As companies begin the process of preparing for an M&A transaction, raising capital, financial restructuring, or other strategic alternative, the first step most of them take is to search for an investment banking firm to assist with identifying an appropriate buyer or investor and negotiating the contemplated transaction and the business diligence process, and to provide other services in connection with the transaction. Once the company has selected an investment banking firm and decides to move forward, an engagement letter comes into play.

The engagement letter usually provides that the investment bank will act as the company's exclusive financial advisor (the "advisor" or "financial advisor"). The letter will describe the contemplated transaction and the scope of services to be provided by the advisor, as well as limits on its liability. Additionally, the engagement letter will generally set forth the advisor's responsibilities and fee arrangements.

While some companies approach engagement letters with investment banking firms as a cursory exercise, the engagement letter should be structured and tailored to ensure that it aligns the interests of the parties and properly incentivizes the advisor to find and close the deal. The critical provisions of an engagement letter are explored below.

Scope of Services, Exclusivity Provisions, and the Term and Tail Periods

One of the first parts of the engagement letter is the scope of services. It identifies types of transactions that the company is pursuing, various services that the advisor will provide, and the transactions that will lead to the advisor earning its fee. Generally, engagement letters include services such as identifying and communicating with potential buyers or investors, evaluating the client's financial condition, preparing marketing materials, or providing underwriting services. Both parties should take a careful look at this section to make sure that the goals and expectations of the company and financial advisor are aligned and explicitly addressed.

Exclusivity is a standard provision of engagement letters, providing for compensation to the financial advisor upon the occurrence of a specified transaction during the term of the engagement or for a set time afterward, often regardless of whether the advisor was the transaction's procuring cause. Financial advisors often spend months reviewing the company's documents to evaluate the company's business and identify possible investors; it is understandable that the advisor does not want another firm to receive compensation for a transaction the advisor spent time and resources on.

Generally, the term of engagement can range from 6 months to a year, but it should be a compromise between how much time the advisor needs to perform the services and how long the company wants to be bound to an exclusive relationship with the advisor. Depending on circumstances, the term typically can either end on a set date or roll over to a month-to-month arrangement with a 30-day written notice requirement. The exclusivity constraints will continue until the engagement is terminated, and, to the extent permitted, any related monthly or other periodic fees will continue as well.

Once the engagement is terminated, the "tail" period starts running. The tail provision entitles the advisor to receive its fees if the transaction identified in the engagement letter occurs during some specified period after its termination. The tail provision ensures that the advisor receives its compensation if it has performed its services and introduced the client to the buyer (or other party to the transaction, as determined by the engagement letter), even though the parties closed the deal after the term ended. It also functions as a bad-faith protection, as it prevents clients from terminating the engagement and entering into a transaction immediately after to avoid paying the fee. The tail period generally may last up to 2 years, and frequently it is applicable only to specified potential buyers or other parties to the transaction.

Fee Structure

The fee structure of an investment banking engagement letter customarily consists of (1) the retainer fee, (2) the success fee or transaction fee, and (3) expense reimbursement.

The retainer fee is a flat amount paid to retain the services of the investment banking firm. It is either paid at the beginning of the engagement in a single lump-sum payment or over the term of the engagement on a periodic basis and is typically nonrefundable.

The success fee or transaction fee is a fee payable upon completion of the desired transaction for which the financial advisor was engaged. This is the largest component of the financial advisor's compensation.

The success fee can consist of a flat fee, a percentage fee (calculated based on the "consideration" received or paid in the transaction), or a hybrid structure, with the most common approach being a percentage fee with a guaranteed minimum fee. The customary percentage approach often utilizes a grid or scaled percentage structure (sometimes referred to as a "Reverse Lehman" formula), with percentages varying from deal to deal. As an example, in a sale context, the client may be required to pay the investment banking firm (i) 1% of the consideration, up to and including $100,000,000; (ii) 2% of the consideration above $100,000,000 and up to and including $150,000,000, and (iii) 3% of the consideration above $150,000,000, with a minimum fee of $1 million, regardless of transaction size.

Additionally, when reviewing the success fee, it is important to focus on the definition of "Transaction Value" or "Consideration," since that definition will determine the overall amount from which the success fee is calculated. It is also worthwhile to scrutinize the contingent amounts (i.e., "earnout") terms.

Finally, the engagement letter will provide that the client will be obligated to reimburse the advisor for certain expenses incurred in connection with the performance of its services. The advisor and the client should carefully review these expenses provisions to make sure that the parties clearly understand their obligations and the scenarios in which they will apply.

Indemnification

The indemnification section is often in an appendix or exhibit that is attached to the engagement letter. It provides that the company indemnify the financial advisor and its officers, directors, and employees (collectively, the "Indemnified Parties") from losses incurred in connection with the engagement. Some engagement letters may include as Indemnified Parties agents and certain other third parties. The indemnification provision is not typically a two-way provision, in that the financial advisor is not obligated to indemnify the company and its officers, directors, or employees.

The indemnification section is usually the result of the financial advisor's internal policies and procedures, so it may not be amenable to much change. However, when reviewing the indemnification section, the parties should pay close attention to the following aspects:

  • Exceptions. Under what circumstances might the financial advisor not be entitled to indemnification? For example, they might include the gross negligence, willful misconduct, or bad faith acts of the advisor.
  • Notification. Will the engagement letter contain a notification obligation of any claim that may trigger indemnification?
  • Settlements. How will the parties be involved in any settlement related to claims covered by the indemnification section? There are different ways to address this particular item, and the right approach can be determined at the appropriate time.