Top 10 Negotiation Points for Sellers in M&A Investment Banking Engagement Letters

Engaging a reputable investment bank to assist in the sale of a business is generally money well spent. A good investment bank will work diligently to maximize the seller’s enterprise value and coordinate a disciplined, organized, and successful transaction.

This article discusses the top ten negotiation issues in investment banking engagement agreements. Although the recommendations below are designed mainly to benefit the business seller, they are also intended to be reasonable to the investment bank. For the purposes of this article, I assume that the seller has an enterprise value ranging from $5,000,000-$30,000,000, which is the typical M&A transaction size among my clients.

1. Transaction Scope. The first draft of the investment bank’s form engagement agreement will often define the engagement to include every transaction imaginable, including a sale, minority investment, equity financing, debt financing, joint venture, etc. To avoid having to retain and compensate the investment bank for services the seller does not require, the agreement should specify that the banker’s services are limited to only those services the seller needs at the time of engagement (e.g., financial advisory services for a sale of all or substantially all of the company’s stock or assets). The engagement agreement should itemize the services to be provided by the investment bank in the engagement, which may include: (i) advising the seller on a target price range; (ii) preparing a confidential information memorandum (CIM) and executive summary (or “teaser”) for delivery to potential purchasers; (iii) locating, contacting, meeting with, and following-up with potential purchasers; (iv) arranging conference calls, visits, and management presentations; (v) reviewing, organizing, and managing due diligence materials in a virtual data room; (vi) obtaining (in coordination with counsel) confidentiality agreements from all potential buyers; (vii) soliciting, analyzing, and comparing competing offers; (viii) advising on transaction structure, negotiation strategies, and deal points; (ix) negotiating the acquisition term sheet and definitive purchase agreement; and (x) coordinating communication between buyer, seller, legal counsel, and other professional advisors.

2. Fees. The investment banker’s fees may be affected by the reputation and capabilities of the bank, as well as deal size, complexity and likelihood of closing. The main fees are the retainer and the success fee.

  • Retainer.  A non-refundable retainer or “work fee” is generally paid to the investment banker from the commencement of the engagement. The retainer demonstrates that the seller is serious about selling the company and compensates the investment bank for its initial work. Retainers generally range from $25,000-$75,000 and are payable monthly or in other increments and capped. It is reasonable for the seller to require that the retainer be paid on a monthly basis and credited dollar-for-dollar to the success fee (described below).
  • Success Fee. The largest component of the investment banker’s compensation is the success fee. It is usually either (i) a simple percentage of the transaction value or (ii) an upward scaled percentage (e.g., 3% of the transaction value up to $X and 4% of the transaction value over $X or from $X to $Y, etc.). If a scaled percentage is used, the bank might set $X at the “walk-away price”, meaning the lowest favorable price at which the seller is willing to close a deal, with value tranches and percentages increasing from $X. As long as $X is satisfactory to the seller, this structure will align the parties’ interests by incentivizing the investment bank to pursue a sale at or above the $Y price to earn the enhanced fee. In transaction values from $5,000,000 to $30,000,00, success fees typically range from 3%-8% of transaction value, with the higher percentages levied on lower valued transactions. There will often be a minimum success fee of $200,000 to $600,000, with most minimums at the lower end of the spectrum. Success fees are payable on closing or possibly over time if the transaction requires contingent payments (as described below).
  • Avoid Progress Fees. Some investment bankers will request a progress fee (e.g., $100,000+) payable upon the signing of a letter of intent or definitive purchase agreement. Progress fees are not standard and the seller should resist them because a transaction will not necessarily close after signing the definitive agreement, and is even less certain of to close after signing a non-binding letter of intent. If a progress fee must be included, it should be payable only on the signing of the definitive purchase agreement, not the letter of intent. Like the work fee, the progress fee should be credited against the success fee.

3. Transaction Value. The success fee is calculated on the basis of “transaction value”, which should be defined to mean the enterprise value paid to seller and its shareholders in the transaction. Transaction value will customarily include: (i) all payments to the shareholders (including cash, securities, and other property); (ii) debt that buyer assumes or pays at closing; (iii) the value of any equity that seller retains in the target post-closing; and (iv) above-market value payments on employment, non-compete, licensing and supply agreements. The transaction value should always exclude cash on hand and pre-closing cash distributions to seller’s shareholders to avoid paying the banker a fee on seller’s existing cash. Similarly, payments to specific employees that do not result in value to the shareholders (e.g., post-closing employment agreements with the buyer) should be excluded from the definition of transaction fee, as should the value of real estate owned by seller or affiliates and any post-closing real estate leases to purchaser at fair market value. It is customary for the banker to seek to have its success fee paid on the full transaction value at closing, including on the value of contingent payments such as escrow holdbacks, earn-outs, or promissory notes. However, in order to better align the banker’s interests with those of the seller, the seller should attempt to require that the banker receive its success fee on contingent amounts only if and when such amounts are actually received by the seller. This position is somewhat aggressive and may be resisted by the investment bank.

