Negotiating Investment Banking M&A Engagement Letters:
Keeping the Investment Bank Incentivized While Protecting Your Interests
Congratulations … we hope. Your company has battled through the past several years of troubled economic times and has come out on the other side stronger for it. Cautious investors who have been hoarding their cash are slowly testing the investment waters, and a flurry of investment bankers are rummaging through the remnants looking for the diamond in the rough that entices some of this sidelined money back into the markets. One of the wiser investment bankers now remembered a distant meeting with you and has realized, rightfully so, that your company’s recent EBITDA growth and margin expansion make you a very appealing candidate to a potential buyer. The investment banker has approached your company, laid out a compelling case for why a sale at this time might make sense for your company, and has convinced you to plant a “for sale” sign in your corporate offices and test the market. The investment banker has served up his firm’s “standard engagement letter,” and asked that you sign it so you can partner up and kick off the process.
Jeff Beck’s Quarterly Tidbit of Interest:
SEC Commissioner Luis Aguilar expressed numerous concerns about the JOBS Act, including that it “would be a boon to boiler room operators, Ponzi schemes, bucket shops and garden variety fraudsters, by enabling them to cast a wider net, and making securities laws enforcement much more difficult.” President Obama signed the JOBS Act into law on April 5, 2012. Stay tuned.
At this point you are conflicted — you know this investment banker is supposed to be “on your side” and “working for you” and you certainly do not want to start the relationship on the wrong foot. At the same time, there are a number of provisions in the engagement letter that make you uneasy, and you wonder whether they are customary or if there is room for negotiation. Beyond some of the obvious negotiable points (such as the amount of the success fee), we highlight below several aspects of the engagement letter that should be evaluated with care and that have room for negotiation.
Without going into all the issues related to the investment banker’s fee, there are a few points that come up frequently in discussions with investment bankers, such as the possibility of a progressive fee structure and the timing of payments to the investment banker, which are worth addressing here. The fee payable to the investment banker in an engagement letter is most likely calculated as a percentage of the price for which the company is sold. While an investment banker should always be working to get the company the greatest value in the sale, it is not uncommon to tweak the fee structure to give the bank some extra encouragement. One way to accomplish this is through a progressive fee schedule (sometimes referred to as a “Reverse Lehman” formula), where the success fee percentage increases as the sale price crosses certain thresholds. Under certain circumstances, minimum and/or maximum fees might be appropriate. While some banks will insist on a minimum fee, it is nevertheless important to negotiate the amount of the minimum fee to ensure that the bank remains properly incentivized to get its client the best deal.
Also worth considering are provisions in the engagement letter that relate to the timing and manner of payment of the investment banker’s fees. It is possible that a potential buyer makes an offer for a company that its owners think is too low, and they counter with a higher price. For example, the buyer may have expressed some concern about whether the company’s projected future revenue levels are realistic, but has indicated a willingness to pay an additional amount for the company following the sale if the projections pan out — commonly referred to as an earnout. In this situation, the company probably would not want its investment banker to collect a fee at the time of closing on the earnout component — it is reasonable that the banker should only get paid if the company/owners get paid. To account for this, the engagement letter should specify that the investment banker does not get paid its fee on the earnout unless and until the earnout component of the purchase price is actually earned and paid. If the investment banker balks at this position, as a compromise, the parties might agree that the banker will receive its fee at the closing of the transaction based on a transaction value that factors in receipt of only a portion of the earnout amount. In addition, if the investment banker is amenable to the idea, it may be prudent to specify that the banker gets paid in the same form of consideration as the company/owners get paid, so that, for instance, if the company/owners receive equity in the buyer as consideration, the company/owners do not have to come up with cash to pay the banker.
In addition, while it is common for an investment banker to receive an upfront retainer and a success fee upon consummation of a transaction, occasionally an engagement letter will call for milestone payments at other points in time. For instance, the investment banker may have included a provision in the engagement letter that calls for payment of a portion of its fee upon the signing of a definitive transaction document, and the balance of its fee upon consummation of the transaction. If the banker has proposed a structure that incorporates milestone payments, and that is something a company is willing to consider, it is best to ensure that the milestone payments are only earned upon the achievement of legally meaningful and objective events. For instance, if the banker has asked for a milestone payment upon the signing of a letter of intent or term sheet, a company will likely want to resist this point, as letters of intent and term sheets are often nonbinding. While a letter of intent may be meaningful from a moral perspective, it typically only requires the parties to continue to negotiate in good faith, which would leave the company paying an investment banker fee with no assurance that it actually has a binding transaction. Most investment bankers will agree to offset any amounts owed for a success fee against the company’s retainer. Finally, the banker may propose that its fee be calculated off a base that includes “value” over and above the cash purchase price, such as lease payments (if there is an affiliated landlord) or the value of compensation under employment agreements entered into in connection with closing. These types of items should be viewed with skepticism and negotiated with great care.
