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Aligning Interests in Sell-Side Engagement Letters

Brian D. Goldstein of Choate Hall & Stewart LLP


As the dust settles from the recent economic downturn, current market conditions are ripe for significantly improved levels of merger and acquisition activity.  As investors and management consider engaging in a sale process, one of the first and most important tasks is to vet, select and negotiate an engagement letter with an investment bank.  While finding the "right" banker can be a critical factor in the ultimate success of the exit, it is also important that the engagement be structured and documented in a way that appropriately aligns incentives.

We recently reviewed engagement letters from a variety of investment banks, from boutiques to bulge bracket firms, to identify key issues to consider when engaging in the sale process in the current environment to better align the interests of management and investors with their bankers.

Take Control of the Process

First and foremost, you likely will select a banker or a banking team whom you believe will contribute specific talents and experience to, and take a personal interest in, the success of the transaction.  Therefore, it is important to identify, by name, the specific bankers that will lead the work on the transaction.  It is important to provide in the engagement letter that the unavailability or departure of a "key person" will afford the company with a right to terminate the engagement.  Also, we recommend that the engagement letter specify periodic telephone and in-person updates to be provided by the named lead bankers and not junior members of the team.

The engagement letter should specify a clear process for identifying and approaching potential buyers.  Among other matters, management and investors should identify an agreed upon list of potential buyers, or a process for coming up with an approved list.  The engagement letter should both prohibit the bankers from approaching others that the company has not approved in advance and from distributing detailed information to any party that has not signed a confidentiality agreement approved by company counsel.  It is important to prioritize the target buyer pool and to document contacts made by the bankers if necessary for the tail period (described below).

The engagement should be limited in time, typically six to twelve months.  After deciding the time is right to seek an exit, you want the bankers incented to meet your time frame, not theirs.  This is also important because of the typical "tail" provisions in these letters, which entitle the bankers to a fee if a transaction closes during a defined period following the end of the engagement should the company fail to sell during the engagement. 

Structure the Fee to Fairly Reward Performance

If done correctly, the fee structure should motivate the bankers to achieve a liquidity event that hits the top end of the valuation range reasonably anticipated by investors and management.  For example, if the expected range is $100-$150 million, and the fee is set at a flat 2% of proceeds, the banker would be entitled to a $2 million fee at a $100 million valuation and a $2.2 million fee at a $110 million valuation.  An additional $10 million may be worth considerably more to stockholders than the incremental $200,000 to the banker.

To solve this issue, set appropriate "break points" (i.e., different percentage fees at different valuation tiers) to motivate the bankers to achieve a valuation that meets your objectives.  Likewise, a floor should be set at a level that deters the banker from just "getting any deal done" to receive the minimum fee.

Fees are typically calculated as a percentage of "Transaction Value," which should be synonymous with enterprise value.  However, often form engagement letters offered by bankers sweep excess working capital, such as cash on hand and pre-closing cash distributions, into the definition of Transaction Value.  The company does not need to pay a fee to sell its cash.  In addition, many sale transactions include payments to specific employees to compensate them for entering into long-term agreements, restrictive non-competes and the like.  Care should be taken to exclude those payments from the definition of Transaction Value as they do not result in value to stockholders generally.

Pay the Banker Only When Stockholders Are Paid

The engagement letter should define the kind of "Transaction" for which a success fee will be paid and should include only the transaction that the company seeks – often that's a pure sale only, but sometimes it is appropriate to include a recapitalization or minority equity raise.  If it does include a minority equity raise, money raised from existing investors, who already are familiar with the company, should be excluded from the fee calculation.  Other than a small retainer, which might be paid monthly or in a lump sum at the outset of the engagement, no fee should be payable at any time prior to closing. 

Often sale transactions include contingent consideration, such as earnouts based on financial performance or other milestones during a period following the closing and escrows for indemnification obligations relating to the company's representations and warranties.  While the aggregate amount of the banker's success fee will be calculated on the full anticipated amount of consideration to be paid, the banker often is not paid the full fee at closing under these circumstances.  The fee corresponding to an earnout should be paid only when the earnout payment is delivered by the buyer to the company stockholders.  On the other hand, payment of that portion of the fee corresponding to the indemnification escrow holdback is often negotiated, with a common compromise being to pay a fee at closing only with respect to a reasonable escrow amount (such as ten percent).  Other deferred payments, such as seller notes to finance the transaction for the buyer, also should not be overlooked.

Protect Your Interest During the Tail Period

As mentioned above, engagement letters typically entitle the bankers to a fee if a transaction closes during a defined period following the end of the engagement should the company not be sold during the engagement.  This "tail" provision creates the potential for an unhappy situation in which:

  • the process run by the bankers was unsuccessful;
  • the company subsequently hires another set of bankers to conduct another sale process: and
  • if the new bankers succeed in generating a sale during the tail period of the initial banker's engagement, the company will owe a fee both to the new banker (who will have earned it) and to the terminated banker (who will not have earned it).

Companies should limit the tail to an appropriately short period of time (ideally, not more than six months), and tie the fee obligation in the tail period to a Transaction only with a party first identified or brought to the table by the banker.  The engagement letter should provide that no fee is payable in the tail period if the company terminates the engagement for "cause" (often limited to staffing changes by the banker or complete failure of performance) or the banker withdraws from the engagement.

While the terms of any given engagement letter will depend on the leverage and specific dynamics of each situation, management, investors and bankers armed with this checklist of issues will be able to structure their relationship in a manner that is fair, balanced and capable of producing the desired outcome for all concerned.


Brian D. Goldstein, Partner, bgoldstein@choate.com

Brian D. Goldstein is a partner in the Business & Technology group at Choate, Hall & Stewart LLP in Boston where he has over 20 years of experience in the areas of general business, venture capital, technology transactions, and M&A. 

Full Bio (http://www.choate.com/people/brian-goldstein)

Choate Hall & Stewart LLP

Choate, (www.choate.com) one of the nation's leading law firms, is consistently recognized for excellence by Chambers USA, Private Equity Analyst and Best Lawyers in America.  Choate focuses on a strategic core group of areas where it provides superior value across the US and internationally, including M&A, private equity and venture capital.  Choate has particular expertise and knowledge of market terms and industry best practices in middle market transactions ranging from $25 million to $1 billion, and is ranked as a tier one firm in middle market M&A by The Legal 500.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Choate Hall & Stewart LLP. This work reflects the law at the time of writing.