4. Expense Reimbursement. The engagement agreement will invariably require seller to reimburse the investment banker’s expenses relating to the engagement, including travel, data room charges, and printing and materials costs. It is usually not controversial for the seller to mandate that reimbursable expenses: (i) include only out-of-pocket payments to third parties (as opposed to the investment banker’s ordinary overhead expenses); (ii) be capped at a certain dollar amount; (iii) be pre-approved by the seller if in excess of a certain individual dollar amount; and (iv) and be subject to reasonableness standard. Expense reimbursements of $25,000 to $50,000 should be expected.

5. Term, Termination and Tail. The customary term of the investment bank’s engagement is between six months and one year, whatever is sufficient to market and sell the business. The seller should generally have the right to terminate the engagement without cause by giving 30 days’ written notice. In addition, the seller should be able to terminate the engagement immediately for cause upon the investment banker’s material breach of the agreement or willful misconduct, gross negligence, or bad faith. Unless the investment bank is terminated for cause, it will have the right to receive its success fee if the seller consummates a transaction during a “tail period” of between 6 and 24 months after termination with any purchaser that the investment bank introduced to the seller during the term. To avoid a dispute regarding whether a success fee is payable during the tail, the agreement should require the investment bank to provide seller with a list of introduced purchasers within 10 days after termination. If the investment bank fails to provide the list, the seller should be excused from the obligation to pay a success fee during the tail period. It is reasonable for the seller to require that the tail period not exceed 12 months after termination. Upon termination, the work fee will typically be non-refundable and seller will be obligated to reimburse the banker for expenses incurred through the termination date. The seller should confirm that the investment bank’s confidentiality obligations (described below) remain in effect for at least 1-2 years after termination of the engagement.

6. Indemnification. It is customary that the seller agree to indemnify the investment bank for all claims and expenses arising from the sale process (whether or not a sale occurs) other than claims and expenses arising from the investment bank’s fraud, gross negligence, or willful misconduct as determined by a final non-appealable court decision. If the investment bank’s acts or omissions give rise to the claim, its liability is generally limited to the amount of fees it received under the engagement agreement. Reputable investment banks will not engage in any substantive negotiation of the indemnification provisions. However, the seller should confirm that the investment bank is obligated to promptly notify the seller of any claims subject to indemnification and that the seller has the right to control the defense of such claims. Since any claims that arise are likely to be attributable to the seller’s disclosures, acts, or omissions (on which the investment bank relies to market the seller’s business), the investment bank generally has a reasonable basis for defending its indemnification rights.

7. Key Persons. The seller should specify in the engagement agreement whether any members of the investment banker’s team must lead the project. If there is key person that is essential to the transaction, the seller should obtain the right to terminate the engagement if he or she disassociates from the investment bank. The investment bank may resist this effort since it has little or no control over the employment decisions of its personnel. In that case, the seller could require that if a key person leaves investment bank, his or her replacement must be acceptable to the seller; and if not, the seller should then have the right to terminate the engagement, perhaps coupled with a reduction in the duration of the tail period.

8. Confidentiality. The seller and the investment bank should enter into a stand-alone confidentiality agreement or include a comprehensive confidentiality provision in the engagement agreement. If the seller discloses confidential information to the investment bank before the engagement, a stand-alone confidentiality agreement should be signed before the disclosure. The seller’s confidential information should not be used by the investment bank for any purpose other than to serve the seller’s interests in the engagement. The seller should confirm that the duration of the confidentiality obligation continues for at least 1-2 years after termination of the engagement, with trade secrets being subject to confidentiality obligations as long as they are trade secrets under applicable law. Finally, the seller should prohibit the investment bank’s disclosure of confidential information to departments of the investment bank that are not involved in the project. If a stand-alone confidentiality agreement is used, the engagement agreement should incorporate its provisions by reference.

9. Conflicts of Interest. To avoid conflicts of interest, the investment bank should generally be prohibited from representing a potential buyer in the same transaction and from engaging any other advisors or sub-agents to participate in the transaction. However, the seller may consent to the investment bank’s request to be allowed to assist a potential buyer with financing the transaction.

10. Exclusivity. It is reasonable for the investment bank to request that it be designated as the seller’s exclusive advisor for the transaction, which avoids having competing advisors working at odds. But if the seller has previously engaged or wishes to engage additional financial advisors for different purposes, the seller should confirm that the other advisory agreements do not conflict with the investment bank’s engagement.

