• Negotiating the Investment Banker Engagement Letter
  • November 29, 2006 | Author: Christian Waage
  • Law Firm: DLA Piper - San Diego Office
  • Negotiating the investment banker's engagement letter poses a challenging and delicate task for the attorney.  At the start of a merger and acquisition transaction, the client will seek to engage an investment banker to advise and guide the process.  The client will usually ask the attorney to review and assist in the negotiation of the terms of the investment banker's engagement. 

    Because the investment banker will be working with the client for several months on a transaction, the engagement letter is really the start of a relationship that all parties hope will lead to a successful outcome.  Additionally, over the course of a transaction, the lawyer will likely interact a great deal with the investment banker and its representatives.  Therefore, negotiating the engagement letter sets the tone for this interaction.  The lawyer's goal should be to lay a foundation that will ensure an amicable and cooperative relationship going forward. 

    The key to establishing a cooperative foundation is to understand the philosophical perspective of the investment banker.  The investment banker will be trying to structure the engagement with the broadest terms.  Its primary goals will be (a) to try to define the transactions that trigger the payment of a fee very expansively; (b) as much exclusivity as possible; and (c) limitation of circumstances that allow the seller and buyer to escape paying a fee.

    The attorney's task is to take into account and communicate an understanding of the investment banker's legitimate interests and concerns, but also, more importantly, to protect the client's interests and to convey that over-reaching will not be tolerated.  Through the engagement letter, the attorney should seek to align the investment banker's interest with the interests of the client.  There are several primary terms in the engagement letter that the attorney should focus on in the negotiation of the investment banker engagement letter.

    Covered Transactions

    One of the primary issues to be addressed is to determine which transactions are covered by the engagement letter. 

    The covered transactions are what drive the process, and are the basis of the investment banker's fee.  The investment banker will try to cast a wide net to cover any type of transaction, including the sale of any portion of the company's outstanding shares of stock or its assets.  This would mean that the sale of one share of stock or a small amount of assets would trigger the client's obligation to pay the investment banker's fee. 

    Given that in many engagement agreements there is a minimum fee that is payable no matter the amount of consideration received in the transaction, special attention should be paid to the proportion of the fee to the transaction at stake.

    To ensure that certain transactions are not unintentionally included, the definition of covered transaction should be carefully negotiated to account for particular carve-outs..For example, two transactions that are typically excluded from the definition are the licensing of a company's intellectual property rights during the ordinary course of its business and any loans or capital contributions by any member of the company.  Additionally, investment bankers may also seek an agreement that triggers the payment of their fee in the event of an option to purchase the client.  Typically, the option should not trigger a fee unless the option is exercised and the option transaction is completed.

    Another issue that arises in considering the definition of covered transactions is whether a purchase by any buyer should be included in the fee arrangement.  It may be the case that the client was negotiating with a buyer before the investment banker was engaged in the process.  If the negotiation process is well advanced, the client may consider excluding a transaction with that buyer from the definition of a covered transaction.  In other circumstances, however, the services of the investment banker may be crucial, even with an already identified buyer, in which case it would probably make sense to include a transaction with such a buyer in the definition of covered transactions.  This will serve to align all parties' interests.

    A related question is the scope of the services that will be rendered by the investment banker.  The investment banker's services should be spelled out as explicitly as possible to try and avoid any unmet expectations on the part of the client.  The services should be defined expansively enough to maximize the utility of the investment banker to the client.

    Fee Arrangement

    Another primary focus in negotiating the engagement letter is the fee arrangement.  Investment bankers will often seek a non-refundable deposit or retainer.  The primary source of compensation for the investment banker will be a success fee for a completed transaction.  The attorney should negotiate to get any non-refundable deposit or retainer fully credited towards the success fee.

    The success fee will generally be a percentage of the value of the purchase consideration in the transaction.  Lower-value transactions will see a larger percentage fee because many investment bankers expect a certain minimum payment for working on a transaction.

    Fee arrangements may often include progressive fee schedules.  A target price is set that indicates what the seller thinks the business is worth, and as the deal moves incrementally? higher than that target, the banker receives a higher percentage.  Progressive fee arrangements provide a strong incentive for the investment banker while aligning the parties' interests in maximizing the value of the transaction to the client's shareholders.

    In any case, except for the deposit, any fee should be payable only when the deal is consummated, and not at any interim steps.

    Defining Aggregate Consideration

    Closely related to the determination of the fee arrangement is the issue of how to define the aggregate consideration that will provide the basis for determining the fee to be paid.

