It is customary for sellers in any M&A transaction to utilize third-party advisors that play a critical role in getting the deal across the finish line. Advisors are compensated in a variety of ways including a flat fee, hourly fee, contingent or success-based fee, or a combination of these. How and how much an advisor is compensated is dependent on many factors, such as the size of the transaction, the quality of the seller’s financials and records, legal or environmental obstacles, and the speed at which the transaction closes, just to name a few.
Beyond the fees generated from the use of third-party advisors, sellers will also encounter other expenses and holdbacks required to close the deal. These expenses, such as purchasing tail insurance policies, and holdbacks, such as funding indemnity or working capital escrows, are either highly recommended to protect the seller against any potential liability after closing or are required by the purchaser as a contingency to close.
This article will focus on the types of advisors a seller may use in a transaction, how the advisors typically get paid, and will briefly touch on commonly encountered closing expenses.
First, it is important to understand the types and roles of advisors that a seller may use in an M&A process:
- Manage the entirety of the sale process from start to finish
- Identify and market the business to potential buyers and negotiate with buyers on the seller’s behalf
- Craft marketing materials and create a competitive buyer environment to ultimately increase the value of the seller’s business
- Assist with negotiation of transaction terms
- Draft critical legal documents to effectuate the transaction
- Focus on the aspects to mitigate risk to the seller post-transaction
- Conduct financial due diligence with a focus on earnings quality, normalized working capital and debt commitments
- Review the accuracy and consistency of financial statements
- Advise on transaction structure
- Identify most advantageous structure for seller in light of after-tax proceeds
- Provide input on applicable provisions of legal documents
- Human resources
- Insurance Benefits
- Environmental
- IT & Cybersecurity
- Real Estate
- Other Consultants
It is customary for each party in a transaction to pay its own advisor fees. However, in some cases, the seller and buyer may agree to split certain fees, such as hiring an accounting firm to perform a quality of earnings review or a consulting firm to perform an environmental assessment. Now, let’s look at how these advisors are typically compensated.
Investment Bankers / M&A Advisors
There are several different ways M&A advisors charge for their services, and advisors will tailor the compensation structure on a deal-by-deal basis. Before we get into it, it’s important to understand that M&A transactions require a significant amount of time and effort – a well-run process can take anywhere from 6-12 months including preparation, marketing, diligence, and closing. For this lengthy endeavor, advisors will use two main fee structures, often used in tandem:
- Engagement Fees
- An engagement fee, or more colloquially a “retainer”, is a flat fee that can be paid either in a lump sum upon hiring or in monthly increments. A retainer helps cover some of the advisor’s overhead throughout the journey to closing but also serves as a buy-in from the seller, showing they are indeed committed to executing a transaction.
- For a sell-side engagement, retainers can range anywhere from low tens of thousands to more than $100,000 in total. The amount of the retainer is typically dependent on the anticipated size of the transaction, the amount of work required to prepare the business for a sale, and the size and reputation of the advisory firm. If a large, reputable firm is representing a business that will require a heavy lift to prepare for a sale and has a heightened risk of successfully closing, the advisor will likely increase the retainer. An advisor may not always require a retainer, choosing instead a fully contingent arrangement for smaller transactions or for larger deals with a very high likelihood of closing.
- Success Fees
- Success fees are exactly that – a fee the advisor receives upon the successful closing of the transaction. The success fee makes up the lion’s share of the advisor’s revenue on a per-deal basis and can be a powerful tool to align both the seller’s and advisor’s incentives – the higher the enterprise value, the more consideration the seller and advisor receive.
- Advisors can get creative in proposing the success fee structure, and structure will vary widely depending on the advisor and the anticipated enterprise value, among other factors. The most common success fee structures are as follows:
- Lehman formula: a declining percentage scale using tiered milestones based on enterprise value.
- Accelerator formula: an accelerating percentage scale using tiered milestones based on enterprise value. An accelerator is typically structured like a reverse Lehman formula or a more simplified one-step accelerator formula.
- Flat fee: a fixed percentage of the total enterprise value.
- Fixed fee: a fixed dollar value regardless of the size of the transaction.
There are many ways for an M&A advisor to structure fees even beyond the examples above. However the advisor slices the structure, it is important to understand the expected enterprise value of your business to know if the proposed fees are reasonable. According to Firmex’s 2023-2024 M&A Fee Guide, the median success fee for the following transaction sizes was reported as:
- 5.5% for a $5 million transaction ($275,000)
- 3.7% for a $20 million transaction ($740,000)
- 2.1% for a $100 million transaction ($2,100,000)
When considering a sale, the seller may be thinking about running the transaction independently. Before committing one way or the other, a seller should fully understand the implications of hiring an M&A advisor so they can make an informed decision that maximizes their time and the value of their business. The services of an M&A advisor often pay for themselves by uncovering value, improving deal terms, and navigating complexities that might otherwise go unnoticed.
M&A Attorneys
Attorney fees are typically straightforward and are contemplated using two main structures or a combination of both.
- Hourly fees
- It is customary for M&A attorneys to bill based on hours incurred multiplied by the attorney’s hourly rate. The unknown variable here is how much time will be spent working on the deal. It is not uncommon for a seller to prefer an attorney with a lower hourly rate with the hope that the result is a lower bill in total. As a seller, exercise caution with this perception. More experienced attorneys will have a higher hourly rate, but that experience will pay dividends – whether it be in the form of risk-mitigation during complex legal negotiations, or fewer hours incurred due to the knowledge of the M&A process.
