By Thomas R. Taylor
When the owners of a business decide to sell their company, they will generally engage an investment bank (iBank) to assist with the transaction. An experienced iBank can add significant value to a sellside M&A transaction. However, it’s important that the iBank’s interests and those of the company be aligned. That alignment of interests is achieved through a properly structured iBank engagement agreement.
This article is written from the perspective of a seller in a middle market sell-side M&A transaction. Certain issues are identified below that sellers should carefully review and consider before entering into an engagement agreement with an iBank.
Scope of Services. The agreement should set forth a detailed list of the primary services that will be provided. Doing so will avoid disputes regarding the services to be provided.
Exclusivity. Engagement agreements will provide that the iBank will be the seller’s exclusive financial advisor for the transaction. Exclusivity is necessary in order to give the iBank a realistic amount of time to market and sell the company. The iBank will ask for as long of an exclusivity period as it can get, whereas the seller will want as short an exclusive period as possible. A six- to 12-month exclusivity period is fairly standard.
Definition of “Transaction” and CarveOuts. Typically, the first draft of an engagement agreement will provide for an all-encompassing definition of what constitutes a “transaction,” the closing of which will entitle the iBank to a success fee (see “iBank Compensation,” below). “Carveouts” to that definition should be considered. If the seller has an established relationship with any prospective buyers, the agreement should be modified to exclude those prospective buyers and/or reduce the iBank’s success fee accordingly.
Transaction Value. Success fees are generally calculated on the basis of “transaction value.” The iBank’s initial engagement agreement generally includes a comprehensive list of how the iBank proposes to determine the transaction value. Failing to carefully scrutinize that definition can be a very costly mistake. As a general rule, the iBank should not be compensated for anything that does not result in value creation for the seller.
iBank Compensation. iBank compensation is generally comprised of two components: a retainer and a success fee.
• Retainer. A one-time, nonrefundable retainer is generally paid at the time the engagement agreement is executed, although sometimes the retainer will be paid on a periodic basis (usually monthly) for a predesignated period of time. The purpose for the retainer is to allow the iBank to recover some of its costs and expenses if the transaction does not close and ensure the seller is committed to selling the company. Retainers generally range between $25,000 and $75,000 and should always be capped and be credited against the success fee.
• Success Fee. The success fee will almost always be calculated based on a percentage of the transaction value. Success fees are generally either, a. A flat percentage of the transaction value or, B. a progressive upward scaled percentage. Success fees typically range from 3 percent to 8 percent of transaction value. Most iBanks will also require a minimum success fee, often in the range of $200,000 to $600,000. The success fee is payable in cash out of the sale proceeds upon the closing of the transaction.
Expense Reimbursement. Engagement agreements will require the company to reimburse the iBank for out-of-pocket costs and expenses incurred in connection with the engagement, such as travel and lodging. While expense reimbursement is customary, sellers should ensure that the agreement establishes some ground rules. The company should require that all reimbursable expenses be subject to a reasonableness standard and be limited to out-of-pocket payments made to third parties. Furthermore, reimbursable expenses should be capped at a predetermined dollar amount and be required to be preapproved if any expense will exceed a specified dollar amount. Reimbursable expenses are often in the $20,000 to $40,000 range.
Escrows and Earnouts. It’s common for one or more escrow accounts to be established with a third-party escrow agent in order to provide for such things as indemnification claims and working capital adjustments. Money from the sale proceeds will be held in such escrow until the contingency has been satisfied. In addition, sell-side M&A transactions sometimes involve an “earnout” or contingent payments to the seller, depending on the post-closing performance or operating results of the target company. Many iBanks will seek to have the full amount of such escrows and the maximum possible contingent earnout amount included in the definition of the transaction value. However, including those amounts in the transaction value is not appropriate and should be resisted by sellers. Rather, the engagement agreement should provide that the iBank will be paid its portion of such monies only if and when paid to the seller.
Term, Termination. Generally, the initial term (the term of most engagement agreements will be six to 12 months. The term should be long enough for the iBank to properly market and sell the company, but not so long as to provide a disincentive for the iBank from working diligently and closing the transaction as soon as reasonably possible. The initial draft of most engagement agreements will provide that the term will be for a specific period of time and will automatically renew for additional successive one-month periods unless either party terminates. However, sellers should consider negotiating for the engagement agreement to automatically terminate at the expiration of the term unless the seller elects to extend. Furthermore, the seller should have the right to terminate the engagement agreement at any time without cause upon 30 days’ prior written notice. The engagement agreement should also entitle the seller to terminate the relationship immediately for cause, including a material breach by the iBank or its gross negligence, willful misconduct or bad faith.
Tail Period. iBank engagement agreements will always include a “tail” or “tail period.” The tail period is a period of time, after the expiration or termination of the engagement agreement, during which the iBank will be entitled to be paid its success fee if a transaction is consummated. Tail periods are heavily negotiated. Sellers should try to limit the tail to as short a period as possible, whereas iBank’s will always advocate for as long a period as they can get. Tail periods generally range between six and 24 months, with 12 to 18 months being fairly common.
Indemnification. iBanks will always insist on being indemnified for any liability they incur as a result of their involvement in an M&A transaction. Indemnification is customary and appropriate because any claims that may arise likely will be attributable to information provided by the seller, which the iBank relied upon in marketing and selling the company. These provisions will require the company to indemnify the iBank, provided that the claim does not arise from the iBank’s fraud, gross negligence or willful misconduct. iBanks and their counsel will generally not agree to any substantive changes to their form indemnification agreement.
Lead Investment Banker. iBanks are commonly hired based on the industry experience, expertise and reputation of one or more key members of the iBank’s team. If any individual investment banker will be essential to a successful transaction and is expected to lead the deal, the engagement agreement should so provide. The agreement should also grant the seller the ability to terminate the engagement if the key investment banker leaves the iBank or for any reason they are not actively involved in the transaction.
Confidentiality. The engagement agreement should contain a comprehensive confidentiality provision. Also, if the seller discloses confidential information to any iBank before an engagement agreement is executed (which is often done during the process of interviewing and vetting iBanks), the seller should enter into a separate, stand-alone confidentiality agreement with each such iBank before disclosing any confidential information. The confidentiality agreement should prohibit the iBank from using or disclosing any of the seller’s confidential information and should remain in place throughout the term and tail period and for at least one to two years thereafter.
Thomas R. Taylor is a corporate and M&A lawyer and a shareholder in the Salt Lake City office of the law firm of Durham, Jones & Pinegar P.C. He maintains an AV/Preeminent rating with MartindaleHubbell, which is the highest rating awarded to attorneys for professional competence and ethics.