Welcome to the dance. Don’t forget to pay the band!

(By guest blogger Oscar Atkinson, Owen Class of 2008)

Advisory fees in the marketplace for private companies

When a business owner decides to sell the equity in the company, it is often the beginning of a drawn-out courtship between buyer and seller that can last more than a year. Match-making bankers preside over this peculiar dance in exchange for an advisory fee based on the size of the transaction.

What follows is an introduction to the bankers who orchestrate the transaction. I will briefly discuss common practices among advisors, including large investment banks, regional firms, boutique shops and business brokers. 

Deal environment

Most of these intermediary advisors focus on the sell side of the equation because the scarce commodity is the seller, not the buyer. Advisory fees from 0.5% to 7% are paid by the seller based on the amount of money raised for the seller of the company.  Some intermediaries have gotten so picky that they will not touch a deal that does not net them more than $2MM in fees. It must be nice to not get out of bed unless there is a seven figure pay-day to spread around the company. The current M&A market has enabled the investment banking middlemen to command healthy fee-based compensation for orchestrating increasingly large deals.  Most often, the advisor's compensation will be derived as a percentage of the total enterprise value of the transaction. The fee structure is fully negotiable and can become a sore bone of contention amid big egos even though the advisory fee is a small percentage of the overall deal value.

The froth of the market

Although it is becoming increasingly common for sellers to engage multiple advisors on a single transaction, the bankers then have to fight over the fixed transaction fee. Accordingly, the larger banks seek to limit the number of parties engaged in a transaction. Large banks don’t want the small deals. Two reasons: They want to maximize their return on their fixed capacity, their people.  Banks rely on the talents number-crunching analysts and the face men and women who manage the relationships. Equally important, they want to build market share. League tables provide a ranking of the banks by the total dollar value of deals completed. The banks at the top of the stack rank will puff up with pride as they market their dominance. Banks want to continually build their brand to gain the next deal. You can hear them now: “We have the best deal flow because we have the best expertise – just look at our rankings from last year.” As you, the astute reader, may have guessed, the banks at the top of the stack can also charge the higher fees.

The Players

Bulge Bracket Investment banks

Fees are impacted by the M&A market conditions of supply and demand. Currently the best advisors are able to charge more since they are resource constrained and there is high deal flow. With liquidity high and rates low, the worldwide market for M&A has gone through the roof. The total dollar value of deals (inclusive of net debt) has risen from $1.1 trillion 2004 to almost $3 trillion in deals in 2006. In today’s frothy capital market, the larger banks prefer to deal with companies that have greater than have $50 MM in EBITDA. Fees will range from 0.5% for larger deals to as high as 2-3% for the smaller deals. Large brokerage houses are turning up their noses up at deals under $500MM in enterprise value.  Since the size of the deal has increased, the fees generally max out at 1.5% enterprise value. Some back of the envelope math tells you the large banks are looking for at least $7.5MM in fees before they will get excited. That being said, there are many mitigating factors that point to a more realistic floor of $2MM in fees.

Retail banks are getting increasingly aggressive because they provide the money for the large deals and covet the rich transaction fees that the pure-play brokers are getting.  Retail banks can leverage their corporate finance and commercial banking relationships, especially in the middle market.

Regional & Boutique firms

Smaller investment banks are a hard category to address because they are more creative in their compensation structure. There is much variation among boutique firms making it hard to give an industry standard. With the large investment banks chasing the larger deals, the retail banks, regional brokerages and boutique firms are moving up the ladder as well, handling deals that fall below the radar of the larger brokerage houses. Some boutiques will not take on a deal with less than $1.5MM in fee income. This threshold can be as low as $500,000 or even $100,000 if there is strategic value to doing a deal.

Deal brokers

This group is harder to pin down than the boutique firms because they are even more flexible in the way they receive compensation.  This tends to be a feast or famine segment of the industry as one or two deals can mean seven-figure income for the members of a small firm.  However, there may only one or two big deals that are closed in a given year. Since they are dealing with smaller companies, they will often take an equity stake in exchange for cash paid as a percentage of transaction value. In this category, the retainer may be a key revenue stream as there are fewer hands in the pot. Consulting income can smooth out cash flows and provide some stability for a smaller shop. Accordingly, many of these groups must be a jack-of-all-trades to the firms they advise. $50,000 in retainer income is commonplace, but by no means the rule.

Impact of Private Equity

Private Equity firms and other financial sponsors are flush with cash and impact the M&A market in a multitude of ways. They pay buy-side transaction fees to intermediary banks for increased deal flow and they also pay fees for the leverage that the banks add to their deals. The clients who put large sums of money into private equity funds expect their dollars to be put to work. Because they need the deal flow, private equity shops have an incentive to grease the wheels of the banks.

Exclusivity

The exclusivity clause is a hot potato for many reasons. The seller does not want to limit their options if another intermediary approaches them with a buyer. On the other hand, it is a powerful notion that you want your banker to be glad to see you. A banker that has a retainer or a promise of payment upon successful deal completion is likely to work harder. Bankers wish to avoid dead-end deals where they spend considerable resources, and receive no compensation.

Retainers

Advisors seek to smooth out their cash flows by charging retainers for the effort they put forth prior to closing a deal.  Retainers are less common with bulge bracket banks dealing with deals larger than $100MM. Often the retainer can serve as a screen to determine if the seller is really serious. Although the retainer is non-refundable, the advisor will generally credit the retainer towards the success fee. Depending on the difficulty of the work and the quality of the company, retainers can range from $10,000 to $100,000.

Parting thoughts

Although I have attempted to paint a picture of the brokers in the marketplace for private companies, the exceptions are often the rule. Fee structure can be negotiated if an advisor has hopes of a bigger payday down the road. Like any salesperson building a book of business, an advisor will participate in a small fund-raising project for a company that may have larger capital needs in the future. As any business owner knows, Everything is negotiable.