Success/No success – some thoughts on the controversial nature of the success fee

Success/No success – some thoughts on the controversial nature of the success fee

“The best revenge is massive success” – said Frank Sinatra, which – most probably does not require any further explanation. Success is an essential part of the business life, otherwise it might not be rational to maintain the activity and operation. We all know that success does not just happen, but hard and focused work might be a condition precedent.

Nature of success. Almost everyone can recall famous stories of outstanding success where the beginning was hard and characterised by lack of support and belief from the external environment. It happens in large and small, simply because people, including business people, have different perceptions about the world. This is the way it is.

What seems to be sure, is that once you enter into a project or process to achieve a particular outcome, you know in advance, even if not to the finest details, what would be considered as success. For example, you might want to enter into a new market and have your first customer there. In such a case, signing your first contract is a success. If you go further, you can define a certain market share to reach in a new market, and – of course – meeting that target share will be considered as success. If you decide to expand via investing, and you are about to buy some shareholding that may contribute to your business strategy, finding the right one with a reasonable price tag is truly success. Such as once you decide to sell off and retire after several decades of hard work, finding a new investor who is to pay an amount as per your expectations, reflecting the business value of your participation, is a considerable success.

Success might not be achieved alone or with an isolated group of people and some external expertise might also be necessary to get through. Let us assume that this constitutes advisory work, the purpose of which is to add some expertise, or extend capacities beyond the internally available ones. Advisers are to work with you and share the hard days such as the good ones. As the results of the joint forces, you can finally achieve the so desired outcome.

Nature of the success fee. When contribution is shared, it is almost natural that the achievements are shared, as well. Success fee, associated with a particular outcome, in such cases is an accepted and widespread means of sharing the upside of the project, regardless of its actual form. For simplicity and analytical purposes, use the term for all kinds of fee arrangements with the purpose of sharing the proceeds of a positive outcome.

Important to note, that there are circumstances that may have an effect on the outcome of a project and are deemed to be out of the competence of either parties (meaning the customer and adviser). These are usually characterised as force majeure, and the risk of it is usually shared in a way, that both parties bear on their own behalf, respectively. Consequently, all other actions shall be governed by the engagement letter (or contract, if you prefer) in a way to enable the achievement of the defined outcome and penalise divergent actions or negligence.

In summary, success fee, by definition, is expected to be associated with a defined possible – but risky – outcome, may be proportional to the level of achievements, with the purpose of sharing the upsides of the project in question. Provided that risk perception is different, success fee arrangements might appear in engagements also differently. So far, so good. Why do we enter into discussion about this topic then?

Lack or different rationale? In order to make it clear why we expose this issue, let us take an example, again. You most probably have an accountant, who provides you book-keeping services and the preparation of the annual financial report. Even if you have a relatively complex activity or operation, you most probably do not approach it with a success fee based engagement proposal. (You might not even be listened to…)

It may happen that your accountant provides tax advisory services, as well, and you approach it with a complex question, the outcome of which is not so straightforward. If the structuring of your activities is crucial, the tax authority has discretion and the tax consequences are severe, a success fee might be a reasonable idea attached to the most favourable outcome – from your perspective. The tax adviser would have a motivation to invest the best of its knowledge to find out the proper details of your activity from tax point of view, such as into convincing the tax authority. As an outcome, you can achieve the lowest possible tax liability in parallel to a legally sound operation.

Besides the relatively clear situations, we are regularly approached by rather strange ideas, almost all with reference to some success fee (meaning only success fee) arrangement. Strange in the sense, that there is no clear idea about an envisaged outcome, and thus, no commitment to achieve that particular, favourable outcome.

As an example, the last few clients came with the idea to either find them a new customer (without any geographical or other specifications), or an investor to whom they might sell their company. When raising the respective questions such as what the priority would be and what the price/turnover/margin expectations are, not to mention what to be considered as ‘success’, we receive no meaningful answer…

To explain a bit further, it is not the polemy itself (developing further or divest) what makes the situation controversial, but when and how it is raised. They may not even realise how detrimental such an appointment – if taken by any adviser at all – would be, for exactly them. How? Why?