Carveouts from the Definition of “Transactions”
The engagement letter will typically provide that the investment banker will be entitled to its fee upon consummation of a “transaction.” In a sale context, the term “transaction” will usually be defined to cover the sale of all or part of the capital stock of a company, the merger of a company with an acquirer, or a purchaser’s acquisition of all or substantially all of a company’s assets. It is also not uncommon for the term “transaction” to be defined even broader, and to pick up capital raising transactions such as issuances of debt and equity securities. Depending on a company’s circumstances, however, there may be a number of transactions that it will want carved out from the definition of “transactions.”
Suppose a company has been in very preliminary talks for several months with one of its suppliers about the possibility of combining the two companies to take advantage of synergies. If, after the investment banker has been engaged, these talks become more serious and a decision is made to pursue a combination with the supplier, arguably the investment banker should not be entitled to a fee. After all, this was a potential transaction the company identified and nurtured on its own prior to discussions with the investment banker. It is not uncommon, therefore, to list on a schedule to the engagement letter a number of parties with whom the company has already had discussions about a sale transaction and to specify that a sale to, or combination with, any of those listed entities will not be considered a “transaction” for which the investment banker will be entitled to a fee. Remembering of course that the goal is to keep the investment banker working hard on the company’s behalf, the company might instead provide for a reduced fee to the banker in connection with a sale to a party listed on the schedule.
Alternatively, imagine a situation where several years ago, as part of a capital infusion from a minority investor, a company granted that minority investor an option to purchase a 51 percent stake in the company at a set price in the future. The company will likely want its engagement letter to make clear that if the minority investor exercises its option during the term of the engagement with the investment banker (or during the tail period, discussed below), then the banker will not be entitled to collect a fee for that transaction.
One important component in an engagement letter is a description of the services that the investment banker will provide in connection with the engagement. This list of services may include reviewing a company’s financials and comparing them to industry data, identifying and approaching potential purchasers, coordinating potential buyers’ due diligence efforts and assisting in negotiations. If the investment banker has not already offered to do so, and it is not addressed in the engagement letter, it is important to reach an agreement at this stage on who will be responsible for drafting the disclosure document that will be used to market the company. If the engagement letter is not clear as to who will bear responsibility for preparation of marketing materials, the investment banker might request an additional fee if the company enlists its assistance with such tasks down the road. The services provision of the engagement letter should also make clear that the company has the final decision on all important transaction matters, such as final approval of marketing materials, who the bank shops the company to, whether to engage a bidder in further negotiations and, most importantly, whether to accept or reject a purchase offer.
The Banker’s Expenses
The engagement letter likely calls for the client to reimburse the investment bank for all expenses it incurs in furtherance of the engagement. While a company will not have much luck asking the investment bank to cover its own expenses, there is often room to establish a cap on out-of-pocket expenses that the investment banker will not exceed without first obtaining the client’s consent. This cap can be a monthly cap or an aggregate cap. Alternatively, the parties might agree that the investment banker will not incur any individual out-of-pocket expenses in excess of a certain amount without first obtaining the company’s consent, though before agreeing to a provision such as this, it is important to note that it affords the investment banker some wiggle room to divide what may seem like one expense that crosses the agreed-upon threshold into multiple separate expenses none of which reach the threshold.
Term, Termination and Tail
Most investment banks structure the term of the engagement in such a way that it will perpetually renew absent some affirmative action by the company to terminate the engagement. For instance, the engagement letter might provide that the engagement lasts for six months, but that it automatically renews for additional successive one-month periods if neither party provides written notice of its intent to terminate the engagement. Provisions such as this are notorious for catching up with unwitting companies who forget to notify their investment banker of their intent to terminate the engagement and wind up on the hook for a hefty commission when they enter into an unrelated transaction some years down the road. Further, as discussed in detail below regarding “tail periods,” sending the termination notice one month in advance of signing up for the new transaction is unlikely sufficient to steer clear of paying the investment banker its windfall. Rather than agree to the investment bank’s standard formulation of the termination clause, it may be preferable to propose that the engagement automatically terminates after a set number of months unless the parties mutually agree in writing to extend the term of the engagement.
