BEWARE OF BROKERS' SYNDROME
In the very first issue of this newsletter we may have coined a phrase, as we described and discussed what we referred to as "brokers' syndrome." In the intervening period, we have come across the problem enough times to feel that the discussion should be repeated.
Most intermediaries, whether brokers or Wall Street investment bankers, operate with a contingency factor as all or a substantial part of their eventual fee. This can, and generally does, lead to what we refer to as brokers' syndrome.
In any transaction originated by an intermediary, there are three parties: the buyer, the seller, and the intermediary. Only two of these, buyer and seller, can be considered as principals to the transaction—by any definition. Broker's syndrome generally operates to the advantage of only the non-principal, the intermediary.
In our conjectural situation, buyer is represented by the intermediary. Assume that the parties are fortunate enough to have been brought together by the now somewhat rare intermediary who is still operating under the traditional Lehman formula. Under this method of calculating success fees, the intermediary receives 5% of the first million dollars of defined transaction price; 4% of the second million; 3% of the third million; 2% of the fourth million; and 1% of the remaining purchase value.
To continue our hypothetical transaction, assume that the purchase price has been established at $10 million, following the issuance of a letter of intent, but prior to negotiation of the definitive contract of purchase. Under traditional Lehman, the broker can anticipate a fee on successful close amounting to $200,000, a considerable amount, and one that represents both the carrot and the stick to intermediaries operating solely on contingent fees.
As often happens during negotiations leading to a definitive contract and close, buyer and seller can reach more than one stick point, which in the present hypothetical situation will be solved only by an increase of the total purchase price. Assume a potential price increase of $500,000, significant to both principals.
Broker's syndrome can occur when the intermediary is involved in negotiations, motivated in most cases solely by the transaction success fee. The price increase of $500,000 represents absolute dollars to both buyer and seller. To the intermediary, it is merely the difference between a success fee of $200,000 and $205,000. Motivation of the intermediary at this point is subject to some degree of questioning. Are his decisions and resulting arguments at the negotiating table entirely based on an analysis of the facts that gave rise to the price adjustment? Is it possible that they could be based on a desire for completion of the transaction, with little or no regard for his buyer client?
This problem can also be encountered when brokers represent sellers. Eliminating those situations where both buyer and seller are large companies, an incident of brokers' syndrome will generally have more invidious results when applied to sellers. This is due to the fact that buyers are generally involved more regularly in transactions than are sellers. Unfortunately, a less sophisticated seller is more inclined to accept counsel from his occasionally ill chosen intermediary.
Reversing the illustration above, and assuming a potential decrease in price, we do not have to reprise the arithmetic calculations. The results, however, can be identical, with the intermediary more concerned with the basic fee than his possible percentage reduction of any hypothetical price decrease.
The solution to this problem is relatively simple, even simplistic, in nature. Many companies have eliminated the problem by utilizing intermediaries strictly to find candidates, and keeping them entirely separate from the negotiating process. In such instances, intermediaries should be kept informed as to the general progress of negotiations, but instructed to maintain a discrete distance from both parties during the process.
The best solution, and one that permits both buyer and seller to utilize the knowledge, experience, and expertise of their respective intermediaries, is to establish a somewhat non-traditional fee arrangement.
One such arrangement could have intermediaries' compensation based on bracketed transaction prices. The broker's fee could be relatively fixed, and based on incremental transaction prices. The broker could be paid one fixed sum for transactions priced from $5 million to $10 million; another from $10 million to $15 million; still another from $15 million to $20 million; and so forth.
If a company works with various brokers on an "ad hoc" basis, receiving occasional solicitations which describe available target candidates or tentative buyers, the problem can be solved by restricting the broker from the negotiating process. Many brokers do not wish to be involved beyond the initial introduction, possibly followed by periodic requests for additional information.
When working with only one or two intermediaries on a regular basis, however, the most effective means of controlling brokers' syndrome is to establish both fees and working agreements with intermediaries, designed to ensure that they are working exclusively for their "defined" clients. A fee as broadly defined in the preceding paragraph will generally accomplish the goal in the area of compensation. A truly exclusive arrangement can be accomplished by an engagement agreement which clearly specifies that the intermediary agrees to work for no more than one client in any specific market area. The relative significance of client to intermediary will generally permit this type of exclusivity to be achieved. Most intermediaries who are interested in working with a particular client will allow a working arrangement that prohibits them from competing one client's interests against those of another.