Understanding Investment Bank Engagement Letters: Key Provisions and Fees

Scope of Services

Definition and Importance

The scope of services section in an investment bank engagement letter defines the role of the investment banker and the end goal of the engagement. This could involve a financing transaction, a purchase, or both. It is essential because it clarifies what services will be provided and what outcomes are expected.

Services Included

Typical services included in this scope are:

  • Valuing the company: Determining the financial worth of the business.

  • Preparing confidential information memoranda: Creating detailed documents about the company for potential buyers.

  • Locating and contacting potential purchasers: Identifying and reaching out to potential buyers.

  • Managing due diligence: Overseeing the process where buyers scrutinize the company’s financials and operations.

  • Negotiating transaction terms: Facilitating negotiations between the seller and buyer.

Flexibility and Customization

The engagement letter should allow for flexibility to accommodate changing deal processes and market conditions. This ensures that both parties can adapt to new developments without being constrained by rigid terms.

Exclusivity

Exclusive vs. Non-Exclusive Relationships

Investment banks often prefer exclusive relationships because they avoid marketplace confusion, deal coordination issues, and communication problems that can arise with non-exclusive arrangements. Exclusive relationships ensure that all efforts are focused on a single transaction strategy.

Duration of Exclusivity

The exclusivity period typically ranges from six months to a year, depending on factors such as transaction complexity and preparation time. This duration ensures that both parties have sufficient time to work towards a successful outcome without unnecessary distractions.

Fees and Compensation

Retainer Fee

A retainer fee is an upfront, non-refundable fee paid to retain the investment bank’s services. It demonstrates the seller’s commitment to the process. Retainers are often paid monthly, ranging from $25,000 to $75,000, and should be credited against the success fee upon completion of the transaction.

Transaction or Success Fee

The transaction or success fee is a significant component of the compensation structure. It can be calculated in different ways:

  • A straight percentage of the transaction value.

  • A tiered fee structure where percentages increase based on deal size (e.g., 2.5% for the first $20 million, 5% for the next $10 million).

Understanding these fee structures is crucial as they can significantly impact the overall cost of engaging an investment bank.

Expense Reimbursements

Investment banks may also seek reimbursement for reasonable and necessary expenses incurred during the engagement. These reimbursements often come with caps and require prior approval to ensure transparency and fairness. It’s important to document expenses with third-party receipts and exclude certain costs like legal fees incurred by the banker.

Timing of Fee Payments

Alignment with Transaction Milestones

Fee payments should align with when the seller receives money from the transaction. This includes considerations for earnouts, escrows, and seller financing. Ensuring this alignment helps manage cash flow effectively.

Negotiation Points

The timing of fee payments can be a negotiation point. Sellers may want to adjust payment schedules to reflect when they actually receive funds from the transaction.

Indemnification Provisions

Protection for Both Parties

Indemnification provisions are critical as they protect both the seller and the investment bank from potential claims and liabilities arising from their engagement. These provisions ensure that neither party is unfairly exposed to risks.

Control Over Defense and Settlement

It is important for the seller to have control over defending any claims and approving settlements to avoid unfair liability. This ensures that any legal actions taken are in line with the seller’s interests.

Tail Provisions

Purpose and Duration

Tail provisions protect the investment bank from losing fees if a transaction closes after their engagement ends. These provisions typically last for a period of 24 months after termination. They ensure that if a deal is completed shortly after their involvement ends, they still receive their due compensation.

Negotiation Safeguards

To safeguard against potential abuses, tail provisions can be limited to deals with buyers contacted during the exclusivity period. Additionally, fees may be excluded if the client terminates the agreement for cause.

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