It is no secret that bankers perform services to make money and shareholders want to benefit from a valuation improvement of their business. What is less well known is the craft experienced bankers employ to determine the appropriate fee structure and quantum of fees for the deal. Each fee structure signals five things to shareholders. You would be wise to consider each of these components next time you price a sell-side engagement.
- Experience of team. Sophisticated shareholders understand how an investment banking operation works and are wary when a top-tier mid-market firm is pricing deals “cheap”. Typically this signals a more junior transaction team will be used on the deal. This is not always bad. For certain situations getting a quality brand name and the Rolodex of the partnership may be more important than the tombstones of the junior team members managing the transaction. If you want to employ this strategy be upfront about it and focus more on the industry and sector expertise of the firm and less so on the junior team members. It is also wise to get out ahead of this and potentially propose fees after a valuation range is set to better understand how difficult it will be to meet expectations before determining the caliber of the team. Just remember your fee signals something about both the experience and the brand you bring to the table.
- Expected valuation range. A Lehman-scale fee structure with a minimum fee and success ratchets based on performance is common and advisable because of its mutual incentive to both parties. The performance ratchet should be based on the desires of the shareholders, around either a certain EV range or based on a particular earnings multiple. Multiples are more difficult to define, because of the uncertain nature of adjusted normalized earnings and the difficulty to understand a fair valuation multiple. However, either way you price the engagement, shareholders will get a clear picture of the expected value you have placed on this business. Typically, between the fixed fee and the first ratchet. Make sure your signalling adds up.
- Cost. The total quantum of fees is important to set correctly as the adviser. Your fee should reflect how long and how many team members are required for the jobs, the risk of completion and the opportunity cost of the occupied resources. These things should all be considered but rarely are. At one of my prior firms we had a price/risk matrix and a review board. The matrix provided a score sheet based on 10 objective measures that calculated a baseline fee for any engagement. The review committee compared the proposed fee with similar prior deals (and their outcome) and adjusted accordingly if risk or fee was not appropriately scored. This is an important process but is often loss with standard fee templates and the fear of missing out on a deal as a result of fees. Either way, savvy shareholders will be able to tell when you have too much fat in the fee based on team size, valuation range and timetable you propose.
- Confidence. If you are charging milestone or retainer fees this signals you are covering your costs as a precaution to a busted deal. Or worded differently, a busted deal is a potential outcome of this engagement. This is not the message you want to send to shareholders. Even though retainer and milestone fees have become commonplace since the financial meltdown of 2008, they are likely commonly removed in competitive situations. However advisors have more leverage then this. Milestones and retainers can be pro-rated against a success fees to provide further coverage to shareholders. Also, milestones can act as an important timetable feature if the seller wants to get to market quickly or run a tight process. This fee could be charged to “prioritize the work” or incentive the deal team to get the CIM approved and released and the receipt of a bona fide LOI. It is important to understand the objectives of the board and shareholders to understand how to structure and position the reason for these fees because you don’t want to signal something you can get away from later during the negotiation.
- Preview of the relationship. The fees presented to shareholders will likely be the first negotiation of the potential transaction. This is a difficult situation. A poor negotiation style or lack of insight into shareholders concerns will reflect poorly on the deal team, while giving away fees to quickly may signal weakness as a negotiator – not something shareholders want to see in their investment banker! The most important aspect of this negotiation is to approach it collectively and resolve each concern. Be flexible on the structure and willing to re-allocate fees between categories. Typically, the quantum of fees is not the concern it is more commonly the value the ratchet kicks in and the quantum of retainers/milestones.
Like most tasks in investment banking setting a fee structures is more art than science. Structuring an appropriate win-win fee relies on a strong relationship and a keen sense of understanding of both the adviser and shareholder viewpoints. We just ask one thing, the next time you structure a fee remember the five things you are signalling to shareholders.
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