Avoiding Pitfalls In Sell-Side Engagement Letters

Prospective sellers of companies routinely engage investment bankers to assist them in the sales process. Investment banks each have their own “standard engagement letter” that they request clients sign as they begin the sales process. Many sellers sign these agreements without seeking counsel, and make the erroneous assumption that they are not negotiable. In fact, such agreements often contain fee terms, tail provisions and indemnification provisions that might surprise sellers in both their meaning and their application. These terms can be, and frequently are, successfully negotiated in the seller’s favor. This article highlights some of the most common and significant provisions of which prospective sellers should be aware.

* Parties to the Agreement. As a preliminary matter, it will need to be determined who will sign the engagement letter on the seller’s side: the target company, all of the selling shareholders, or just certain “lead” shareholders who are in control of the process. This may become relevant in the event of any dispute and will determine who is ultimately liable for the fee. Since individual shareholders cannot ordinarily be held personally liable on a contract without their express agreement, lead shareholders who are considering being a direct party to the engagement letter should consider asking their fellow shareholders to be parties as well.

* Definition of “Transaction.” The engagement letter should clearly state the nature of the transaction for which the investment banker is being hired and upon which any fee will be based, such as a completed sale, sale of a controlling interest, sale of a division or subsidiary, issuance of new securities or a refinancing or recapitalization.

* Determination of Aggregate Consideration. Fees are typically determined on the basis of the “aggregate consideration” received by the seller. Usually this includes (i) for stock sales/mergers: the consideration paid for the company’s securities (including options, warrants, etc.) plus indebtedness assumed or repaid at closing, and (ii) for asset sales: the total consideration paid for such assets plus debt assumed or repaid at closing. In addition, “aggregate consideration” is often drafted to include any other payments received by the sellers, such as non-compete payments, severance payments, bonuses and even amounts payable under post-closing employment and consulting agreements. Below are several issues that often crop up when defining aggregate consideration.

Issue 1: Included Debt. The term “debt,” standing alone, includes not only indebtedness for borrowed money and capitalized lease obligations, but also ordinary trade payables which would not normally be included for purposes of determining the fee. Care should be taken to insure that “debt” for purposes of determining aggregate consideration is properly (and narrowly) defined. Sellers should also endeavor to offset “debt” with cash (or at least “excess cash” above normal working capital levels), thus yielding a “net debt” concept that effectively reduces “aggregate consideration” by the amount of cash (or excess cash).

Issue 2: Pre-Closing Distributions. Engagement letters sometimes attempt to include pre-closing dividends or distributions in the determination of aggregate consideration. While certainly a point of negotiation, a strong argument can be made that any cash available for distribution reflects the results of past operations (and strategic decisions as to whether to retain or distribute such cash) and not ongoing enterprise value that should be included in the determination of aggregate consideration. In any event, tax distributions made by flow-through entities such as limited liability companies, partnerships and S-corporations should be excluded.

Issue 3: Interim Acquisitions and Other Events. Where the sale process is likely to be protracted, or there is otherwise a likelihood that the target company could consummate an acquisition before closing, the sellers may seek to carve out any value assigned to such acquisition from the determination of the fee. Sellers may also consider requesting an aggregate fee cap, especially where improvements from operations over the duration of the sale process (rather than solely the investment banker’s efforts) contribute to a higher purchase price. (In lieu of a cap, the portion of the consideration attributable to improved operations could be valued and excluded from the fee calculation.)

Issue 4: Other Consideration. A somewhat thornier issue is presented by the inclusion of other payments in “aggregate consideration.” The issue is whether such payments are more properly characterized as additional proceeds from the sale, or whether they are more akin to compensation for services. While there is no clear line to be drawn, this is often resolved by including items such as non-compete payments and closing bonuses, while excluding bona fide employment and consulting agreements.

