18 Sep Why Investment Banks Charge Engagement Fees
Nothing is free. Capital is certainly no exception. TANSTAAFL (there’s ain’t no such thing as a free lunch) applies. In that light, here’s a conversation I play on repeat on a weekly basis.
Potential client: “Do you work to raise capital?”
Me: “Yes, but whether or not we work with a client is dependent on many factors.”
Client: “What are the factors?”
Me: “The team, growth stage, traction, intellectual property, existing cap table AND whether or not they can afford the most minimal of engagements. We also do not typically work with startups, especially those with little to no revenue. Create a solid business and a reason for investors to risk capital first.”
Client: “What?! You charge an upfront fee for raising capital? Why can’t your fees be based solely on the successful requisition of capital?”
The prospective client will then proceed to dive deeper into his/her sales pitch. What should be at most a five minute elevator pitch will almost invariably extend into an hour. I assume they’re under the impression that if they can sell the banker on the viability of their plan/team/idea, that banker will cave to a structure devoid of an engagement fee with something larger on the backend. Truth be told, for every ten pre-revenue firms completely unwilling to pay upfront for capital, there are a small handful of already successful companies with proven revenues and a track-record who are ready to pay for the service of raising capital through an investment bank.
While the aforementioned scenario paints the picture from the capital raise side, balking at deal fees can also occur on the buyer and seller side. However, the most promising and highest quality deals will never balk at deal fees. They “get it” and recognize they’re paying for a needed service. It’s a cost of doing business. My intent is not to overly beleaguer the point, especially for those that understand the need for upfront fees, but to provide clarity for those who cry foul at them–startup or not–and to help such understand why they exist.
Commit the Client
Nothing speaks commitment like a little skin. It’s the pre-deal equivalent of a break-up fee. This is even more glaringly true for buy-side engagements where–without the “skin” of a engagement–the acquirer could walk away at any time without it ever costing them a dime. If for nothing more, an up-front fee provides at least some confidence for the banker that the client is committed to a full process.
While break-up fees are often a sticky negotiation point in the Investment Banking Agreement, engagement fees often represent a much smaller bite and help to alleviate the ongoing costs of the investment bank.
Investment banking is a risky business, particularly for smaller boutique, private investment banks. The ongoing compliance and regulatory costs are completely non-existent in other industries. And, unlike recurring revenue companies like those we’ve worked with in software-as-a-service businesses, rarely do we receive repeat business from the same customer. It’s “wham bam thank you ma’am.” Bankers often live and die by the deal. Said a third way, if you want to eat it, you have to kill it. Up-front fees ensures the wolf stays away from the door until the deal is in the can.
Filter the Riff Raff
The reason Berkshire Hathaway has never split Class A shares of its common stock is (in Warren’s own words) to “keep the riff raff out.” The most legitimate entrepreneurs, if they truly believe in the viability of their product, service or team should be able to cobble the friends/family cash together to raise capital the right way. Often the right way includes raising the friends/family round to pay for the engagement fee to hire a bank to raise debt and equity through a full outbound marketing process from individual and institutional investors. Investment bankers–with an understanding of how deals are done in today’s market–will always be better at putting a deal away than internal management. Let the bankers focus on what they do best.
The clients we prefer to work with have revenues of $50 million+ (preferably +) with hefty balance sheets. Such companies have a much easier time attracting capital from institutional players. Investment bankers are also more comfortable working with an existing, established business. Bankers also have a moral obligation to be sure they can put a deal away. I hate to over-promise and under-deliver. That’s bad business.
Truly, “money talks” and “cash is king.” I know what it means to be a startup using bubblegum and duct tape to get by, but understanding that capital has a cost is often extremely difficult, even for those who may call themselves seasoned businesspeople.