The Lehman Formula: A Structured Approach to M&A and Capital Raising Fees

Core Description

• The Lehman Formula uses a tiered structure with descending percentages applied to defined portions of transaction value. It is a benchmark globally for M&A and capital raising advisory fees.
• Clear definition of the fee base, understanding of common modifications, and matching the fee model with the characteristics of a transaction are vital for transparent and fair compensation.
• Awareness of different variants, best documentation practices, and common pitfalls helps ensure the Lehman Formula is applied and negotiated properly in engagement agreements.

Definition and Background

The Lehman Formula is a recognized compensation structure introduced by Lehman Brothers in the 1960s. It was originally designed to standardize success fees for intermediaries in mergers and acquisitions (M&A) and capital raising. Its main feature is a tiered, marginal commission schedule—most commonly the 5-4-3-2-1 percent structure—granting the adviser a higher percentage on the initial value of a transaction, with lower percentages applied as the transaction size increases. This tiered approach was designed to align the incentives of the adviser with the client and give both parties clarity on expected fees.

Over time, as markets evolved and deals became larger and more complex, the original formula was adapted in its application and structure. The Lehman Formula is now used by investment banks, business brokers, placement agents, private equity sponsors, corporate development teams, and venture capital fundraisers, especially in the middle market. Although the application can vary by sector, geography, and the specific nature of the transaction, one principle remains: compensation is only owed on a closed transaction and is based on specified bands of transaction value.

The continued use of the Lehman Formula is due to its transparency, scalability, and adaptability. It remains prevalent in both US and European markets, with many variants and adjustments tailored to specific transaction needs and ongoing industry developments.

Calculation Methods and Applications

Classic Lehman Scale

The original Lehman Formula calculates success fees according to a marginal, tiered approach as shown below:

Each percentage applies only to the part of the transaction value within that tier—not to the total amount.

Example Calculation (Hypothetical, for illustration)

Assume an advisor completes the sale of a business for $120,000,000 using the classic Lehman Formula:

• First $1,000,000 at 5% = $50,000
• Second $1,000,000 at 4% = $40,000
• Third $1,000,000 at 3% = $30,000
• Fourth $1,000,000 at 2% = $20,000
• Remaining $116,000,000 at 1% = $1,160,000

Total Fee: $1,300,000

Common Variants

• Double Lehman: Doubling each rate (10-8-6-4-2%) for smaller or higher-risk deals.
• Modern Lehman: Modified steps (for example, 4-3-2-1-1%) to better fit current deal sizes.
• Reverse Lehman: Less common; applies higher percentages to larger value tranches.
• Hard Caps or Minimums: Specific fee floors and ceilings to manage risk and avoid excessive or insufficient compensation.

Transaction Base Definitions

The amount on which fees are calculated—the “transaction value”—must be defined in the engagement letter. This may include:

• Enterprise value: Equity value plus assumed debt, minus cash (common in M&A).
• Equity value: Cash proceeds to shareholders.
• Gross proceeds: All cash, stock, notes, or any other consideration received.

Items like working capital adjustments, earn-outs, assumed liabilities, and considerations paid in stock or warrants should be addressed clearly in contracts to avoid misunderstandings.

Usage by Different Intermediaries

• Investment Banks: Use classic or modified scales, sometimes with caps for larger deals.
• Business Brokers: Adopt simplified Lehman schedules for middle market or owner-led exits.
• Placement Agents: Fee based on gross proceeds in private placements—tier structure varies by deal.
• Private Equity: Compare adviser fee proposals using Lehman variants to match incentives.

Comparison, Advantages, and Common Misconceptions

Advantages

• Transparency: Easy to communicate and benchmark across transactions.
• Alignment: Structure connects adviser compensation to client’s outcomes.
• Marketability: Familiarity helps make negotiation more straightforward.

Limitations

• Large-Deal Overcompensation: Significant fees can arise on large transactions without caps.
• Complexity Mismatch: May not reflect the actual work in certain asset-light or non-cash deals.
• Potential for Incentive Skew: Flat or success-only fees may incentivize faster closing over value optimization.

Common Misconceptions

Misapplying Marginal as Flat Rate

It is incorrect to apply the highest reached tier’s rate to the full deal value. Each rate applies only to its respective tier.

Confusing Equity and Enterprise Value

Disputes may occur when transaction value is not precisely defined, especially regarding cash, debt, and non-cash terms.

Assuming Global Uniformity

There is no universal standard. Markets such as US, UK, and Europe differ in tier preferences and also use custom or reverse formulas.

Using Equity Tiers for Debt Placements

The Lehman Formula is designed for equity transactions; using it for debt may misalign incentives and pricing.

Ignoring Retainers and Expenses

Not accounting for retainers, minimums, and expenses can lead to unforeseen costs if not clearly documented.

Practical Guide

This part provides actionable guidance for structuring and negotiating Lehman Formula-based agreements, supported by a hypothetical scenario.

