warrant a fee reduction. As noted previously, investment bankers invest the vast majority of their efforts in managing the negotiated auction, structuring an evolving transaction, advising through the drafting and execution of an LOI, and providing additional support in final negotiations through the close of the deal. M&A representation is less about matchmaking than the layman usually understands, at least until he actually been in and observed the myriad other issues that constitute a successfully completed deal.

But investment bankers should be willing to concede a fee reduction when the seller has generated significant traction in discussions with from one to usually no more than three prospective buyers. Alternatively, the investment banker might allow a “carve-out” of success fees for one or two prospective buyers while nevertheless arranging to charge the client on an hourly basis or a reduced success fee, often some combination of the two for services provided relating to those particular prospects.

But any carve-out or fee reduction arrangement may raise at least an unconscious conflict of interest for the investment banker. When one prospective buyer will generate a large success fee for the investment banker, while the other will yield no more than a limited number of hours billed at a set rate or a substantially reduced fee, even the most scrupulous of investment bankers may at least subconsciously hope that the higher-fee prospective buyer wins the day. It’s only human nature. A way around this, and usually a fair one, is that the carve-out can be designed so that it expires at some point after the engagement begins. In my experience, about 30 to 45 days makes sense. If the carved-out buyer has not put an executed LOI on the table within that period, the chances are he is a full participant (in terms of time and effort by the investment banker) in the auction. And it is that auction conducted by the banker that will actually raise the likely offer from the carved out buyer.

One last observation that is hard to resist making: Ironically, and counter-intuitively, investment banking representations involving single buyer deals should in fact involve fee premiums, not discounts. Of course, it is not easy to convince clients of this fact, let alone get them to understand it, and therefore as a practical matter it is unworkable in most cases. Nevertheless, in single-buyer representations, the seller and the investment banker would do well to agree to a hybrid compensation package combining facets of hourly rate billing and contingency billing. Doing so would serve to acknowledge the additional challenges arising when the seller, for whatever reason, does not want the investment banker to conduct a sale of his firm through negotiated auction.⁵ This type of hybrid arrangement is also a good approach from the client’s point of view, as a pure hourly rate can run a up a very large fee quite fast without a deal ever closing. When a reduced hourly rate is combined with a reduced success fee, the client is somewhat insulated against the high-fee, no-deal situation. In turn, the banker in this type of arrangement shares the risk reward equation in perhaps a more balanced way with the client.

Compensation to the Investment Banker in Warrants, Options, or Other Equity

In most Middle Market M&A deals, the seller simply takes the money or other consideration and runs, at least figuratively, as a result of a total outright sale of his entire company. But in recapitalizations and equity-sourcing engagements, where the client retains a portion of the company, investment bankers not uncommonly ask for a warrant or an option to buy up to 5% of the stock in the refinanced company at the same price the company was valued at (the strike price) when the deal closed, or sometimes at a lesser price. In the alternative, the banker may just ask for an outright equity position, but probably at a much smaller amount than an option or warrant would provide. This recognizes the fact that the banker has to negotiate the value of the entire company, and both parties (investor and investee) at the close of the transaction now own a more valuable investment as a result. This also establishes the value for future follow on transactions. But the investment banker is typically paid only for the value that changes hands.

Warrants or options may be appropriate in other instances where for a small capital raise (say, $2 million), the investment bank’s minimum fee (say, $250,000) may not make sense in terms of the net proceeds to the investees (especially from the point of view of the investor), but both the bank and the client nevertheless want to work together to do what is probably an A ⁶ round.

Equity positions with no exercise price, warrants, or options with an exercise price in lieu of some reduced fee may make sense. Reasons for wanting to work together could include a real expertise on the part of the banker in this industry, combined with his real confidence in the client and the fact that later capital rounds may be more in line with the bank’s normal fees. For example, the investment bank’s option strike price could be expressed in terms of the A round valuation . . . and then exercised later, when a B round causes the value to go up. This approach is not only a way to preserve cash for the client in the A round but also a way to really bind the investment bank to the client and vice versa in terms of goals.

Some investment banks and bankers ask for equity or options or warrants as a routine matter in every capital raise, recognizing the greater difficulties inherent in these engagements.

