When Two Become One: Legal Considerations in the Mergers & Acquisitions Process — Part II Engaging a Financial Advisor and the Drafting of the Engagement Letter

Part II: Engaging a Financial Advisor and the Drafting of the Engagement Letter

Last month, I began a seven-part series on the legal consideration for buying, selling, or merging businesses, in which I introduced the mergers and acquisitions process, generally and briefly explaining the six most important steps:

(1) engaging a financial advisor;
(2) entering into a non-disclosure agreement;
(3) negotiating the term sheet or letter of intent;
(4) due diligence;
(5) drafting and negotiating definitive documents; and
(6) the closing.

This month, I will discuss the engaging and drafting the engagement letter with the financial advisor more in depth.

Engagement Letter Defined

A company embarking on the M&A process will often work with a financial advisor to represent and guide the company through the deal, even if there is no tentative deal on the horizon.  This advisor, most often an investment bank, will perform a number of roles for a variety of fees, and these roles and fees will be laid out in the engagement letter.  This letter acts as the contractual agreement between the company and the advisor.

Finding the Financial Advisor

While the negotiation and finalization of the letter is only the first step in the completion of the M&A process, it is important to recognize that the relationship between the company and its financial advisor is a transaction in and of itself with potentially huge financial consequences for the company.  Thus, there are a number of things to keep in mind as you work towards engaging the financial advisor.

The first step is finding the right financial advisor, and this is crucial because you are trusting the advisor with finding the best possible deal for the company.  The company’s current investing partners may be a good source of referrals.  The company’s legal representation might also be a good resource for referrals.  Several financial advisors may compete for the company’s business, where the advisors will examine the company and then offer competing bids on what each advisor can offer the company and on what general terms.

Negotiating the Scope of the Financial Advisor’s Duties

Once an advisor is selected, the next step is to determine what duties the advisor will undertake on behalf of the company in the M&A process.  Negotiation of duties and fees are often done concurrently in reaching a final agreement, but, from the company’s perspective, the range of duties should be what drives the justification for the fees.

A financial advisor may take the lead on finding a buyer for the company or a target company to purchase.  This could entail the financial advisor pursuing one particular company, approaching a list of potential buyers or targets, or working to invite as many potential buyers or targets as possible to bid on the purchase, sale, or merger of or with the company.

The advisor may also provide a valuation of the company, based on the current tangible and intangible assets as well as future profits.  Further, the financial advisor might draft a “fairness opinion” to the company’s board of directors, evaluating the terms of a buyer or target’s proposed offer to purchase or sell the company and provides recommendations to the board in favor or against the proposed purchase.

In addition to these potential roles, an advisor will provide general guidance for the company through the M&A process, specifically in negotiating the terms of the deal and overseeing the closing process.

Negotiating Fees

The various fees that an advisor will be paid should be based on the services provided to the company throughout the M&A process, and should be the product of a negotiation between the company, the company’s representatives, and the advisor.  Generally, the advisor will receive a retainer fee, which is paid regardless of the outcome of the process.  The advisor may also receive interim fees, contingent on meeting certain benchmarks such as finding a buyer.  Finally, the advisor will typically receive a “success fee” for the successful completion of the deal.  This fee may be paid in cash, securities in the company, or a combination of both.

Other Issues

Scope of duties and fees are the major issues to be negotiated in an engagement letter, but, as with any major business contract, there are other issues to be considered as well.  These include determining what expenses of the financial advisor the company will be required to pay, how disputes between the advisor and the company should be resolved (for example, should the company advisor submit to binding arbitration), and how the company and the advisor might be indemnified in the event of third-party litigation, such as with potential buyers and other investors.

Conclusion

Ensuring you choose the right financial advisor and drafting an engagement letter that comprehensively lays out the company’s and the advisor’s rights and responsibilities can take some significant work and focus, but putting in the effort to ensure that these initial steps are done correctly can have enormously positive effects on the purchase, sale, or merger of the company in the long run.  To ensure your deal stays amicable, occurs smoothly, and results in the best deal possible for all parties involved, make sure to follow the rest of this series of blogs on the M&A process.  The next blog in this series will delve deeper into the drafting of the non-disclosure agreement.