Structuring the Engagement

1. Define “Transaction Value” Clearly

State whether the base is equity or enterprise value, and specify the treatment of earn-outs, escrows, reimbursements, and assumed liabilities.

2. Select an Appropriate Tier Structure

Choose tiers matching deal size and current market standards. For example, use classic 5-4-3-2-1 tiers for a $60,000,000 technology business, or Double Lehman up to a threshold on a $300,000,000 PE divestiture.

3. Integrate Retainers, Minimums, and Expenses

Negotiate a retainer, determine the minimum fee, and set processes for expense submission and approval.

4. Consider Caps or Kicker Provisions

Apply caps for very large transactions or introduce bonus fee steps for outcomes exceeding targets.

5. Multi-Advisor or Syndication Arrangements

Set out adviser roles and fee splits to avoid double payments if more than one party is engaged.

6. Post-Engagement (Tail) Provisions

Include tail clauses, usually 12–24 months, to cover fees where a transaction closes with an introduced party after engagement concludes.

7. Address Tax, Currency, and Cross-Border Elements

Document tax status, governing law, payment currency, any VAT, and details for cross-border mandates.

Case Study: Marginal Tier Application

Hypothetical scenario; this is not investment advice.

A US investment bank is hired by a software business with an expected transaction value of $150,000,000. The engagement letter states the base is “enterprise value, cash-free, debt-free, normalized for working capital, including all contingent consideration.” The parties agree to a classic 5-4-3-2-1 scale, a $150,000 retainer, $500,000 minimum fee, capped expenses, and a 24-month tail.

On closing at $150,000,000 (all cash):

• First $1,000,000 at 5% = $50,000
• Second $1,000,000 at 4% = $40,000
• Third $1,000,000 at 3% = $30,000
• Fourth $1,000,000 at 2% = $20,000
• Remaining $146,000,000 at 1% = $1,460,000

Total fee: $1,600,000 (retainer credited). Expenses are reimbursed under the established cap.

Thorough documentation and clear structure reduce the risk of disputes concerning seller notes or other special components.

Resources for Learning and Improvement

• Books

  • “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions” by Joshua Rosenbaum and Joshua Pearl – Detailed overview of engagement structures and fee models.
  • “Mergers, Acquisitions, and Other Restructuring Activities” by Donald DePamphilis – Discusses fee structures, market practices, and regulatory context.

• Industry Reports and Benchmarking

  • Refinitiv, Dealogic, and Mergermarket publications—Periodic analyses of M&A advisory fee norms by geography and sector.
  • ACG Intergrowth and Preqin surveys—Practitioner commentary on compensation models.

• Legal & Regulatory References

  • FINRA materials on fee disclosure and conflict management.
  • SEC and FCA advisories on registration and permitted compensation approaches.

• Templates and Tools

  • ACG toolkits, ABA model letters, and online calculators for Lehman scenarios.
  • Law-firm sample letters supporting exclusivity, tail, minimums/caps, and expense mechanisms.

• Professional Associations

  • Association for Corporate Growth (ACG)
  • CFA Institute courses on transactional compliance

• Academic Cases

  • Harvard Business School, INSEAD, and London Business School collections with transactional fee examples.

FAQs

What is the Lehman Formula in investment banking?

The Lehman Formula is a tiered fee schedule for calculating success fees in M&A and capital-raising transactions. Typically, it applies 5-4-3-2-1 percent rates to successive million-dollar tranches of the deal value.

Why do fee percentages decline in higher tiers?

This reflects economies of scale and attempts to maintain commercial reasonableness for large transactions.

How should the Lehman Formula be applied?

Apply the percentage for each tier only to the respective tranche of the transaction value, and sum the results to get the total fee.

Can the Lehman Formula be negotiated or capped?

Yes. Customizations including minimums, maximums, retainers, and kicker fees are common in negotiations.

How are fees on earn-outs, escrows, or contingent payments handled?

Fees on contingent compensation typically accrue as earned or paid out, with clear terms specified in the engagement agreement.

Do all advisors use the same Lehman schedule?

No. While the classic scale is widely quoted, Double, Modern, and even reverse models are used, often reflecting local market conventions.

Is the Lehman Formula enforceable internationally?

Enforceability depends on jurisdiction, regulatory licensing, and contract clarity.

Are Lehman-based fees tax-deductible?

Usually, these fees are transaction expenses for the client and recognized as income by the adviser. Tax implications vary and should be reviewed with a professional.

Conclusion

The Lehman Formula remains a widely used and structured method for determining advisory success fees in mergers and acquisitions, capital raising, and private placements. Its tiered, marginal structure provides clear, objective, and adaptable guidelines for both advisers and clients, helping to create efficient and transparent engagements. Successful application depends on precise documentation, thoughtful adjustment to transaction specifics, and ongoing attention to market standards. By understanding the structure, variants, and industry context, both advisers and clients can use the Lehman Formula as a reliable framework to support fair and practical fee arrangements in a diverse range of transactions.