Different kind of rationale. Business people are mostly rational, meaning they would like to achieve the most for the same cost or achieve a particular outcome at the lowest cost. It does not need any further explanation. One thing is usually forgotten though: the advisers and consultants are also business people. They have their own rationale, which does not necessarily matches the clients’ one. It does not mean that they would work against their clients, but does mean that clients may be surprised if not raising their issues at the right time and in the right manner. In a “positive” case, clients might not be in the situation to compare the outcome of their actual case to an optimal one. In a “negative” one, they will once realise that what they achieved, received was something else than they really meant…. Not to mention the following generalisations, in a negative context, about the whole adviser and consultant community…

Coming back to the original point, the different kind of rationale, in the context of success fee based engagements, see those items where we see the most important arguments.

Valuation. Valuation of not only the company (the client or the subject matter), but also the situation (circumstances), where the expand-or-exit strategic question is raised.

Not surprisingly, in the majority of the cases, clients do not have a proper value in mind. Obviously, they either under- or overvalue their company (their participation), not just because business valuation is considered not to be a so-called ‘exact science’, but also because of the human nature and all its biases. In a case, where the value of the company in the client’s mind is lower than a reasonable one, any solution, which seems a bit better, would receive appreciation. If we put it into the context of the success-fee based engagement, easy to see, that sub-optimal solutions may trigger the success fee. The client does not have a proper knowledge, the adviser is optimising its efforts according to the fee structure and the scope of work. If you approach this from a distance, you can see, that the adviser would go for the low-hanging fruit, as per its rationale….

From your perspective, you catch another client, to survive, though an earlier divestment and the yields of investing the (probably lower-than-expected) income would be a better overall solution. In a different case, to meet a prospective investor, who is talking about nice figures for the first glance, might be delighting, although a well-targeted sales development and then a partial divestment would be the ultimate solution for your case… Is it what you really want or need?

When clients significantly overvalue their actual assets, which is the majority of the cases, the situation is slightly different. The outcome – accepting sub-optimal solutions – is more or less the same, although the way to get there is significantly different. An unrealistically high value association usually leads to systematic refusal of investor proposals, simply because of the price tag. In a success fee context, it means that costs and expenses on the adviser’s side can easily jump to a height where the engagement does no longer make sense. The adviser most probably will cut its resources and switch to an “if-something-pops-up” mode, meaning no active connection-building or preparation to deliver.

If you can recall, what the purpose of a success fee arrangement is, you can see, that in situations like the above, it can be controversial. In turn, it is detrimental to you, as delays, if not eliminates possibilities of yours, giving wrong impression both on the investor/customer availability and the advisers’ community. Investors may find other targets and some other product may meet the existing demand.

Order of events. There is, of course, an adequate order of events to avoid the aforementioned traps. You also have to be honest with yourself, even though that seems to be the hardest part. “Honestly is the first chapter in the book of wisdom”, as Thomas Jefferson said.

First, you must have a sharply realistic picture about your position, meaning the market environment, and the intrinsic value of your assets, as a minimum. In minority of the cases, clients have internal resources to provide such studies, and what an adviser can contribute is the second opinion on the conclusions. Vast majority of the clients need external help, because it is not rational for them to maintain such costly intelligence internally. They had better have it in front of them when thinking about which way to go with their investments.

Having a good picture on your own potential is a good start. Good in this sense of being realistic. You can adjust your strategy and concentrate your efforts on those directions where you see the most value to add.

Important to emphasise, that asking for customer or investor origination in an earlier phase, using it as a kind of value discovery project, almost never works, because of the aforementioned reasons. If does, that is rather the question of extreme luck than professionalism.

Risk distribution. Real life seems to be very far from the ideal world, where market participants are all perfectly informed and rational, so following their own interests leads to the desired outcome, which is, of course, the best.

The world, and as a part of it, markets, are full of ambiguities, and market participants are also working with the human factor. The longer the project in questions, the higher and extensive the associated risks are. Continuous adaption and adjustments are needed to achieve the desired outcome. What shall be unchanged is the determination to achieve it and the best endeavours to do it.

