Negotiating Investment Banker Engagement Letters

Companies often hire investment bankers for capital fund-raising and M&A activities, and these investment bankers can be very valuable partners. In order to expedite the process and ensure that companies are agreeing to reasonable market terms, this article discusses certain guidelines that are appropriate when drafting an investment banker engagement letter.

Investment bankers always attempt to start the negotiation with their purported “standard form” letter, which is always one-sided in favor of the investment banker. It is a mistake for the company to accept the “standard form.” The company has the most leverage during the bankers' “courting” process, and a banker should not be told it has gotten the assignment until all of the language of the letter has been negotiated.

Responsibilities of the Banker

It's valuable to see a specific description of the services to be provided in the engagement letter. The services should include:

• Financial advice and assistance in connection with the potential transaction


• Financial analysis


• Assistance in the preparation of a confidential information memorandum or executive summary


• Coordination of efforts to ensure that prospective investors or buyers execute appropriate non-disclosure agreements


• Coordination of meetings and visits of potential investors/buyers


• Assistance in negotiating terms of the transaction


• Good faith diligent efforts to secure a transaction (either M&A or investment) acceptable to the company


• Assistance in preparation and review of an online data room


• Assistance in the company's preparation of a disclosure schedule for a buyer or investor


• Meetings with the company's Board of Directors to discuss the proposed transaction and its financial implications, and to provide advice concerning the proposed transaction to the Board


• In connection with an acquisition of the company, the rendering of a fairness opinion and bring-down of the fairness opinion, if requested by the company


• Other customary investment banking services for the transaction

Contact with Potential Investors or Buyers

The company should have the right to approve any contacts with prospective buyers or investors in advance, with the following sentence in the engagement letter:

Banker agrees that it will not contact any potential investor or buyer without the Company's prior consent.

Fees

Fees with bankers are always negotiable. Generally, I prefer to see the following:

• There should be no upfront retainer, with any fee being payable only upon the close of a transaction. If there is a retainer, it should be small and creditable against the ultimate success fee.

• If there is a fairness opinion fee, it should be creditable against the ultimate success fee.

• In an M&A transaction:
  
  
  
  • The amount of the fee will typically range from 1% to 3% of the net consideration received by the shareholders, although the amount is deal specific. If a prospective buyer has already contacted the company prior to engaging the banker, the fee for that buyer should be lower than for a buyer procured by the banker.
  
  
  • The base on which the banker's fee is calculated should exclude any consideration attributable to cash or cash equivalents held by the company; cash the company receives from option exercises; and compensation for employment, consulting, or “stay” bonuses.
  
  
  • If a portion of the consideration to shareholders is deferred, escrowed, or contingent, then payment of the investment banking fee applicable to that amount should only occur when and to the extent that the shareholders actually receive the deferred consideration.
  
  
  • No portion of any “break up” fee payable to the company should be owed to the banker.
  
  
  
  

• If the transaction is a fund-raising, then no fee should be payable for existing stockholders of the company who participate in the financing round.

• Any minimum success fee should be avoided, as it produces a misalignment of interest between the company and the banker. If a minimum fee cannot be avoided, the success fee must be reasonable in light of the transaction. I have seen many deals where the minimum fee is no greater than $500,000. 

Future Rights of the Banker

Engagement letters should not provide that the banker has the unilateral right to be the company's banker for future IPOs, M&A assignments, or fund-raising. If the banker performs well on the particular assignment, then the company will evaluate whether it makes sense to hire the banker for a future transaction at the time of the future transaction. Any number of events could occur in the interim that would make it inadvisable for the banker to act as the company's banker the second time (e.g., loss of personnel, the banker being sold in a fire sale to a competitor such as the Bear Stearns/JPMorgan transaction, the company not being satisfied that the banker is best equipped to handle the new transaction, etc.).

Tail Obligations

Many engagement letters will have a “tail” obligation by the company, where even if the transaction is not satisfactorily consummated with an investor or buyer during the term of the engagement, a fee will still be owed to the banker if a future transaction occurs within a certain period. Such a tail is typically appropriate only if (a) a future transaction occurs within 9 months of termination of the engagement, (b) the future transaction occurs with a party who has signed an NDA with the company during the engagement term, and (c) the banker has not been terminated for a “Good Reason” (defined below under “Term and Termination”). The following is suggested language for an M&A assignment:

The Banker's right to a fee shall also apply if a Transaction with a “Qualified Buyer” closes within 9 months after this engagement is terminated, although no fee will be due to Banker if the Company terminated this letter for Good Reason (defined below), or if Banker terminated this letter. A “Qualified Buyer” is a person or entity contacted by Banker, and with which the Company and the prospective buyer executed the company's form of Non-Disclosure Agreement, both during this engagement. Banker will provide Company weekly with an updated list of Qualified Buyers.

