Most mid-market business owners do not regularly go through mergers and acquisitions, so it is generally not something they are familiar with. But for many, selling their business will be the most significant financial transaction of their lives.
So for something so important, how do you pick an adviser?
There are no reliable sources of information that make it easy to compare M&A advisers when “shopping around.” The process remains mysterious to a lot of people, and advisers will all run their deals a bit differently. So most of the time you will just have to speak directly with a potential adviser and ask them questions.
Choosing the right M&A adviser is a lot like choosing an accountant or a lawyer. You want to qualify them for their ability to align their expertise with your own needs and priorities. But while a business owner needs an accountant and a lawyer on a regular basis, an M&A adviser is a much more specialized professional who carries a proportionately larger responsibility because their work is more focused on a particular transaction.
One of the biggest questions that comes up when choosing an advisor is how the commissions work.
QUESTION: “What are the commissions charged on a business sold for less than $1 million? Over $1 million?”
Many advisors use some variation of the “Lehman formula,” named after Lehman Bros., the ill-fated Wall Street investment bank that collapsed during the 2008 financial crisis. It was initially used to determine commission structures when underwriting stock issuances, but it has been popular in the M&A business.
The basic pattern of fees for the old Lehman formula was: 5% for the first million dollars of the transaction, 4% on the second million, 3% on the third, 2% on the fourth, and 1% on everything over $4 million.
However, this formula was originally devised in the 1970s and price inflation since then has been significant. For this reason, the modern day “Lehman formula” is actually the “double Lehman formula” — so 10% on the first million, 8% on the second million, and so on, with 2% on everything over $4 million. This makes sense because nowadays the relative transaction values are larger than they were 40 years ago.
One might think that it would be optimal to structure commissions so that larger percentages are earned on additional millions instead of the first million. While this seems intuitive, it can lead to some weird and undesirable results. Imagine that you have signed up with an adviser to test the market for your business at a given valuation range. Now imagine that some exceptional macro-level event raises valuations in the entire industry. Should the adviser get a proportionally larger fee because of that? It seems unfair because they had no influence on what happened. But on the other hand, the adviser has no influence on whether the economy crashes or the business encounters some internal hindrance that puts downward pressure on its value. This would be unfair to the adviser, especially because doing a $10 million deal involves a similar amount of work as a $20 million deal. So a “Lehman formula” sort of structure can make sense for both the seller and adviser.
Another possibility is a straight linear percentage. So regardless of the final transaction value, the adviser would simply earn a flat percentage of the final transaction value in commission. Depending on deal size, this might be suitable.
That being said, it is important to note that whether the commission structure is linear or “Lehman”-style, they should come out reasonably close to one another on the total value of the deal if they are fairly calculated.
And practically speaking, there is not a “one size fits all” commission structure. Quite often, advisers will work with their clients to develop a specific agreement appropriate to the project.
Furthermore, our focus here is on middle market transactions. This will generally cover companies with revenues anywhere from $3 million to $100 million.
As you move up or down the revenue scale, the corresponding commission percentage changes. The investment banking division at a big bank like BMO or RBC might “only” earn 1.5% commission, but that could be on a transaction worth a few billion dollars (and most of these M&A deals are never completed anyway, because there are few potential buyers and the deals are especially complex). Regardless of the percentage, big investment banks and “Big 4” advisers (like E&Y or PwC) will usually want at least a million dollars in fees to take on a project.
At the lower end of the scale, where businesses sell for less than $1 million, business brokers will often want 10% to 12% on the transaction value. Additionally, business brokers frequently want to establish a minimum commission on a closed transaction (this is less common for M&A advisers and bankers, although it is something to watch out for).
Middle-market advisors like MAXIMA, working on transactions of size and complexity somewhere between big investment banks and business brokers, might have commission percentages somewhere between 5% to 10%. This depends a lot on the size of the deal and the challenges associated with it — a bigger transaction typically entails a smaller commission percentage; an M&A deal projected to be especially challenging project might entail a larger percentage.
The above discussion should give you some ideas on how to talk about commissions with a potential adviser.
But that is just one part of the conversation.
In Part II, we will discuss M&A adviser work fees and retainers.