* Deferred or Contingent Consideration: Often a portion of the aggregate consideration is deferred or contingent. Ideally, payment of the portion of the fee allocable to such consideration would be deferred until such consideration is actually received. An additional issue arises where a portion of the consideration is paid in non-marketable securities, such as stock in the purchaser. Where the purchaser is a newly-formed entity, such securities may have recently been issued at a known valuation. In other situations, valuing such securities may be difficult. Sellers or the investment banker may prefer to simply give the investment banker the applicable portion of its fee “in kind,” although that may require the agreement of the purchaser. Alternatively, the investment banker could be asked to wait until such securities are ultimately sold before receiving the fee on that portion of the consideration.

* Tail Provisions: Sell-side engagement agreements often contain provisions that extend the investment banker’s entitlement to the fee for some period of time following termination of the engagement. Below are some issues to consider when negotiating tail provisions.

Issue 1: Continuing Services. Where a tail has been negotiated, a seller may require that the investment banker render at least some services during the tail period to the extent relating to a transaction to which the fee would apply.

Issue 2: Reason for Termination. Where the engagement has been terminated by the seller for “cause” (e.g., gross negligence, malfeasance or material breach of the agreement by the investment banker) or by the investment banker’s resignation, it would ordinarily be inappropriate for the tail provision to apply.

Issue 3: Identified Prospects. The seller may also seek to limit the tail to prospective purchasers whohave been identified by the investment banker prior to termination. The seller may further endeavor to limit the tail to prospective purchasers who have actually been contacted prior to termination, or even to those with whom substantive conversations have occurred.

Issue 4: Timing Matters. The tail provision should be clear as to what has to happen by the end of the tail period for the fee to be payable. The most favorable provision from the seller’s perspective would be the requirement that the sale actually be consummated during the tail period. In contrast, the investment banker would most likely seek to have the tail apply to any transaction as to which a definitive agreement (or perhaps even a letter of intent) has been signed during the tail period, in which case the seller should at least insist that the closing must occur within some specified time thereafter.

* Exclusivity for the Benefit of the Investment Banker: Consideration should be given as to whether to grant exclusive status to the investment banker. If another banker may be necessary or desirable, an appropriate split of fees should be considered to avoid double-paying.

* Exclusivity for the Benefit of the Seller: It may be desirable to insure that the investment banker will not advise or finance any other party in connection with a potential transaction. Depending on the nature of the seller and the other operations of the investment banker, the seller may also desire to prohibit or wall off trading activities by the investment banker in respect of the company’s securities. Violation of the exclusivity provisions should be a basis for termination of both the agreement and any fee tail.

* Expenses: Investment bankers typically request reimbursement for their expenses. These should be limited to true, out-of-pocket expenses payable to third parties (i.e., not internally allocated overhead, such as in-house counsel). Once expenses exceed a specified amount, seller’s prior written approval should be required.

* Indemnification: Sell-side engagement letters typically include lengthy indemnification provisions for the benefit of the investment banker. Any changes usually have to be approved by the investment banker’s counsel, but that should not dissuade sellers from insisting upon reasonable modifications, such as the following:

General Limitation on Indemnification. The seller is typically obligated to indemnify the investment bank and its partners, employees, etc. (the “Indemnified Persons”), for any losses (broadly defined) arising from the engagement. Such provisions should make it clear that no indemnification should be owed in the case of either an Indemnified Person’s own gross negligence, bad faith or willful malfeasance or that of any other Indemnified Person.

Contribution: Indemnification provisions often include technical provisions obligating the seller to make a “contribution” in respect of claims for which the investment banker may be liable. Care should be taken to insure that such contribution obligation only arises where indemnification is not available due to legal limitations, and not as a “back door indemnity” for situations in which an Indemnified Person has committed gross negligence or willful malfeasance.

Control of Claims: The seller should be entitled to control the defense of any claims made by third parties for whom it may be obligated to provide indemnification, subject to customary carve-outs for conflict of interest situations.


The sales process often marks the successful exit for entrepreneurs, private equity funds and other investors in the company being sold. Careful attention to the engagement letter can help assure that the relationship between the seller and its investment banker is clearly defined and that there are no surprises at the back end when the sale is finally consummated.

Gary R. Silverman is a partner in the New York and Chicago offices of Kaye Scholer LLP where he focuses his practice on mergers and acquisitions, leveraged buyouts and private equity transactions. Reach him at gsilverman@kayescholer.com