- Depending on the complexity of the deal, the experience of the attorney, and the attorney’s hourly rate, fees for legal services can range from mid five-figures to low-to-mid six figures.
- The seller’s M&A advisor will have experience working with effective M&A attorneys and can recommend appropriate counsel to consider ensuring a smooth closing process.
- Fixed fee
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- Attorneys may instead propose a fixed fee structure, defined as a predetermined dollar amount, regardless of if the deal closes or not.
- Again, depending on the expected complexity of the deal, a flat fee could range from mid five-figures to low-to-mid six-figures.
Accountants
An accounting firm’s fees will depend on the type of advisory they are providing.
- A CPA may be needed to provide financial documents or respond to financial questions from the buyer. This type of service will likely be billed at an hourly rate similar to what is already agreed upon for the existing work.
- Additionally, some sellers may utilize accountants to perform a Quality of Earnings (“QoE”) review.
- A seller can elect to perform a sell-side QoE, having a CPA represent the company’s normalized earnings to ensure a prospective buyer’s confidence in the financials presented. The seller is responsible for the fees incurred from a sell-side QoE.
- Depending on the accounting firm’s existing backlog and the reputability of the accounting firm, QoE fees are typically a flat fee that can range anywhere from $30,000 to $150,000+.
Tax Professional
Whether an accountant, an attorney, or both, tax professionals typically bill at an hourly rate. Tax professionals can help advise on the ideal structure of the transaction to limit potential tax liabilities incurred by the seller.
Other Professionals
Other services required in a transaction, such as environmental assessments, human resources reviews, insurance consultations, or cybersecurity evaluations. It is case-by-case dependent on whether these services will be covered by the buyer, the seller, or split between both.
Other Common Fees and Expenses
As mentioned above, there are additional expenses a seller will likely encounter and will be required to satisfy as a condition to closing. These expenses are usually required by the buyer, but in most cases serve to benefit and protect the seller against any potential liabilities that arise after the transaction has closed.
- Tail Insurance Policies
- A tail policy, sometimes referred to as a “run-off” policy, is insurance coverage that helps protect the seller against any potential claims that may arise after closing for items that have occurred prior to closing while the company was still under seller control. The most common policies purchased are Directors & Officers (“D&O”) insurance and Representations and Warranties “(R&W”) insurance.
- R&W insurance protects the seller from a breach of contract, or any errors and omissions arising from the representations made by the seller regarding the business up to the sale. R&W policies are typically 3-6 years and premiums are usually 1% of the transaction value.
- D&O insurance protects the directors and officers from any issues arising from a breach of duty, namely fiduciary duty, and protects the business in the event it is named in the claim. D&O policies are typically taken out for anywhere between 2-5 years and premiums could range from $25k – $50k, depending on the size of the business.
- A tail policy, sometimes referred to as a “run-off” policy, is insurance coverage that helps protect the seller against any potential claims that may arise after closing for items that have occurred prior to closing while the company was still under seller control. The most common policies purchased are Directors & Officers (“D&O”) insurance and Representations and Warranties “(R&W”) insurance.
- Escrows
- Buyers will commonly require the seller to set aside a pre-determined amount of cash, taken out of the purchase price, in an escrow account for any issues arising post-close. Escrows are a holdback, not a transaction expense, so while they do still impact cash at close, the shared objective is for the escrowed funds to ultimately be returned to the seller once the agreed conditions are met. Common escrows required include an indemnification escrow and a net working capital escrow.
- Indemnification escrows are used to set aside cash from the purchase price to compensate the buyer for any breach of warranties that arise post-close. If an R&W insurance policy is taken out, then indemnification escrow amounts are significantly reduced or may go away altogether. Without an R&W policy, indemnification escrows could be as high as 10%-15% of the transaction value. If there are not any breaches discovered post-closing, the escrow is released back to the seller in 1-2 years.
- Net working capital escrows set aside cash from the purchase price for any post-closing true-ups that result in a shortfall of the net working capital that was agreed to be delivered to the buyer at close. The amount of the escrow, if required, is negotiated between the buyer and seller prior to closing. If there is a net working capital surplus, no adjustment, or if the shortfall is less than the amount escrowed, the remaining funds will be released to the seller after the net working capital true up that occurs 3-6 months after closing. Net working capital is a complex deal point that is further covered in this blog.
- Buyers will commonly require the seller to set aside a pre-determined amount of cash, taken out of the purchase price, in an escrow account for any issues arising post-close. Escrows are a holdback, not a transaction expense, so while they do still impact cash at close, the shared objective is for the escrowed funds to ultimately be returned to the seller once the agreed conditions are met. Common escrows required include an indemnification escrow and a net working capital escrow.
Ultimately, executing a transaction requires a tremendous amount of time, energy, and resources, and having the right advisors on your side can make or break a successful result. Having an experienced M&A advisor in your corner guiding you through each step of a transaction, helping you choose which types of advisors to hire, and understanding who is right for the situation are all crucial decisions that help ensure a smooth and successful outcome.