In addition, and almost without fail, an investment banker will insist that the engagement letter include a “tail period.” The tail period is a period of time after the termination of the engagement during which, upon the completion of a transaction, the investment banker would still be entitled to its fee. While it is fairly common to negotiate the duration of the tail period, there are other features of the tail that can often be revised to a company’s benefit. Frequently, the investment banker will propose that the phrase “transaction” means the same thing for purposes of the scope of its own engagement as well as the tail period. Depending on the amount of leverage a company has with its investment banker, the company may have luck narrowing the scope of the types of “transactions” that would be covered by the tail. For instance, the investment banker might agree that it will only receive a payment for consummation of a transaction in the tail period if that transaction is with a third party who was solicited by the investment banker during its engagement and received a copy of the company’s disclosure document. Depending on the circumstances, it might even be appropriate to limit the investment banker’s fee in the tail period to cover transactions with parties who were brought to the company’s attention by the investment banker and with whom the company engaged in “active and substantive negotiations” (which is a phrase that should be defined in the engagement letter). To limit the potential for disputes down the road, it is also not uncommon for the engagement letter to provide that upon termination, the investment banker must provide the company with a list of those parties who fit within the “active and substantive negotiations” standard.
Probably the most confusing part of any engagement letter for a company is the indemnification provision, which is notorious for being filled with run-on sentences that can extend for up to half a page. If the indemnification provision is not contained in the body of the engagement letter, it will be attached as an annex or exhibit to the main letter. In general, there is relatively little room for negotiation of the indemnification provision. The investment banker will generally insist on being indemnified for any liability it incurs in connection with or as a result of the engagement other than any liability resulting from its own willful misconduct or gross negligence. This standard is common across banks, and it would be highly unusual for a bank to agree to accept liability for any conduct on its part that does not rise to this level. Investment banks are of the view that it is someone else’s company they are marketing, and therefore the company needs to be responsible for what is said. While a company may have some success tinkering with the terms of the indemnification provision on the margins, banks are typically very reluctant to deviate from their standard language.
While it is no doubt important for a company to maintain a positive and collaborative relationship with its investment banker, that does not mean the company should simply accept the initial draft of the engagement letter that its investment banker serves up without negotiating certain fundamental points. In fact, discussing the points set forth above prior to signing of the engagement letter will help the parties avoid disputes during the course of the engagement, which should help foster a productive working relationship. An investment banker can add tremendous value to a sale process by helping to demonstrate a company’s value, identifying and engaging potential buyers and assisting with negotiations; however, before engaging an investment banker, it is important that a company do so on reasonable terms that strike an appropriate balance between incentivizing the banker and protecting certain of the company’s legitimate interests. A reputable banker will understand and appreciate the company’s needs for many of the protections discussed in this article, and will probably even respect the company more as a client if the company recognizes and can articulate its need for these protections.
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Social Media Practices and Policies for the Pharmaceutical Industry
The Food and Drug Administration’s much anticipated draft guidance related to the use of social media by pharmaceutical companies fell far short of what the industry expected. More than two years after the FDA held initial hearings on the topic, it quietly released social-media guidelines that addressed only one particular issue: communications relative to off-label uses of their products. But, there is more guidance to come. The FDA indicated upon release of this limited guidance that it expects to release multiple draft guidances relative to social media and other issues, including fulfilling regulatory requirements when there are space limitations (i.e., the 140-character limit of Twitter) and correcting misinformation.
While the guidance itself is important and marks the first time that social media channels such as Twitter and YouTube have been mentioned by name in FDA guidance, its narrow focus provides little in the way of direction to an industry yearning for clarity relative to online marketing issues generally. Despite its narrow focus, there is a silver lining. The pharmaceutical industry can take comfort in the fact that the guidance does not appear to suggest that the industry stop using social media for marketing purposes.
The pharmaceutical industry has been understandably disappointed by the pace of progress relative to guidance on the use of social media. Big Pharma spent $1 billion in online promotions last year and is expected to reach $1.5 billion in spending by 2014; however, we believe this represents a fraction of the spending that might be expected if clearer guidelines were established. Rather than wait for definitive guidance from the FDA that many predict will never come, a host of industry players are making attempts at developing consensus on a way forward. In February 2012, the Digital Health Coalition introduced its Social Media Guiding Principles and Best Practices for Companies and Users, which represents a consensus of the industry’s top digital marketers on issues relating to social media and online communications. Though the document was conceived as an exercise in industry self regulation, the group hopes it will inform FDA thinking on the topic.
Regardless of the ambiguous state of the law, the use of social media continues to grow as a major form of communication between FDA-regulated companies and their customers. Companies must interpret the FDA’s guidance and use it as a means of understanding the FDA’s thinking on the subject of social media. Below is some information on how participants in the industry are using social media despite the lack of guidance, followed by some suggestions for implementing an effective social media strategy at a pharmaceutical company.
Big Pharma’s use of social media is expanding but companies still need to be cautious. Big Pharma currently utilizes many types of social media platforms to discuss public policy, corporate responsibility and to generally promote their brand and products to the public. For example, companies like Sanofi and Pfizer have used websites and online videos to engage in educational campaigns in connection with the need for various products. It is estimated, however, that the vast majority of companies in the pharmaceutical industry do not participate in social media. For these companies, there may be a larger burden associated with remaining compliant with applicable regulations in the fast-pace world of social media. New tools are developed on a rapid basis, which requires companies to improvise and to consistently review and/or modify their social media strategies. For example, when Facebook Inc. began allowing customers to post messages on companies’ pages, companies such as Johnson & Johnson and AstraZeneca deleted some of their pages and temporarily removed others due to the uncertainty created by the situation.