Integrity and Investment Banking and Large Sums of Money

Just as it is with clients, integrity is especially required when large sums of money are at stake on the part of the investment banker as well. But how does a seller ensure that he will receive that from his banker? Money encourages unpredictable behaviors in different people, sometimes highly unpredictable and distasteful ones. The best bet is for the client to do all the homework he can before engaging an investment banker. Check references with several of the investment banker’s former clients. Consider using only an investment banker who has been around for a long while, completed a number of deals, and works for a reputable firm. The more transaction experience the better, and the more transaction experience, the less fascination with large sums of money, per se: Seasoned investment bankers will usually consider their own financial outcomes important, but secondary to obtaining the best deals for their clients. It is not that they are altruistic, especially. It is rather that they are more used to the high stakes and no longer fascinated by them or dependent on them, either—at least as to any individual transaction. And finally, a client should trust his gut; intuition often is invaluable in making such choices, especially if the client tends to value his intuition for good reason.

Another test of integrity is that when the investment banker weights alternative deal proposals with his client, the rankings generally should reflect the face value of the consideration weighted according to the net cash value or equivalent to his client, which often will result in a deal being recommended that results in a lower fee for the banker. There is usually much information available on the market values of noncash consideration offered. Most really good investment bankers present to their clients comparisons of alternative proposals in terms of their cash equivalencies, and they are not afraid to steer a client away from a deal that would otherwise produce a larger fee for the investment banker. I also discuss this briefly in Chapter 18.

After a banker is hired, a client can also observe how hard the investment banker pushes to improve prospective buyers’ proposals to the client. Is the investment banker ready to accept the first deal that comes along? Does he point out the problems with specific offers and sometimes encourage his clients not to accept them? Is he patient, willing to collaborate with his client over the long haul at the expense of not generating a fee in the short run? If the banker does not seem to be acting this way (with integrity), the client can always fire him should he find his initial judgment erred, or simply allow an engagement term to expire without renewal.

Bankers Fees Paid at Settlement—More about Large Sums of Money

The deal is about to close. Along with everyone else, the investment banker is looking forward to getting paid the fees to which he is contractually entitled, having fulfilled all of his obligations to the seller. Sometimes on the seller’s big day—and big payday—the seller unreasonably and groundlessly demands that his investment banker accept a lesser fee. Investment bankers can and should protect themselves from such day-of-closing nightmare scenarios by stipulating in the FSA that the settlement agent, at the time of closing, will pay the investment banker’s fees by wire transfer, much in the same way (and for the same reason) that things are done in a real estate transaction. Such stipulations in the FSA will make the seller’s contractual obligations to the investment banker unambiguous from the start. They also, quite arguably, will provide the investment banker with a powerful ally—the buyer—in ensuring that he or she receives the agreed-upon fee in full at closing, in accordance with the FSA. This is because in the case of deals in which the investment banker is denied fees contractually agreed to in the FSA, the buyer may incur transferee liability for those fees, particularly if the transaction involved the sale of a corporation through a stock transaction but even in the instance of an asset sale. This situation may be a concern on the part of the buyer if he has been put on notice of the fee due the banker in advance.

M&A Lawyers and Fees

I offer the following solely as guidance for sellers trying to estimate their costs for a transaction, and in no way mean to suggest what reasonable attorney fees are. That depends on each and every individual transaction, and they can involve very different issues of complexity. But a seller might preliminarily reasonably estimate legal fees of between 0.25% and 1.00% for deals generating between $100 million and $5 million in transaction value. Attorneys will typically charge an hourly rate, but this range in terms of percentages, will often in basic transactions be a good preliminary estimate of legal fees.

Fees more likely than not will prove to be larger as a percentage of transaction value in smaller deals and vice versa, just as with investment banking fees. It can take as much or more time for a transaction attorney to close a small deal as a larger one. All estimates should be taken with a healthy grain of salt, though. Complexities arising from securities or tax laws, complex entity structures, a particularly tough negotiation on representations and warranties, or fundamental inadequacies in the client’s basic legal documents can dramatically affect billable hours.

Accountants and Fees

• At the risk of some redundancy as to earlier chapters in this book, CPAs normally play three roles in connection with sales-side M&A transactions: First, the CPA ensures that the company’s financials are in good shape before the due diligence process begins. When deals fall apart (or are substantially renegotiated, to the seller’s chagrin) following execution of a LOI, most of the time it is because of accounting inadequacies in the seller’s financials. Such records must be in pristine shape—no surprises here. If the seller’s business does not have a CPA, it should hire one.

