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Chapter 3 of 3 · 9 min

How advisors are paid

Success fees, incentive fees, retainers and fairness opinions, and the effective rate they add up to.

By the end of this chapter you can
  • Calculate a success fee with an incentive above a hurdle
  • Apply a retainer credit and a fairness opinion fee
  • Work back from the fee to the price achieved
  • Explain how fee structures shape the bank's incentives
1

The intuition

An estate agent usually earns a percentage of the sale price, and only if the house sells. Some sellers add a bonus: a bigger cut of anything above a target price. Now the agent cares about the last few thousand dollars as much as you do.

Sell-side M&A bankers are paid the same way, just on bigger numbers: most of the fee arrives only at closing, as a share of the price.

The key idea

Most of the fee is a success fee: a percentage of enterprise value, paid at closing. An incentive fee on value above a hurdle sharpens the bank's interest in price. The retainer is credited back, and the fairness opinion is a fixed fee.

2

Why it works

  • Base success fee = base rate × enterprise value achieved. The rate falls as deals get bigger, because the work does not grow in proportion to the price.
  • Incentive fee = incentive rate × the value above a hurdle. In these questions the hurdle is set as a share of the price achieved.
  • Retainer. A monthly payment during the process. On a sell-side mandate it is usually credited against the success fee, so the seller does not pay twice.
  • Fairness opinion. A formal letter telling the board the price is fair from a financial point of view. It is a fixed fee, not contingent on closing, so the opinion is independent of the outcome.
  • Effective rate = total fee ÷ enterprise value: the honest way to compare fee structures.
$1,000M sale; 1.0% base; 3% above a $900M hurdle; $1.5M fairness opinion; $1.0M retainer credited
Base fee: 1,000 × 1.0%$10.0M
Incentive: (1,000 − 900) × 3%$3.0M
+ Fairness opinion$1.5M
− Retainer already paid$1.0M
= Due at closing$13.5M
Effective rate: 13.5 ÷ 1,0001.35%
Backwards: (10 + 3 + 3% × 900) ÷ (1.0% + 3%)$1,000M
3

The formulas

Base success fee = base % × enterprise value

The core of the fee, paid at closing.

Incentive fee = incentive % × max(0, enterprise value − hurdle)

An extra cut of the value above the hurdle.

Due at closing = base + incentive + fairness opinion − retainer credited

What the seller writes the check for.

Effective rate = total fee ÷ enterprise value

The whole fee as a share of the price.

Implied EV (above the hurdle) = (success fee + incentive % × hurdle) ÷ (base % + incentive %)

Above the hurdle, every dollar of price earns both rates, so the fee can be turned back into a price.

4

Worked example

The whole engagement letter. Base fee, incentive on the slice above the hurdle, then the opinion and the retainer credit.

Drawing the numbers…
5

See it move

Same sale. Change the price achieved and each term in the engagement letter.

Drawing the numbers…
Try this
  • Raise the incentive rate. Only the incentive bar grows; the base fee does not move.
  • Raise the hurdle. Less of the price sits above it, so the incentive fee shrinks.
  • Raise the retainer. The amount due at closing falls by the same amount, but the total paid over the whole process does not change, because it is credited.
  • Raise the price achieved. The base fee and the incentive fee both grow with it.
6

Run it backwards

Same engagement letter, reversed: you know the success fee. What price did the bank achieve?

Drawing the numbers…

Above the hurdle, the fee is base % × price plus incentive % × (price − hurdle). Collect the terms: fee = (base % + incentive %) × price − incentive % × hurdle. Add incentive % × hurdle to the fee and divide by the combined rate.

Check the premise first: the fee must be more than the base fee at the hurdle. If it is not, the price never cleared the hurdle and only the base rate applies.

7

Traps

Charging the incentive rate on the whole price.
It applies only to the value above the hurdle.
Forgetting to credit the retainer.
On a sell-side mandate the retainer usually comes off the success fee. Otherwise the seller pays for the same work twice.
Making the fairness opinion contingent on closing.
It is a fixed fee. An opinion that paid more if the deal closed would not look independent.
Comparing banks on the headline base rate.
Compare the effective rate: total fee over the price, including incentives, opinions and credits.
Assuming a success fee makes the bank care only about price.
A flat percentage rewards closing almost as much as price: an extra $1M of price moves a 1% fee by only $10,000. The incentive fee is what sharpens the interest in the last dollar.
8

Say it in the interview

The interviewer asks

“How are sell-side M&A advisors paid, and how does the structure affect their incentives?”

Say yours out loud first, then compare.
9

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4
Drawing your questions…
Remember
  • Success fee = base % × enterprise value, paid at closing.
  • Incentive fee only on value above the hurdle.
  • Retainer credited; fairness opinion fixed.
  • Compare structures on the effective rate.