Social Media Practices and Policies: Some Suggestions
Being part of a heavily regulated and competitive industry can result in a cultural environment that does not easily lend itself to safely making the kind of instant unfiltered communications often seen in social media channels. To combat the associated risks, companies today must work closely with both their legal and marketing teams to maintain an up-to-date social media policy and to ensure its compliance with its terms.
As FDA-regulated companies continue to expand their use of social media, the need for diligent monitoring of the company’s and employees’ communications is more important than ever. Large numbers of employees engaging the public (on their own behalf or the company’s) amplifies the potential for violating applicable laws or a company’s internal policies. It has been predicted that in 2013 and beyond, all industries are likely to encounter a new generation of privacy, employment, defamation and other legal claims arising out of these social media platforms. Proper and consistent training will allow employees to safely use social media while still growing a customer base and business.
Below are some basic tips to help a company maintain a healthy social media existence in the pharmaceutical industry.
- Maintain a Written Social Media Policy
- Basic Terms. The purpose of the social media policy is to guide the company and employees’ use of social media. A well-drafted social media policy will discuss the basic guidelines regarding permissible and prohibited conduct, best practices and the level of privacy employees should expect when using either company or personal equipment.
- A Social Media Policy Should Establish Processes and Procedures. A social media policy should include processes and procedures to ensure that social media communications are properly vetted by the appropriate departments. Having a clear workflow will allow the company to properly create, monitor and censor communications before they are sent, including posting any disclaimers or declaring the company’s sponsorship of a website or product. This “workflow” also will help to prevent communications that are distributed through an incorrect medium. For example, while promoting a drug through a social media site, companies should ensure that promotion is restricted to the physicians who have agreed to receive promotional content and does not reach the public.
- A Social Media Policy Should be Transparent.
- Employees. Employees should be aware that all communications on company-owned equipment can be subject to review by the company. The company’s social media policy (in conjunction with other policies) should establish realistic privacy expectations for employees, referencing the fact that each employee’s right to free speech is not unlimited, and that they are prohibited from disclosing the company’s confidential or proprietary information and they are prohibited from disclosing off-label information to the public at large. If your company monitors its websites and social media accounts (Facebook, blogs, etc.) for unapproved, harmful, deceptive or illegal comments, have disciplinary actions in place and be diligent to enforce them.
- Customers and Business Partners. Every comment or response to the company’s communications may affect its reputation or relationships with other parties, not to mention violate applicable regulations (think: doctors posting recommendations on how to use products to the public). Although the current thought is that companies are not responsible for the comments of others, this issue can be further mitigated by making it known to the public what types of communications will not be tolerated.
- Every Employee Should Sign an Acknowledgement. Each employee should sign an acknowledgment stating he or she has read the company’s social media policy and agrees to abide by its terms and conditions.
- Train All Employees
- Training is Crucial. Companies can substantially mitigate their exposure by training all employees about its current policies and the “dos and don’ts” related to social media. According to a recent study, almost 15 percent of employees have made a status update or tweeted about their work; 31 percent of employers surveyed reported having taken disciplinary action against employees for the information they communicated about the company.
- Employees are Responsible for Their Own Messages. Well trained employees should understand who is responsible for creating, editing and reviewing communications before they are published to one of the company’s social media accounts. Employees should be on notice that any comments related to the company or its products must be accompanied by a statement verifying they are an employee of the company, along with an appropriate disclaimer.
- Keep Organized
- Given the regulatory controls placed on companies in the pharmaceutical industry, the threat of an audit by the FDA or another governmental agency is real. Companies should prepare for this reality by using technology that automatically archives all communications in a way that makes them easily accessible in the event of an audit.
- Other Important Tips
- Security measures always should be taken to protect confidential information.
- If social media communications include a disclaimer, remember that per FDA guidance, the public should be able to access all related information easily with only “one click.”
We expect the FDA to provide additional guidance in the future related to social media. In the meantime, FDA-regulated companies should be careful with their approach and apply existing laws to social media communications just as one would to other forms of media governing the industry. Above all, remember that social media can be an incredible asset to a company’s objectives when used responsibly.
 Note that while the FDA has not provided guidance related to social media, other government agencies such as the U.S. Federal Trade Commission, the National Labor Relations Board and the Securities and Exchange Commission have provided guidance that may be applicable to a company’s social media communications. [back]
 For example, “the views expressed herein are mine alone and do not necessarily reflect the views of [my company].” [back]
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