HOW MUCH SHOULD YOU PAY YOUR INVESTMENT BANKER?
By James Verdonik

You have completed development of your product and have hired 100 employees to begin manufacturing and selling your product, but your company will go out of business in three months if you cannot raise $10 million to pay all those salaries. What price should you pay someone who helps you raise $10 million to save your company? This article discusses the fees typically charged by investment bankers.

Investment bankers generally charge three types of fees: cash reimbursement of expenses, cash as a percentage of the transaction and equity compensation.

Cash for Expenses.

Some investment bankers charge expenses that exceed the actual expenses related to the transaction. In some cases, this takes the form of a fixed expense allowance that is not refundable even if the actual expenses are lower. This expense allowance may be either in lieu of, or in addition to, reimbursement of actual expenses. A fixed expense allowance is usually a profit center for investment bankers and may be a way of charging a retainer fee without calling it a retainer fee.

Percentage Cash Fees.

The part of the investment banker's fee that usually draws the most attention during negotiations is the cash fee that is paid upon the closing of the transaction. This fee is usually based on a percentage of the money raised in the offering. Percentages vary from one deal to the next, but the range for a private placement is generally 5% to 10%. Having a fixed percentage of the deal can be very lucrative for investment bankers as the size of the deal increases. For larger deals, therefore, a "Lehman" formula is sometimes used which charges a lower percentage as the amount raised increases. For example 5% of the first million dollars, 4% of the second million dollars, 3% of the third million, 2% of the fourth million and 1% above five million. The "Double Lehman" formula uses 10%, 8%, 6%, 4% and 2%. The dollar break points at which the percentage is reduced are negotiable and vary from one deal to the next.

Some investment bankers charge a monthly cash retainer, as well as the percentage fee payable at closing. Usually the retainer that is paid can be applied as a credit that reduces the amount of the percentage fee payable at the closing. With the retainer, the investment banker reduces its risk by receiving some compensation whether or not a deal closes.

Equity Compensation.

Most equity compensation paid to investment bankers is in the form of warrants. The warrants are generally for a number of shares equal to between 5% and 10% of the number of shares sold in the deal by the investment banker. The warrants generally have an exercise price equal to 100% to 120% of the price of the securities sold in the deal and have a term of from one to ten years. In some cases, the warrants terminate on IPO of the company.

Although investment banking fees for most transactions contain a combination of expense reimbursement, cash percentage fee and warrants, the amount in each category of fees varies from deal to deal depending upon a number of factors that include the following:

• Size of the Deal. The general rule is the lower the dollar amount to be raised, the higher the percentage the investment banker receives. This is the case because the amount of time and effort it takes to raise $25 million is often not much more than it takes to raise $5 million.
  
  
• Stage of Company. With younger companies there is usually greater risk that the deal will not close or that it will take more effort by the investment banker.
  
  
• Industry. If your company is in a hot industry, the investment banker may agree to a lower fee because the deal will be easier to sell. Also, the warrants may be deemed to be more valuable.
  
  
• Market Factors. If a company has no other visible sources of funding, the fee will generally be higher than if other investment bankers are competing for the business or if the company's existing investors are willing to fund the company.

Although the size of the fee is important, it is often more important to assure that the fee is structured to incentivize the investment banker to get the deal closed on terms that are favorable to you. Therefore, it may be in your interest to agree to a percentage fee that is at the low end of the normal range, but to agree to a higher fee if at closing the deal meets specified valuation criteria. For example, 10% if the pre-money valuation at closing is twenty million or more and 5% if the pre-money valuation is less than $20 million.