A deep dive into definition, triggers and tails

Even though sell-side investment banking and corporate finance advisory fees are typically paid upon the closing of a sale transaction, the contractual right to contingent fees are established in your engagement letter; before your engagement has even kicked off. This dynamic creates several challenges for advisors as their fee constructs must cover a wide variety of transaction structures and deal with several interrelated concepts (such as fee triggers, fee calculations and tail protections). 

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Additionally, until an engagement letter is signed, the engagement itself is at risk; introducing the element of time pressure into negotiations that establish the overall profitability of the engagement to come.

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Proper consideration of the relationships between, and the negotiation of, the following critical clauses can mitigate contractual fee risk and help advisors maximize the profitability of their contingent fee engagements.

 

Critical Clause - Client Definition

Who have you defined as your “Client?”  While this seems like a simple question, there is actually more nuance here than appears at first glance.  Care should be given to ensuring that your engagement letter covers all entities that will be marketed in your engagement, but does not blindly include entities that will not be marketed. 

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An overly narrow Client definition may mean sales of assets of, or equity interests in, entities that fall outside of your Client definition could be outside of your scope (introducing liability, indemnity and regulatory “know your customer” risk), could not trigger your “Transaction” definition or may not be picked up in your success fee calculation.

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An overly broad Client definition creates other issues; including making it potentially more difficult to trip a Transaction definition that is based on a percentage of assets (or equity) sold.

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A detailed understanding of the corporate structure of your client and its affiliates, the capitalization table of each of those entities and where the assets of the marketed business reside is essential to crafting a proper Client definition.

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Another solution to mitigating risk associated with the Client definition is introducing a dynamic term that is separate from the Client definition itself that automatically covers marketed entities and is utilized in drafting the scope, Transaction definition and fee calculation.

 

Critical Clause – Transaction Definition

Proper construction of the “Transaction” definition is critical to fee protection in any contingent fee engagement.  The Transaction definition is your fee trigger and it is separate from, but related to, the fee calculation itself.

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If the transaction consummated is not included within the Transaction definition, you will not be entitled to any success fee.  Said differently, a well written, Consideration definition or fee calculation is meaningless if a Transaction has not been consummated.

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To protect contingent fee revenue, it is critical that the Transaction definition be broad enough to cover any reasonably foreseeable transactions.  If your standard form contains (or you are being pushed to agree to) a Transaction definition that is based on the transfer of more than 50% of the equity or assets of the Client (sometimes referred to simply as a transfer of control), you can expect to be paid nothing if your Client sells 49% of their equity or assets.  Change the percentage as you will, the result will be the same.  Be wary of any percentage-based Transaction definition absent other fall-back fee protections in your engagement letter. 

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If your scope is tied back to assisting in connection with a Transaction (and there are many ways this concept could appear within a typical corporate finance scope) and the consummated transaction is not included within your Transaction definition, there is risk that your engagement letter (and your limitation on damages and indemnity) may not apply.

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While a Transaction definition should be broad enough to cover any reasonably foreseeable transaction structure, care should be given to ensure that the chosen definition does not give your client a sense that your intent is to pursue transactions outside of their desired results.  Striking the proper balance in this regard may involve framing statements within the scope of services or the inclusion of more than one transaction definition (such as one term for a minority/capital transaction and another for a control transaction).

 

Critical Clause – Consideration Definition

Often presented as “Aggregate Consideration” “Consideration” or “Implied EV”, the function of this definition is to describe the total amount of consideration that the contingent success fee calculation will be based upon.

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While advisors often draft their standard form of Consideration definition carefully, two issues are common.  First, and potentially most harmful, the misunderstanding that a strong Consideration definition reduces the risk of a weak Transaction definition.  Second, is that the Consideration definition is often the subject of intense negotiation and certain “gives” are often part of engagement letter negotiation.  Internal and external legal counsel may view the Consideration definition as a business issue; leaving bankers to negotiate this critical fee concept on their own.  We will unpack each of these two issues below.

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First, a strong Consideration definition does nothing to address weakness in a Transaction definition.  If the consummated transaction is not included within the Transaction definition, no Success Fee would be due and therefore the Consideration definition remains inoperative.  By way of analogy, if you do not pass go (your Transaction definition) you do not collect $200 (your success fee which is based on your Consideration definition).  Your Consideration definition is part of calculating a success fee once one is due; it does nothing to ensure that you are due a success fee in the first place.

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Second, Consideration is a heavily negotiated concept.  Care must be given to your Consideration definition starting off broadly enough to include not only the full implied enterprise value of the client implied by the Transaction but also other modes of transferring transaction consideration while also protecting against preclosing erosion of value (such as through in-kind dividends of EBITDA producing assets).  Developing a thorough understanding of the client’s corporate structure, location of EBITDA producing assets within such structure, and any third-party agreements or intellectual property utilized in producing EBTIDA will create an informed starting point for the negotiations to come.  Expect significant negotiation of the concepts of retained equity/assets, assumed/refinanced/retained debt, preclosing dividends, post-closing service/consulting agreements, royalty/license/exclusivity or lease arrangements, timing of payments on escrowed amounts and post-closing contingent consideration, as well as proceeds received by affiliates and equityholders to name a few. 

Tactically structuring your Consideration definition to make it easy to negotiate and leaving room for “gives” that do not materially affect overall engagement revenue can materially speed engagement letter negotiations while preserving a strong Consideration definition.

Once a Transaction has been consummated, the strength of your Consideration definition will be the primary contractual driver of the overall profitable of your engagement.

 

Critical Clause – Tail

The tail is one of the most uncomfortable clauses for an advisor to negotiate in an engagement letter and it is also the one that provides the most protection on a contingent fee engagement.  The hesitance to push for a strong tail stems from the awkwardness of explaining to a prospect that has not hired you, why you should be paid a success fee if your engagement is terminated. 

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While market protection is for a tail that is often longer than 12 months and is counterparty agnostic; this clause will be a focus for nearly all prospective clients.  Be wary of each and every limitation to both the length (time) and scope (transaction counterparties covered) of your tail provision.  Tails that are excessively narrow can allow a client to run a side process during the term of your engagement or force a substantial fee reduction if the likely counterparty is not covered by the scope of the tail. 

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While tails are an uncomfortable concept to discuss with a prospect, skilled negotiation together with careful framing of the equity, trust and collaboration fostered by market tail protections are essential protections for any engagement contingent fee engagement.

 

Takeaway

While a seemingly straightforward services agreement, a corporate finance engagement letter must be a carefully structured agreement that covers many separate but interrelated business points, risk and legal protections. 

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Ensuring that all stakeholders (business, risk and legal) are focused on, and have sufficient time and expertise to properly structure and then negotiate a corporate finance engagement letter is critical to protecting revenue and maximizing the value of each engagement.

If you are unsure of whether your engagement letters sufficiently protect your investments of time and resources and maximize engagement profitability, or you simply want to refocus your internal resources on market facing activities, please do not hesitate to contact us here.  

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