With a dramatically declined M&A market, companies continue to conduct sales processes, and transactions are being consummated despite the difficult economic environment. In this challenging atmosphere, it is more important than ever to select the proper financial advisor to effectuate a proposed transaction with the most appropriate terms and conditions. And the formal arrangement, the engagement letter, is crucial to align your interest with that expert to maximize price and the likelihood of a closed deal while minimizing risk. Sophisticated clients often negotiate these investment banker engagement letters themselves without consulting a skilled M&A lawyer under the mistaken impression that such a letter contains “boilerplate” and is pretty much non-negotiable. We have outlined the Top Ten issues to spot, review and analyze in negotiating that engagement letter.
1. Clearly and narrowly define the scope of the Transaction
The engagement letter clarifies to all participants the specific services the investment bank is going to provide and under which circumstances they will receive a fee. Providing clarity to those services and the definition of the transaction assists the client in understanding what they are paying for and helps the advisor understand what they have to accomplish in order to get paid. As any investment bank will be paid if they are able to cause a “Transaction,” such term will likely be broadly defined. For example, the advisor will likely want to include “any transaction, in which the sellers or the company receives any proceeds.” The client should carefully define the Transaction to narrowly include only specifically what is expected (i.e., the sale of the entire business or all of its equity). A broad definition will likely provide an investment bank with more opportunities to earn a fee. If a client wants to sell all or substantially all of its assets or it will only entertain a transaction with an unrelated third party, those elements need to be clearly stated in the definition of Transaction.
2. Identify and value any “special” services provided
Standard services are listed in every investment bank engagement letter, such as reviewing and analyzing the financial condition of the company as well as negotiating the financial aspects of a proposed transaction. However, the scope of the engagement letter may need to include special, one-off services being provided by the investment bank as well, such a providing any specific analysis to be conducted or the issuance of a fairness opinion. The client should identify any special services and the related compensation that the investment bank will be paid for providing such services, if any.
3. Limit exclusivity
Typically, the investment bank is engaged on an exclusive basis to provide services to the client related to a sale or recapitalization, for example. A broad “Transaction” definition may limit a client’s ability to hire another firm to provide certain services. Additionally, a broad definition will usually enable the bank to earn additional compensation related to many different transactions.
4. Resist any effort to include a retainer or engagement fee
Investment banks may include an “engagement” or “retainer” fee in its engagement letter, either as a one time or monthly fee, particularly in smaller or more difficult deals. This fee is a nonrefundable fee paid to the investment bank as compensation for its services. Ideally, it would be eliminated entirely. Bankers often believe that the payment of such a fee will likely morally commit a client to a potential transaction. However, the ability to avoid this fee will often depend on the size and complexity of the deal, any leverage between the client and the investment bank and the investment bank’s prestige and standard operating procedures. If the investment bank requires an engagement fee, the client should include a favorable payment schedule such as paying the fee over a number of months from the commencement of the engagement. In any instance, any fee should be credited against any other fee that the investment bank can potentially earn on the transaction.
5. Tier and incentivize the transaction fee
A “transaction fee” is a payment made by the client to the investment bank and usually calculated as a certain percentage of the overall transaction value. The transaction fee is the largest part of an investment bank’s compensation and may be heavily negotiated. If the sale of the business is consummated at its market value, an investment bank should receive a smaller percentage fee than if it achieves outsized success.
As an incentive to the investment bank, if the overall transaction value exceeds a certain dollar threshold, the client should be willing to pay a higher transaction fee for a superior result. For example, the client may agree to pay the investment bank a transaction fee equal to 2% of the overall transaction value if valuation of the transaction is between $8 million and $10 million. However, the client would pay the investment bank a transaction fee equal to 3% of transaction for any portion of the transaction value that exceeds $10 million. Multiple tiers of increasing higher fees may also incentivize a banker to achieve a greater fee.
6. Confirm the value of any minimum transaction fee
Some engagement letters may also include a minimum transaction fee or “floor” regardless of the actual transaction (e.g., language stating a fee will be paid “but in no event will be less than $1,000,000”). Clients need to analyze whether the minimum fee is fair based on the facts and circumstances of the specific transaction. Clients should request market data supporting a minimum transaction fee and the fee structure in its entirety. All investment banks have access to current data on investment banking fees. As described below, payment of any transaction fee tied to contingent payments should be conditioned on the seller receiving such contingent payments.
7. Limit the investment bank’s expenses
Engagement letters typically require the client to reimburse investment banks for their expenses. Clients should carefully examine which types of expenses are expected and which can be excluded, potentially saving money. Any travel should be limited and characterized as economy only, for example.
Any expenses incurred should be properly documented with third party receipts. Any discounts, rebates, incentives or other compensation available for volume purchase by the investment bank should be applied. A cap on third party fees, which cannot be exceeded without client approval, can also limit surprises.
8. Carefully craft the term and termination based on the parties’ relationship
The engagement letter should be terminable by either party upon providing thirty days written notice. Additionally, the client should have the right to terminate the engagement letter for cause, such as the investment bank’s breach of a material term of the engagement. If the investment bank requires that an engagement fee is earned once paid and such fee is not credited toward the transaction fee, any letter should narrow the circumstances in which the investment bank can terminate the relationship because such payment becomes a nonrefundable retainer.
9. Require the receipt of contingent fees before being paid
Usually an engagement letter includes any and all amounts that are paid or could be paid to a client, even if not paid or earned as of the closing, in the transaction value, maximizing their fee. The investment bank will insist that all of their fee related to the transaction be paid at closing. However, the client may still be waiting to be paid on certain contingent payments such as an indemnity holdback, escrow or an earn-out. The client should only pay a fee to the investment bank when and if these amounts are actually received by the client, even if it is months or years later.
10. Limit the tail period in multiple ways
Even if an engagement letter is terminated, the client may be responsible to pay a fee for a transaction or relationship which commenced during the investment banker’s engagement. The tail period is that period of time following termination that provides the investment bank with the right to receive its transaction fee if the client enters into a transaction with a buyer. Investment banks are always worried that if the client terminates the relationship, the investment bank will not be paid for the work performed. Because of this, it is important for the client to try and narrow the tail period in various ways.
First, narrow the tail period by its relevant time. Usually six or nine months is sufficient. Investment banks will attempt to have the tail period be a substantial amount of time, such as 18 or 24 months.
Second, narrow the tail period to a specific class of buyers. For example, the tail should only apply to buyers that the investment bank formally introduced to the client through an executed NDA or otherwise. The tail should not apply to any buyer that consummates a transaction.
Third, the tail period should only apply to a transaction that actually closes and the client receives a certain amount of proceeds. Avoid application for the execution of a letter of intent or other preliminary steps. Also limit the tail to a specific type or transaction or threshold of actual proceeds received.
As with any complex transformative M&A project, it is best to obtain the advice of experienced M&A counsel.
 US volume is down by 50% compared to the first quarter of 2019, according to Reuters. Global activity is down over 28% compared to the period first quarter in 2019. See https://www.reuters.com/article/us-global-m-a-review-coronavirus/global-ma-dwindles-as-coronavirus-batters-worlds-economies-idUSKBN21I0LT
 Each M&A has particular facts that need to be considered when negotiating the engagement letter. This article is for general informational purposes and should not be construed as legal advice. Please consult an M&A attorney for legal advice concerning a specific M&A engagement.