A plain English examination

Any contingent fee structure in an investment banking or corporate finance advisory engagement, by its nature, has risk. Work done upfront, fees paid (maybe) in the future.  Inherently risky for sure, but much more so if your engagement agreement is not clear on several key concepts.  We’ll refer to those concepts here as our “Revenue Clauses.”

 

First, what has to happen to trigger your fee?

 

Second, who does that thing have to happen to? 

 

Only after both of those questions have been addressed, can a well written engagement agreement focus on addressing the amount of the contingent fee that would be due and when it would be paid. 

 

All of these concepts are essential to structuring a contingent fee.  An engagement agreement that does not effectively cover the first two questions does not create a clear obligation to pay the contingent fee.

 

If you are structuring a contingent fee engagement agreement yourself, keep Revenue Clauses in mind as you build your agreement.  Go carefully though each concept.  They are all built on each other, and all are required to earn the intended contingent fee.

 

Client Definition (the “Who”)

Typically, your “Client” consummating a “Transaction” is what triggers the obligation to pay a contingent fee under a typical contingent fee engagement agreement; so an appropriate definition of your “Client” is a critical first Revenue Clause in structuring your contingent fee and getting it right requires more thought that you may initially expect.

 

Make sure that you understand the relevant capitalization table when you define your “Client”.  If you define your “Client” too narrowly, you may miss a transaction that you intended to trigger a contingent fee or you may miss proceeds paid to other entities owned by, or associated with, the entity you called your “Client”. 

 

Include too many entities in your definition and it will be harder to achieve a contingent fee triggered based on a percentage of your “Client’s” equity or assets sold. 

 

These potential issues are both addressable once you understand your prospective client’s corporate structure and capitalization tables and will help avoid any gaps in your “Client” definition which may not otherwise come into focus until a transaction is upon you.

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Transaction Definition (the “What)

Now that you have a carefully constructed “Client” definition, you need to make sure that it is clear when that “Client” has consummated a “Transaction.”

 

Your contingent fee is likely only due if a “Transaction” has occurred, so careful construction of this definition is the second critical Revenue Clause to deal with before focusing on the amount of that contingent fee.  A carefully written fee provision does not help you if you do not have a strong Transaction definition; and neither does the tail.  That is a point worth stopping to read twice.  A well written fee calculation is inoperative (useless) unless a “Transaction” has happened. 

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No “Transaction,” no contingent fee to calculate. 

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Your tail provision is probably also based on a Transaction happening, so no “Transaction,” no tail protection. 

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Try to avoid percentage-based “Transaction” definitions that do not provide any protection if the consummated transaction falls below the specific percentage and be sure to cover non-traditional structures for exchanging value (like JV, licenses, etc.).  Your client may tell you they would not consider a non-control deal, but ask yourself this, if you work on the engagement for months and then your client sells 49% of their business, do think you should not be paid a fee?  Unless you said “yes, I should not get paid,” your engagement agreement needs to provide for this possibility.

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Remember an “agreement to agree” on a fee if a transaction occurs that falls outside your “Transaction” definition does not entitle you to anything.  Rely on such “agreements to agree” at your peril. 

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Now, after writing a flexible “Transaction” definition based on a thoughtful “Client” definition, you can turn to the Revenue Clause that immediately comes to mind when you are thinking though a contingent fee.

 

Consideration Definition

Now that a “Transaction” happened to your “Client” you will likely calculate a contingent fee that is based on “Aggregate Consideration” “Consideration” or “Implied EV.”  Whatever you call this concept, the effect is the same. This is the amount that the fee calculation is based upon.

Remember, a strong definition here does nothing to help you if the other Revenue Clauses discussed above are weak.  You cannot skip steps and hope to get the result you intend, so make sure the foundations of your fee calculations are solid. 

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When drafting and then negotiating your “Aggregate Consideration” concept make sure to understand your “Client’s” corporate structure and where EBITDA producing or business-related assets are owned and used.  Be certain to capture “Transaction” proceeds that move between the parties in addition to the full value of enterprise value of the “Client” implied by the “Transaction.”  Expect significant negotiation of the concepts of retained assets or equity, treatment of post-closing service or consulting agreements and timing of some post-close payments. 

While pushing payments out past closing on deferred proceeds is a popular ask by clients, it may cause problems with a buyer at closing (often literally at, or right before, closing) as buyers generally want to confirm at closing that they will have no further payment obligations to the sell side advisor after closing. 

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With appropriate parameters around who the “Client” is, what constitutes a “Transaction” and how to calculate your contingent fee, you Revenue Clauses are covered during the term of the engagement.  But for your contingent fee agreement to provide market protection, care must be given protecting contingent fee revenue for a period of time in the event of termination of the engagement.

 

The Tail

Tails are one of the most uncomfortable concepts to talk about when negotiating an engagement agreement, but they are, nonetheless, a critical Revenue Clause.  Focusing on when a client still has to pay you after you have stopped working is a never an enjoyable conversation.  Be wary of each and every limitation to both the length (time) and scope (transaction counterparties covered) of your tail coverage. 

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The focus of any discussion with a client on tail coverage should be on a scope that is appropriate for months of work where fees are totally dependent on decisions the client may or may not make in the future.

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Tails that are excessively short or narrow create an inherent disconnect between a client and a contingent fee advisor.  For an engagement agreement to effectively align incentives and foster partnership and collaboration, an advisor being paid on a contingent basis needs comfort that it can invest fully in providing services without concern that it may be terminated on the eve of closing without receiving a success fee or that the advisor may be sent on a fool’s errand by pricing the market for a carved-out insider or affiliate transaction.

 

Takeaway

There are several separate but related Revenue Clauses to address in structuring a well written contingent fee engagement agreement.  One clause is not a substitute for the other; all parts of an engagement agreement must be carefully drafted to work together to help protect revenue and maximize the value of each engagement. 

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If you want to talk about your engagement agreements, or you simply want your MDs spending more time in market and less time trying to negotiate engagement agreements, please reach out to jescuder@thirhatconsulting.com.  

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With over $200 million in aggregate success fees structured, we are experts at obtaining better terms; faster.