What Does an Investment Bank's Fee Structure Look Like?
- Why fee structure is important for creating alignment between banker and founder
- Which financial aspects of a fee structure a founder should consider
When you hire an investment bank to represent you, their rewards will be connected to your own outcome in the sale of your business.
Given this arrangement, what is the most important aspect of a banker’s fees that you should consider as a founder? Whether or not the fee structure creates alignment.
Aligned incentives drive the transaction in a positive direction for both founder and banker. Misaligned incentives, on the other hand, can lead to a suboptimal outcome.
When considering whether a fee structure fosters alignment, the two specific financial aspects of the structure that you should consider are the banker’s retainer fee and success fee.
A retainer fee is what a bank receives when they officially engage to represent a founder for an M&A or capital raise transaction.
Some banks will charge an ongoing monthly retainer fee. The issue with this model is that it creates an opportunity for a bank to unnecessarily prolong their engagement with you for added fees. For example, if the bank thinks that there is not likely to be a successful transaction it is in its economic best interest to “stall” the process to capture additional retainer payments.
At Vista Point, we charge a fixed, one-time retainer fee at the beginning of our engagement, the term of which is perpetual but can be terminated at any time by the client.
A success fee is what a bank receives for closing a transaction, represented as a percentage of valuation (or, in the case of a minority transaction, of the capital raised*).
Because success fees are calculated as a percentage of a successful outcome, they help align the incentives of the founder and the bank—the higher the ceiling on deal size, the greater the reward for both parties.
*Success fees for minority transactions are not based on valuation because security structures can be engineered to increase valuation without economically benefiting the founder.
What is the typical rate for a success fee?
Some banks provide standard rates as part of a "rate card," indicating specific success fee rates at given valuations.
At Vista Point Advisors, we do not have a standard rate card because different companies have different paths to their optimal valuation. To set a standard rate across all companies would create a misalignment of incentives for companies who have a great opportunity but require extra resources to arrive at an outsized valuation. Achieving a $100M valuation might be harder for one company than another.
As a founder, you’re not so much concerned about what it takes to arrive at a better outcome—you simply want a better outcome. But an experienced banker will have the foresight to know which companies will need the extra push to get to that great outcome, and therefore will structure their fees to reflect the difference. Doing so creates alignment between founder and banker.
So, given the above, before a banker can quote a specific success fee, they will need to first:
- Evaluate your business in the context of the market and relevant buyer universe
- Identify the path to reach an optimal valuation
- Structure their fees based on the resources required to achieve that optimal valuation
Watch out for minimum fees
In some cases, a bank will propose a minimum success fee, which sets a floor on what a banker receives, independent of the transaction outcome. Be careful of minimum fees because they can create misalignment.
Consider this: if a banker can realize a good return by doing the bare minimum then taking home their minimum fee, rather than by pushing harder towards a higher, riskier outcome, which course are they most likely to follow?
You want your banker to focus on the ceiling, not the floor. Which is why we recommend performance-based ratchets with no minimum fee.
Aligning incentives via performance-based ratchets
While the economics for both bank and founder improve as valuation increases, so do the resources required to realize an incremental improvement, along with the risk of the deal.
Why is this insight important? Because while a 10% improvement on a $100M valuation is significant for you as a founder, for a banker who charges a fixed-percentage success fee, a 10% improvement may not be a strong enough incentive for them to allocate incremental resources to make the next big push.
To make sure incentives remain aligned as valuation and risk increase, a bank will commonly employ a performance-based ratchet model. Under this model, the success fee paid to a bank gets "ratcheted up" as they achieve certain valuation milestones (such as going from $100M to $120M in enterprise value).
While the total percentage you pay to a banker will increase as valuation increases, the net benefit to both parties is greater because the bank has the incentive to realize those incremental improvements for themselves and the founder.
Your Bank Will Pay for Itself
Ultimately, a bank will earn its own fees by increasing a company’s enterprise value via a structured, competitive process. As an example, of our last 5 deals at Vista Point Advisors where our client had a term sheet on the table before we started working with them, we were able to add 62% to the enterprise value and 14.5x our fees.*
When incentives are aligned and opportunity is there, both founder and banker can benefit from an appropriate fee structure.
*Note: Past results are not an indicator of future outcomes.