Force majeure is a different cup of tea. It is, by nature, something that parties have to live with, as the part of the game, as we discussed earlier in this article.

Risk of non-performance or misconduct on the advisors’ side can be handled in the engagement, as was also mentioned before. However, risk of change in mind and irrational or unfair behaviour on the client side is a bit more difficult.

We will come back to this point a bit later. It is sufficient at this point to be aware of the risks and have the means of handling them, such as to be aware of the costs of it.

Concentrating efforts. If you took the advice and for now, you have a realistic picture on your assets such as your circumstances, you are in the position to conclude on your own intentions. This is what nobody else can provide you with. You are either enthusiastic about developing further and enter into a business development project, or ready to move on and cash out of your current investment. You can do it yourself, or you can ask for some expertise, likewise. This way or that way, you will have (you need to have) a clear idea on the future directions.

This is the point in time, where asking for advisory proposals makes perfect sense. You have the direction, a more-or less clear timetable, and you are determined to get the best out of it. The adviser, who will finally be engaged, can provide you with proposals how to make your case shiny and attractive, and – which is also important – when to proceed with it and how.

In the success fee context, it is a situation, where a success fee arrangement makes the best sense. All the major conditions are met: goals are set, determination is there, and the market environment is known, to perform best endeavours on both sides.

Misuse or misunderstanding? You see now an “ideal” case, which is ideal from both the client’s and adviser’s perspective.

Nevertheless, as the world is not perfect, as was stated before,  knowledge base is limited, human intentions can be changing and can be highly irrational (at least from economic point of view).  Visions might not be in line with the availability of financial resources, such as changes in the market environment might be in contradiction with the original visions.

Adaption and adjustments to the original strategy need time. Depending on the human factor and the resource availability, less or more.

Our impression is that the roots of the unreasonable success fee based engagement proposals can be found there. The client feels the need to do something, but does not know what, and have not enough resources. Thinks he/she can save on the financial resources and shift the risk of not just the activities and operation, but also the personal intentions to the adviser. Looks good on paper. But only on paper…

Do you really believe that someone is ready to take your full risk, including your wilful actions, for an unknown amount of success fee, paid out in an unknown point in time with an unknown possibility? These are quite many variables to make even the consideration of such an engagement questionable.

Of course, in our imperfect world, we, advisers learn quickly that there is always someone who is cheaper than us, and desperate enough to enter into situations which are controversial. Pricing arrangements are – at least – as much based on tactical considerations as on the characteristics of the project. These advisers then either fail to deliver, provide sub-optimal solutions, or generate an economically unreasonable engagement for themselves. All, at the end of the day, distorting the general reputation of the adviser community and leaving unhappy clients behind …

Do you really want to work with an adviser who is irrational with its own business? Would you trust its professionalism? If you answered ‘yes’ at least one of these questions, this article is not for you.

As a summary, putting all the above into the context of success fee based engagements, our conclusions are the followings:

  1. Certain things cost money, regardless of their outcome. In our examples, accounting is one of them, and business valuation of your company (assets) may be another one. You have the highest probability of receiving a reliable one, if you do not try to influence the adviser in ways to trigger its own rationale (being different from yours).
  1. Risks of your wilful actions and intentions, being rational or emotional, are not considered to be such to be anticipated by the adviser. Taking a chance to force it to do so may easily result in a behaviour to minimise that risk, in its own competence. One of these may be to avoid investing sufficient resources into delivery. Risks result in costs, and nobody is about to take the costs without participating in the benefits.
  1. Decision is yours. Do not forget. The investment is yours, the risks are yours and the benefits, also. You can, of course, share a part of them. Only share. And to share risks and the associated costs only when you are ready to share the benefits. Do it in a reasonable and rational way. It is your success (or failure) at the end of the day. Embrace it. There is no free lunch.

If you feel that you do not want or cannot afford to spend on something now, you will, anyway, pay for it later, although in different forms. Missed opportunities, bad timing can hurt.

If you are an entrepreneur, always remember, why you have started. If you do not believe in your own story, nobody else will. 

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