Investment bankers are not bankers. Nor do they invest. The name is an historical misnomer. If banking were described as the business that banks typically do – receive deposits of public money – it is something that investment bankers are forbidden to do. What investment bankers do is (a) use their own limited capital, plus such borrowing power as that capital will support, to buy such portion of a long term security issue as they can afford, and (b) endeavour to resell it to investors as quickly as possible. They cannot themselves be investors, or their limited capital would be locked up and they would go out of business. Nevertheless, investment bankers are an important source of venture capital, through their contacts with institutional venture funds or sophisticated individual investors who understand and can bear the economic risks of startup capital investments. Investment bankers may also serve as advisors in the structuring of the financing even if not involved in raising the venture capital.
Essentially, an investment banking firm is a combination of men of two different kinds –men with capital and men with a great deal of initiative and enterprise. Their primary business is to suggest to a startup a form of publicly issued security by which it can raise capital better than through a sale to institutional investors or to its own shareholders. Because the startup wishes to be assured of the money, the investment banker's suggestion must carry with it an undertaking (a) to use his own capital to underwrite a portion of the issue and (b) to find among other investment bankers additional so-called participants in the underwriting in sufficient number to purchase in the aggregate the whole issue.
Many investment bankers are not willing to undertake a small private financing through individual investors because of the high due diligence responsibilities and corresponding securities law liabilities. Unless the financing involves several million dollars, there may not be sufficient sales commissions and other fees to justify the due diligence responsibilities and securities law liabilities of the investment banker. For this reason, many investment bankers will only solicit financing from professional venture capital funds who usually perform their own due diligence, relieving the investment banker of such responsibility and corresponding liability. If a startup appears to have such growth potential as to require additional private and/or public financing within a relatively short period of time, an investment bankers may be willing to raise the initial capital so as to position itself to handle the later stage financing, including the initial public offering which is more lucrative in commissions, underwriter's warrants and consulting fees.
Investment bankers typically charge three types of fees: (1) Cash Retainer Fee – many investment bankers charge an initial cash retainer fee payable either as a lump sum upon execution of the engagement letter, or over a period of months. The amount of the fee varies with the investment banker, the complexity and difficulty of the assignment and other factors; (2) Success Fee – this cash fee is payable upon closing of the financing for which the investment bankers were retained. It is typically a percentage of the amount of financing raised and varies whether the financing is equity, subordinated debt or senior debt; (3) Warrants – often investment bankers request warrants to purchase common shares, usually at an exercise price equal to the same price the outside investors are paying in the subject financing, in the range of 5% to 10% of the amount of securities being offered.