What Is the Lehman Formula?

The Lehman Formula, also known as the Lehman Scale, is a traditional compensation structure historically used by investment bankers and mergers & acquisitions (M&A) advisors. The formula helps these professionals determine their commission or success fees when facilitating business transactions, especially when sellers and buyers negotiate the purchase price.

What Is the Lehman Scale?

The Lehman Scale was developed by the Lehman Brothers investment banking firm in the 1960s and has become an essential tool in M&A transactions, providing clarity in deal structure and business valuation. This methodological approach offers a fresh perspective on M&A advisory fees. Rather than sticking to a straight flat fee, the Lehman Scale created a tiered fee structure. This system is designed to mirror the complexities, future performance targets, and milestones characteristic of larger deals.

As the purchase price rises, the effort put forth by the broker might not increase proportionally. This is especially true when considering elements like earnout provisions, the performance of the business post-acquisition, and the potential for revenue growth. To ensure fair compensation, the Lehman Scale divides commission percentage fees based on purchase price thresholds, effectively navigating the intricate landscape of financial performance, cash flow considerations, and the valuation gap that might arise.

Additionally, this method can be instrumental for determining earnout payments and the terms around the earnout period or when the retention of key employees becomes a pivotal part of the purchase agreement. An earnout period is designed to alleviate disparities in valuation perceptions between the buyer and the seller. It is a structured payment plan where a business owner can earn additional compensation based on the future performance of the business they've sold.

The stipulated earnout period in an agreement defines the timeline which these performance targets should be met. This method not only bridges valuation gaps, but also synergizes with the Lehman Scale to ensure that advisory fees mirror a deal’s intricacies and potential challenges.

Who Uses the Lehman Scale?

The Lehman Scale is by used business brokers, M&A advisors, and investment bankers when discussing compensation methods with business owners considering the sale of their businesses. The Lehman Method is tried and tested, let's explore how M&A advisors and business brokers employ this tiered commission structure and the reasons behind its usage.

M&A Advisors

M&A advisors are at the forefront of some of the most significant business deals. They are involved in the intricate processes of merging two companies or overseeing the purchase of one company by another. Given the complexities and vast sums of money at play, their compensation needs to be proportionate to their work. The Lehman Scale, with its tiered approach, ensures that M&A advisors are compensated fairly, especially when the deal involves complex valuation metrics, due diligence, and future performance considerations.

Business Brokers

Business brokers typically operate in the small to middle market segment. These transactions require a keen understanding and hands-on involvement with local markets and industries. The Lehman Scale offers a balanced commission structure, rewarding brokers for the initial efforts and the challenges they overcome in closing a deal.

The Double Lehman Scale

The Double Lehman Scale is an evolution of the traditional Lehman Formula, adjusting for scenarios where brokers or advisors believe the transaction demands a higher compensation rate. Essentially, the Double Lehman doubles the percentage values of the original Lehman Scale. This might seem aggressive initially, but it's often applied in contexts where the complexity, intricacy, or sheer effort required for a particular transaction justifies such an increase.

Every deal has its challenges, nuances, and potential pitfalls. The Double Lehman comes into play when these challenges are especially pronounced. For instance, a deal might involve a business with considerable growth potential, but significant upfront issues in integration or a startup with promising tech, but complex earnout clauses. In these scenarios, the risk and effort required by the intermediary is higher. By employing the Double Lehman Scale, intermediaries ensure they are aptly compensated for their pivotal role in such laborious transactions.

The Formula

The beauty of the Lehman Scale lies in its tiered structure which considers the scope of the transaction's scale and the broker's or advisor's role in facilitating it. Here's a closer look at the formula and its breakdown:

Standard Lehman Formula

• First million: 5% of the first million of the sale price
• Second million: 4% of the second million
• Third million: 3% of the third million
• Fourth million: 2% of the fourth million
• Beyond fourth million: 1% of everything thereafter
• First million: 10% of the first million
• Second million: 8% of the second million
• Third million: 6% of the third million
• Fourth million: 4% of the fourth million
• Beyond fourth million: 2% of everything thereafter

This structure ensures that the advisor or broker is incentivized from the outset, receiving a higher percentage as a starting point which typically requires foundational groundwork. As the transaction value increases, the percentage decreases due to the overall higher commission amount received from larger transactions.

Double Lehman Formula

As the name suggests, the Double Lehman doubles the percentages of the standard formula. Therefore:

The Double Lehman comes into play for deals that require additional expertise, involvement, or risk. It has a higher commission structure to justify the increased challenges and intricacies of such transactions.

Both formula versions are a transparent and methodical approach to calculating commissions, ensuring that compensation aligns with the transaction size and complexity.

Negotiating Terms

The Lehman Scale, though structured, isn't set in stone. Knowledgeable sellers, adept with financial metrics like EBITDA, depreciation, and amortization, and understanding the intricacies of financial statements, can negotiate the terms. Armed with insights from due diligence, both parties can ensure that the earnout agreement, post-acquisition synergies, and even potential earnout disputes are addressed. The Lehman Scale guarantees transparency, positioning businesses for successful transaction outcomes.

Visit BizQuest’s Broker Directory to find an advisor to help you navigate the intricate process of valuing and selling your business.