Personal Finance: The Low Down
Why Your Investment Banker Isn't Really On Your Side
They Have the Wrong Incentives and Motivation
When you’re going through the process of selling your business, one of the first steps you’ll make is to hire an investment banker. These are the guys and gals who are hyper-educated at the best schools, they look good in suits, and they know every in and out of the sales and acquisition process. You definitely want one of the best on your team.
But there’s a catch. While you might get them on your team, they’ll never really be on your side. It all comes down to a problem with incentives and motivations. Let me explain.
The truth is that investment bankers operate in a similar way to real estate agents-the people who help you sell your house. Both real estate agents and bankers earn a commission based on the sale of your home or business. They’ll both tell you that everyone’s incentives are aligned because the more money you get as a seller, they more money they’ll make on their commission-which averages about 1-2% for an investment banker and about 6% for an agent. While this supposed alignment makes sense at first, it’s not actually true. The disconnect is that unless the banker or agent make a sale, they don’t get paid at all. (Technically, an investment banker might collect a small fee.) That means their actual incentive is to close a deal at any price -maybe by lowering the price or asking you to make changes to your business in a way that’s not necessarily best for you.
Consider how the authors of the book Freakanomics studied the behavior of real estate agents in the Chicago area. What they found was that when real estate agents sold their own homes, they got a much higher selling price that other similar homes sold in those same neighborhoods that they represented. In other words, when the agent was going to benefit by receiving 100% of the proceeds of the sale, they worked harder or waited longer to get a higher price than when they represented a client. When they got a lesser cut, they were much more willing to encourage their clients to drop the asking price so they could log the sale and take a commission. The same dynamic applies to selling businesses.
If you’re looking to sell your business, especially these days, you will need to consider selling to a financial buyer like a private equity (PE) company. There are a ton of PE companies out there with a lot of money desperate to buy good companies. And, because of that, your investment banker will likely bring some of them to the table. But here is the issue: you probably will only sell a business once in your lifetime. But an investment banker will likely make dozens or hundreds of deals across his or her career-which means they have more motivation to please potential buyers than to please you. They need to keep the PE companies happy so they can do another deal with them in the future-while you’re just a one-and-done. The point is that your investment banker might not be as aligned with your interests as they say they are because they have much more motivation to keep a long-term healthy relationship with the PE firm than they do with you.
So, while anyone selling a business needs a good investment banker on their team, it’s critical to keep your own counsel-especially if this is the one and only time you’ll sell your business. Just remember that their incentives and motivations are not as fully aligned with yours as they might admit.