If you have any questions regarding this article, please feel free to contact me at

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How to Maximize Your Minority Rights in Small-Scale Private Equity Investments

Even if you consider yourself a small-scale investor in private companies relative to today’s private equity giants, you should seek certain basic minority rights to protect your investment and enhance your exit opportunities.  In fact, most minority protections that a small-scale investor should seek are exactly the same as those that any larger PE fund would require.

Among my clients, these small-scale private equity investments generally range from $100,000-$3,000,000 for purchases of 10%-30% of a company’s outstanding equity.  They may be investments in corporations or limited liability companies (LLCs).

Here is an overview of rights you should consider:

  1. Preferred Equity.  The preferred stock (corporation) or preferred membership interests (LLC) may have any or all of three elements to help compensate you for placing your capital at risk:
    • A preferred right to dividends or distributions, which should be coupled with a tax distribution clause in an LLC;
    • A liquidation preference, giving you the right to be paid prior to other investors upon a dissolution or sale of the company or its assets; and
    • a right to convert into common equity if the common’s value would be higher than the value of the preferred in a change in control transaction.
  2. Preemptive Rights; Anti-Dilution Protection. A preemptive right is the right to acquire your pro rata share of any new securities issued after the date of your investment, which is self-help protection against dilution.  Preemptive rights may also be coupled with anti-dilution protection, allowing you to receive additional equity if securities are issued below the per unit price you paid for your equity.
  3. Board Appointment. The right to appoint a member of the board of directors (corporation) or board of managers (LLC) gives you a seat at the table at board meetings and the right to vote on board matters.  If board appointment rights cannot be negotiated, you could seek to appoint a non-voting board observer to attend meetings.  Your director/manager should receive at least the same indemnification benefits as other directors.
  4. Veto on Material Transactions.  You should seek a veto over company actions that could materially and adversely affect your investment, such as:
    • Bankruptcy or other liquidation or winding-up;
    • Acquisitions of equity or debt securities or assets;
    • Mergers, consolidations, conversions, or reorganizations of the company;
    • Sales of substantially all of the company’s assets;
    • Formation of subsidiaries;
    • Amendments to governing documents;
    • Transactions with affiliates;
    • Incurrence of debt or expenditures above a certain limit;
    • Termination of key employees; and
    • Changes in board size or composition.
  5. Financial Reports. Quarterly and annual financial reporting may be required, as well as audited financials in certain cases. If the investment is in an LLC, annual tax reports should also be provided to enable you to timely file Form 1065 K-1.
  6. Warrant/Option Rights. The warrant or option is a useful tool for mitigating risk while retaining upside opportunity.  Depending on the terms, a warrant or option can allow you to increase your investment incrementally during an agreed exercise period at the same price and the same valuation associated with the original investment.  This reduces your downside risk if the company fails to perform as anticipated and helps preserve your upside.
  7. Right of First Offer (ROFO).  A ROFO requires an equity holder who receives a third party offer for the purchase of his units to first offer to the other equity holders the right to purchase their pro rata portion of the seller’s units on the same terms as those offered by the third party.  The ROFO can enable you to increase your equity ownership by purchasing the equity of others, which is particularly beneficial if the company’s prospects are favorable and you are able to capitalize on distressed sales by other equity holders.
  8. Exit Rights.  There are several different types of valuable exit rights, a few of which are described below:
    • Tag-Along.  The corollary to the right of first offer is the tag-along right, which gives you the right to “tag-along” on a unit sale by a selling equity holder to a third party on the same terms as those given to the selling equity holder.
    • Drag-Along.  The drag-along right allows a group of equity holders (usually a supermajority) to require all equity holders to participate in a sale of company equity or assets.  If you, as the minority investor, do not wish to be made subject to the tyranny of the supermajority in a drag-along provision, you could negotiate for an appraisal mechanism requiring determination of the fair market value of the equity proposed to be transferred as a condition to the supermajority’s exercise of its drag-along rights. If the appraisal determines that the actual fair market value is greater than the proposed drag-along sale value, you would have the right to retain your equity.
    • Right to Cause a Liquidity Event. You may wish to negotiate the right to obligate the board and shareholders to pursue a sale of company equity or assets the company fails to achieve certain pre-determined milestones.

Top 9 Warning Signs in a Business Deal

One of the benefits of being a corporate lawyer is the opportunity to participate in a variety of interesting deals.  In these, you encounter a motley crew of characters.  You witness a range of negotiating styles and tactics, and learn which are effective and which are not. You see some ventures succeed and many others fail.

In the great theatre of the deal, there are rare moments in which something may not feel right to the lawyer or the client about a proposed business transaction or partner.  The thing amiss may only be verifiable by circumstantial evidence.  To paraphrase the Delaware Chancery Court, it may be that the circumstances surrounding the person or transaction stink bad enough that they simply do not pass the “smell test“.