• Second, the CPA closely collaborates with the investment banker concerning his client’s tax issues, especially as they can be addressed by various alternative provisions in the imminent transaction.

• Third, the CPA performs compliance work once the deal has closed and tax returns must be filed on behalf the seller. Related CPA fees may well reflect this work.

All in all, a CPA might bill from $25,000 to $150,000 for undertaking an average amount of work required in support of a Middle Market M&A sales-side transaction.

Clients’ Overall Estimate of Professional Fees for a Typical Engagement

Having addressed so many permutations and variations in the setting of fees may have left a reader somewhat confused. That was not the purpose, however understandable the outcome. As a rule of thumb, then, let’s just create one “for instance” for a $20 million transaction, which probably would generate fees as follows:

• Investment banking fees: between 3% and 4%, or $600,000 to $800,000

• Basic attorney’s fees: between .50% and .75%, or $100,000 to $150,000

• CPA’s fees (assuming an audit or review was being undertaken anyway, regardless of the transaction): between .25% and .375%, or $50,000 to $75,000

• Total fees: Approximately $750,000 to $1,025,000, a very rough estimate for a $20 million sales-side transaction. Overall, a seller might estimate total fees of between 3.75% and about 5.12% of the sales price of his firm. Averaging out to 4.5% would work as an approximate early estimate just to get one’s bearings.

Chapter Highlights

• FSAs (see Exhibit 13.1) are necessarily complex documents whose main features include:

• A success fee schedule that usually resembles a Double Lehman formula or any of several variations:

• A minimum fee (e.g., $250,000), but not a breakup fee

• A sales-side retainer (commitment fee) of from $25,000 to $50,000 payable upfront, which may or may not be credited against an eventual success fee

• Provisions describing transaction value (including contingent and noncontingent, deferred and noncash) that allow the success fee to be determined

• A basic contract term of from 6 to 12 months with automatic 60- to 90-day serial renewals

• Trailers defining how the investment banker will be compensated for a buyer that he introduced to the seller when that buyer closes a deal after the expiration of the investment banker’s engagement has expired

• Carve-outs and/or hourly rate agreements involving buyers with whom the seller already has initiated negotiations

• Attorneys’ reviews of FSAs are usually helpful, but in rare and inappropriate occasions, they are not. Attorneys should limit reviews to legal terms rather than business terms except in special cases. Reviews regarding investment banking fees, especially those that are already agreed upon, are inappropriate except in certain defined cases.

• Wire-transfer fee payments at settlement are ignored at the peril of the investment bank.

• Client checks on investment banker integrity and experience are critical before and after the engagement agreement is established to select the right investment banker.

• Estimates of the M&A support professionals’ fees (lawyers, accountants, and others) are likely ranges, because of the complexity of one engagement compared to another.

EXHIBIT 13.1 Sample Financial Service Agreement (FSA)

Notes

1 Once again, I am indebted to Richard Restak’s The Naked Brain (Harmony Books, 2006). The whole book is an incredible read about the way we think.

2 Most experienced Middle Market investment bankers would argue that very small deals often involve more work proportionally. Smaller deals also tend to be harder to do, because they are less attractive and to fewer potential buyers. Furthermore, the parties involved—both sellers and prospective buyers—often are less sophisticated and less experienced with mergers and acquisitions. As a result, they tend to require a great deal more education and hand-holding along the way, often making them considerably more difficult and time-intensive where investment bankers are concerned.

3 “Adequate” in this context is from the sales-side point of view, as it defines the convention, meaning what a buyer is entitled to but not necessarily what he needs. The buyer will compute needed working capital, especially where a lot of future growth is contemplated, in his own private and subjective calculations, usually in some form of a discounted cash flow analysis. But if this is a calculation of additional working capital needed to expand as opposed to maintain the business then this working capital conventionally would come from the buyer and not the seller.

4 A discouraging outcome, especially for new investment bankers, of a client’s innocent unawareness of the sometimes herculean efforts to add millions of dollars to his transaction value is that the client will be very quick on occasion to quarrel about some other amount of transaction value that is relatively minor while unwittingly ignoring the free transaction value his banker has extracted for him.

5 Often, this reluctance is associated with the client’s confidentiality concerns which, while understandable, usually tend to be exaggerated. (See Chapter 8).

6 Subsequent rounds of capital raises are usually characterized, starting with the initial round as “A,” “B,” “C,” etc.