Term and Termination

I prefer to see the following provisions with respect to the term of the engagement and termination rights:

(a) The term of the engagement letter should have a maximum, typically 6 months, and will automatically expire at the specified time frame. The “tail” would then apply.

(b) The company should be free to terminate the engagement for any reason on 3 days notice (and in that case the “tail” would continue to apply).

(c) If the banker terminates the engagement, the banker would not be entitled to any “tail” fees.

(d) If the company terminates the banker for “Good Reason,” no “tail” fee would be due.

I recommend the following language:

Company may terminate this letter at any time, and for any or no reason, on 3 days notice to Banker.

This letter will terminate automatically six (6) months after the date it is signed by both Company and Banker.

Company may immediately terminate this letter for the following (each a “Good Reason”) and in the event of such termination, the Company will have no further obligations to Banker for payment of any fees: if the Board of Directors of the Company notifies Banker that the Board has determined in good faith that (a) Banker has materially breached its obligations under this letter, or (b) has failed to perform reasonably adequately as the Company's financial advisor, or (c) that Banker or its affiliates has a conflict of interest detrimental to the Company, or (d) the Banker has suffered a material adverse change in its business and such change calls into question the Banker's ability to effectively render the services contemplated hereunder or (e) if for any reason ____________ [the key individual banker] is not the lead banker on the deal representing Banker and actively involved in the prospective Transaction.  

Banker's Compliance with Law

I expect to see the following covenants in the engagement letter:

• Banker will comply with all applicable federal and state securities laws, rules, and regulations in connection with its activities hereunder and all applicable broker-dealer registration and compliance rules and regulations.

• If the transaction involves a private placement of securities, Banker will take no action that will jeopardize the company's private placement exemption from federal and state securities laws.

Expenses

Engagement letters typically have a provision to the effect that the banker is to be reimbursed for all of its expenses in connection with the engagement. I expect to see the following limitations on expense reimbursement:

• The amount of reimbursement is subject to a cap of $25,000, without the prior written consent of the company.


• The reimbursement is only for out-of-pocket, necessary, and reasonable expenses incurred by the banker.


• No reimbursement will be provided for legal fees incurred by the banker in negotiating the engagement letter.

Conflicts

Companies need to be particularly sensitive to the potential conflicts that the banker may have. Many engagement letters attempt to sanction all conflicts. For example, some bankers try to allow themselves or their affiliates to advise, invest in, or work with any company, even a direct competitor. That is usually not acceptable given the potential harm to the company. As such, I would expect to see the following paragraph inserted into the engagement letter:

Notwithstanding any other provision of this letter:

• Banker represents and warrants that Banker and its affiliates have no material conflict of interest in connection with the assignment contemplated by this letter.

• During the term of Banker's engagement, Banker and its affiliates will not invest in, or represent or provide services to, the following direct competitors of the Company (“Listed Competitors”): [list of names]

• During the term of this engagement, Banker will promptly advise the Company in writing of any conflict of interest detrimental to the Company of which Banker's become aware.

Confidentiality

The engagement letter should have a confidentiality obligation of the banker. The following is suggested language: 

Banker will treat as confidential any non-public information relating to the Company or the proposed transaction, and will not use such information except as (a) required in order to perform services under this engagement, (b) such information becomes publicly available other than through disclosure by Banker or its employees, representatives or agents, or (c) otherwise required by law or judicial or regulatory process (and, in such case, only after seeking with the Company's assistance a protective order or other confidential treatment). This paragraph will survive any termination of this letter.

Announcements

The banker may give itself the right to unilaterally announce its role in the transaction. It is appropriate that any announcement about the transaction or the banker's role in the transaction must be first approved by the company.

Indemnification

The engagement letter will provide for very broad indemnification of the banker. For the most part, such indemnification provisions are industry standard (and often sacrosanct for the investment banker), but the following caveats are appropriate:

• Indemnification is required only to the extent permitted by law.


• Indemnification is not required if the damage primarily resulted from the bad faith, gross negligence, willful misconduct, or material breach of the engagement letter by the banker.


• Reimbursement for legal fees and expenses should only be for “reasonable” legal fees and expenses.


• Indemnified persons must provide prompt notice of potential claims.


• No settlement of an indemnified claim is allowed without the company's consent, which consent will not be unreasonably withheld or delayed.

 

Copyright © by Richard D. Harroch. All Rights Reserved.

Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on investing in Internet and digital media companies, and he was the founder of several Internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, FoxBusiness, and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He was also a corporate partner at the law firm of Orrick, Herrington & Sutcliffe, with experience in startups, mergers and acquisitions, strategic alliances, and venture capital.

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