    The investment banker wants the broadest possible definition for the consideration, because the size of the success fee is directly related to the value of the purchase consideration paid to the client.  A broad definition of the consideration could therefore have the client paying a fee based on any payments received in connection with the transaction, such as rents or salaries.

    A more equitable definition would exclude any payments received for goods, services, properties, or equipment that are substantially equivalent to such payments that would be negotiated in arms length transactions with unaffiliated parties and that relate to the ordinary course of business.  Another item that may be included in the negotiation of the covered consideration is the assumption of debt as part of the purchase price.  For purposes of valuing any non-cash consideration, the attorney should negotiate for a good faith determination by the client's board of directors.

    Paying for Expenses

    Another area of focus in negotiating the engagement letter will be controls on the expenses incurred by the investment banker while pursuing the client's transaction.  While the investment banker would want to have all expenses incurred in connection with the transaction reimbursed, the client should exercise some control by requiring the investment banker to obtain prior approval for expenses above a certain threshold, or, by specifying that no expenses will be paid in excess of an aggregate of a certain total amount without prior approval.  The agreement should include a provision that says that should the specified threshold be passed without prior approval, then the expenses incurred are not reimbursable.

    Term of Engagement

    For how long should the investment banker be engaged?  This question is an inevitable part of negotiating the engagement letter.

    The investment banker will want the longest possible period of exclusivity to negotiate a transaction.  However, it is not in the best interests of the client to be locked into a situation where it is unable to terminate its relationship with an investment banker.  The most obvious reason for this is to protect a client from an investment banker who is not performing properly.  Another reason to seek a shorter term of engagement is that the longer a deal has been available, the staler it seems and the harder it becomes to close.  Therefore, in general, six months is a reasonable exclusivity period, allowing ample time for the investment banker to prepare a confidential information memorandum, send out summaries to potential buyers, and solicit interest, receive offers, and negotiate a deal.

    Termination and Tail Period

    The agreement should explicitly state a right of termination after the initial period expires.  However, investment bankers will want to impose what they call a "tail period"—a period of time after the termination during which, if a transaction is completed, the investment banker will still be paid.

    Often, the investment banker may try to negotiate a fee for any sale to anyone that occurs within the two-year period after the termination date whether or not the sale was connected to efforts expended by the investment banker during the term of the engagement.  The attorney will want to negotiate a shorter tail period and also will seek to require that the ultimate buyer be someone who was connected to the process during the investment banker's period of exclusivity with the client. 

    One way to restrict the set of buyers that would trigger payment during the tail period is to require that the buyer be someone who received the solicitation information from the investment banker, expressed an interest in the transaction, signed a confidentiality agreement, and received the confidential memorandum.  This is a minimal level of restriction, because there may be many potential buyers who signed the confidentiality agreement.

    Another, tougher approach would be to require that the buyer not only must have signed a confidentiality agreement, but also must have actually engaged in negotiations respecting the transaction.  This is significantly more restrictive from the investment banker's point of view.

    Between these opposite poles, the lawyer has considerable space to find a common ground that permits the investment banker to receive a fee during the tail period, but that limits the payment of this fee to transactions completed with buyers that the investment banker brought into the process.


    A final potential area of contention is the indemnification provisions of the engagement letter. 

    The general standard of conduct that subjects the investment banker to liability is willful misconduct or gross negligence.  Many attorneys will try to argue for lesser criteria, but this standard is virtually impossible to modify.

    However, there is one scenario that merits negotiation: when the client and investment banker are both involved in a lawsuit, but no liability is ultimately found.  In this instance, the issue becomes: who should bear the costs of litigation?  The client will not want to bear any of this cost and will argue that the investment banker's fees are just the price of doing business.  There are a number of ways of addressing this issue.  One example is for the client to agree to bear fees up to a certain amount; the investment banker then becomes responsible for the excess.  Another solution is to agree that the client and investment banker will divide the fees equally up to a certain amount, and then the banker will bear the excess.

    The point is that there are ways to deal with such fees that will render the indemnification provisions more equitable to both parties.


    The terms discussed are economic points that go to the heart of the engagement between the investment banker and the client.  Although the investment banker will initially propose a broad and perhaps over-reaching engagement letter, the role of the attorney is to apply perspective to this process and align the interests of the parties in a way that will not alienate a key team member in the transaction. 

    By understanding the interests and concerns of the investment banker, the attorney is better able to negotiate an engagement letter that will establish a cooperative basis for completing the transaction.