Hi, it's CJ Gustafson and welcome to Looking for Leverage.

Today’s term: the success fee. There are two numbers in it.

In my experience most management teams spend more time on the percentages and sliding scales than defining the “total consideration” number (which can get larded up pretty fast).

The last time I was part of a company sale, we interviewed bankers for the job. This is commonly referred to as a bake off, characterized by four different sets of people in the same blue suits explaining that your company is super special.

Every pitch had the same backbone.

The number each pitched was larger than I had personally penciled for a valuation. Which felt great!

But you have to remember that the banker with the largest number is typically not the best. They’re probably over compensating for something (like reputation or lack of precedent transactions). The majority of the time it ends up being over-promising and under-delivering, and you find that out way after you’ve committed (now feeling underwhelmed and oversold).

Along with the presentation came an engagement letter which included a fee structure. It had a minimum amount payable upon a successful deal, then a sliding scale based on deal value that stepped up as the outcome got bigger. We spent a lot of time on those percentages and breakpoints after the meeting, internally forecasting what the effective rate and reduction to headline price would be.

And in all honesty we should have spent more time on the definition of “deal value” than we did.

The banker gets paid two ways.

A retainer or work fee, paid monthly through the process, call it $25K to $75K a month in the core middle market. In recent years I’ve seen this as simply a flat amount for the term of the engagement (say $100K or $250K). It’s non-refundable, and it’s usually creditable against the success fee, which means it comes off the final bill if you get to a close.

Tip #1: Push for 100% creditable. It’s rarely a fight and it’s free money assuming you get a deal done. This is meant to be a small consolation, or downside protection for the banker if a deal doesn’t go through.

Then there’s the success fee at closing, which is shown as a simple table.

There’s almost always a minimum, say $2M, and then a sliding scale.

There’s surprisingly not much more to the fee structure than this two column table. You have a floor, and then the incremental rates you’d pay them at after crossing certain valuation thresholds.

This leaves you two things to negotiate.

These rates work like tax brackets. The 1.75% applies only to the $50M tranche between $200M and $250M, not to the whole deal. Your total fee is the sum of what each band produces, and your effective rate is that total divided by the price.

The bank’s table gives you neither one, so you have to do it on your own. Here is the same grid with both columns filled in.

The $2M minimum applies below $133M, because that’s where 1.50% of the deal reaches $2M. On anything bigger you are paying the percentage and the floor becomes irrelevant.

At a $300M close your fee is $4.88M. Of that, $3.00M comes from the first $200M of price, so roughly 62% of what you pay is earned before the sliding scale kicks in. Then an additional $0.88M comes from the next band, and another $1.0M from the band after that. In this scenario, the 2.25% band contributes zero, because it does not start until $300M.

Tip #2: Make sure the letter says the brackets are incremental. Loose wording can be read to mean the whole deal gets priced at the single rate for whichever band it lands in, which at $300M would be 2.00% of all $300M, or $6.00M, against $4.88M using the brackets.

Let’s go through a quick hypothetical to demonstrate how incentives drive outcomes:

The letter also defines the number those percentages get multiplied by. The term you’ll see is usually “transaction value” or “aggregate consideration,” and the definition runs much, much longer than the rate table. And to be clear, you want this to be as small and straightforward as possible (ideally: cash proceeds upon closing).

Tip #3: Here are four things that commonly get pulled into the total consideration that you should try to negotiate.

Tip #4: And make sure to get the dates right.

The fee should be earned at closing, not at signing. Deals sign and then fall apart, and you do not want to owe a success fee on a sale that never happened.

Tip #5: It should also be calculated on what actually gets wired, not on the number in the LOI. The close price is often lower than the LOI price, and you should not pay a percentage on the difference.

I learned this one from a friend rather than from a deal.

We were talking about earnouts he had negotiated for his management team on the way out, and almost in passing he told me to make sure earnouts stay out of the deal consideration bankers get paid on. Because a lot of the time they don’t pay out.

Then he described a team he was a part of. More than a quarter of the total consideration was structured as earnout. The management team lasted under six months at the acquirer. They were gone before any of it was earned.

However, the bank had collected on all of it at close.

Nobody hid anything and nobody breached the engagement letter. The bankers were simply comfortable pushing more of the price into the earnout bucket, because they knew that money was certain for them and contingent for everyone else, and therefore easier for the buyer to agree to.

Wishing you a fee grid measured against money you actually receive,

CJ

Looking for Leverage breaks down one PE term, clause, or mechanic each week, written for the CFOs and finance leaders who actually have to live with these things. If this got forwarded to you, subscribe at lookingforleverage.com. If there's a term you want broken down, reply and tell me. I read everything.

Thanks for reading, and make sure to check out our sponsor, Netsuite.

Readers of Looking for Leverage can try NetSuite Next for free.