Questions may arise following diligence on the target (which should minimally include Google and litigation searches), from a person’s conduct in negotiation or from other third party sources.  There will not typically be any proverbial smoking gun, so your judgment and careful diligence will be your guiding light.

In my years as a deal lawyer, the appearance of any of these nine elements (not in any order of priority) has been a fairly reliable harbinger of difficulty, dishonesty or even fraud in proposed business deals.  If any of these elements arise in your dealings, you should consider diving deeper into diligence to determine if there is genuine cause for concern or possibly re-negotiate or abandon the deal altogether.

  1. The demanding long-winded negotiator of trivial things.  Excessive demands for non-substantive or patently unreasonable changes to the initial non-binding deal document, such as the term sheet or letter of intent, may foreshadow protracted and possibly agonizing negotiation of the definitive agreements and a challenging ongoing business relationship.  If the demands are coupled with the party’s long-winded or repetitive arguments why he is right and you are wrong (or other ridiculous anectdotes), they may suggest personality issues.  In my experience, character defects are not easily remedied and often worsen with time. The unreasonable negotiator should distinguished from the tough savvy negotiator, who requests substantive deal points but is often reasonable and a good business partner after the deal is papered.
  2. The deal requires urgent participation and won’t be available after “X” occurs.  This is the classic illusion of scarcity tactic.  If your prospective business partner claims that if you fail to act now, (i) a large investment from Mrs. “Y” will soon be received and the price of the investment will increase or (ii) the deal will not be available for “Z” reason, the claim may be a red herring and should be carefully scrutinized.  Fictional future money is sometimes characterized as coming from abroad or from some well-known person with whom the partner purports to have a close relationship.
  3. The secrets that cannot be revealed.  If the target’s founder or your prospective partner is unwilling to reveal certain fundamental aspects of the business or how it expects to make money, the company may not have a business plan.  You have a right to know the company’s business model and growth strategy, with the understanding that the model will likely evolve over time. In one startup deal I reviewed for a client, the founder made repeated excuses why he could not provide information about critical company inventions and provisional patent applications.  Later diligence revealed that the company had no inventions and its business plan was impracticable. After spending the other investors’ money, the founder abandoned the company and the U.S.  This is akin to Bernie Madoff’s “black box” investment strategy that was “so good” that it could not be understood or replicated by any reputable investor.
  4. The anonymous “big money” partner.  Any person who must remain anonymous is often a red flag, particularly if this mystery man is a primary financing source.  A client once instructed me to prepare the draft documents for a “big investment by a Chinese investor who needs to remain anonymous.”  A third party had informed the client that the Chinese wanted this, that, and the other, and I prepared several draft iterations at the client’s request.  The Chinese investment never materialized and the client wasted money on legal fees. Some celebrities and others have genuine reasons to protect their privacy, but if you are doing a deal with someone (including a celebrity), you have a right to know their identity and to size them up.  Always insist upon lifting the veil of anyone who says they must remain anonymous.
  5. The shell company spider web.  Domestic and offshore entities are often formed to execute lawful business strategies, including liability and tax mitigation, particularly for companies with substantial non-U.S. source income.  But as the Panama Papers confirmed, offshore shells with limited assets may also be created for tax evasion and other corrupt purposes.  Before doing any deal with a company that owns or operates affiliates, especially offshore shell entities, you should fully understand the organization chart and confirm that each entity exists for lawful and legitimate purposes.
  6. The paperless office.  It is fine if your partner keeps a clean desk and operates in the cloud, but a lack of paperwork memorializing a business’s structure, assets and operations is almost invariably a red flag.  You should have access to reasonable diligence paperwork and you should be able to freely ask questions and to have them answered.
  7. No skin in the game.  If the deal does not require your business partner to put money or something else of value into the deal, your interests may be de-aligned from the beginning.  In the startup context, this could be the situation where a founder’s shares are fully vested from day one and he has no invested capital or other hook to prevent him from walking away when the going gets tough or he receives a better offer.  In a joint venture, it could be the ability of a party to enrich himself at the expense of the venture.  De-alignment can usually be remedied by careful drafting of the legal incentives in the deal documents.
  8. The promise of abnormally high or guaranteed returns. This trick is as old as prostitution: returns above market rates or guaranteed returns on invested capital are often signs of a Ponzi scheme, where the prompter lures you to invest to pay his prior investors rather than to make bona fide investments with you money. You should always determine the source of returns and whether that source is capable of generating the projected payout.  Most financial projections are exactly that, and vary dramatically from actual results.  There is no such thing as a guaranteed return.
  9. It sounds too good to be true.  This is a corollary of abnormally high returns.  As the adage goes, if what you are to receive in exchange for your participation sounds too good to be true, then it probably is.  In most of these cases, you should run away from these deal absent a reasonable and verifiable justification for its sweetness.