“FinTech” has redefined the way that the Financial Services sector operates and its importance is ever increasing. New entrants to the market are introducing new, disruptive technologies that have forced traditional financial services firms to rethink how they do business.
To compete, established players are looking at investing in and/or acquiring FinTech businesses. At the same time, private equity and venture capital funds also continue to find FinTech businesses attractive and are investing in them.
The investment in or acquisition of a FinTech business leads to a number of specific issues. Issues that need to be fully understood by a potential investor/purchaser to be able to successfully complete a FinTech M&A transaction. The relative importance of these issues varies dependent on the nature of the investor/purchaser (eg trade v private equity/venture capital).
DLA Piper is one of the leading global law firms advising on all aspects of the FinTech sector. We also act on more global M&A deals than any other law firm and have done so for each of the last nine years. We understand how the sector operates and the key issues that will need to be considered. This paper seeks to list out these key issues at a high level.
Given the pace of change, regulators across the globe are still evolving in their regulation of FinTechs and are seeking to achieve the right balance between protecting consumers and allowing innovation. Understanding the regulatory position of the relevant FinTech business now and in the future is a critical part of any M&A transaction. Whether a FinTech should be regulated in a given jurisdiction is not always a black and white answer.
An investor/purchaser will need to confirm through its diligence whether the relevant FinTech is regulated in all jurisdictions where it needs to be regulated. It will be important to ask the FinTech for copies of any advice that it has previously received in relation to its regulatory status. Where any such advice concludes that the FinTech does not need to be regulated in a given jurisdiction, the investor/purchaser and its advisors will need to assess whether they agree with the analysis or whether they believe that the FinTech should be regulated. The investor/ purchaser will also need to assess:
- whether the FinTech will need to be regulated in the future as it grows;
- whether there are any jurisdictions that the FinTech intends to expand into where it will need to be regulated; and
- whether the FinTech will still be able to operate in the manner that it has historically operated if it becomes regulated.
In most jurisdictions (including the UK) the change of control of a regulated FinTech will require the prior approval of the relevant regulator. Clearly, obtaining such approvals will extend the transaction timetable.
Future intentions for the business and integration
On any investment into a FinTech, the investor’s future intentions for the business and its rationale for undertaking the transaction will drive a number of important issues.
Where they continue to hold equity in the FinTech following a transaction, the founders/management team of the FinTech will clearly want to maximise the future growth of the business in order to maximise their ultimate exit proceeds. However:
- if the investor is an established player, the investment may be defensive and the investor may look for sole use (or limited role out) of the underlying product/service offered by the FinTech. As well as the commercial issues that this will give rise to in negotiations, such “exclusivity” could also lead to competition law concerns;
- the investor may, due its own compliance appetite, look to restrict/prevent the FinTech’s business in certain markets, products or services or to certain customers. This can be an issue for all types of investor but is more likely to be an issue where the investor is an established, regulated player; and
- the investor may want to take an active role in the strategic direction of the FinTech. The investor may be unwilling to act as a “silent partner” and let the founders/management team manage the business as they see fit.
When a FinTech is acquired by an established player, the established player will want to integrate the FinTech into its group to maximise synergies and ensure appropriate oversight of the FinTech’s operations. As a result, there will almost certainly be an increased compliance burden for the FinTech and its management team. However, the established player should be careful that it does not place additional, unnecessary compliance burdens on the FinTech. The established player is acquiring a disruptive player that offers something different to the established player’s existing business and the established player should be conscious of that fact during integration and thereafter.
Where an established financial services player makes an investment in a FinTech, a strategic collaboration agreement or commercial agreement is generally entered into by the established player and the FinTech in relation to the provision of services by the FinTech to the established player.
The terms of such agreements are of paramount importance and will be a key area of negotiation for the parties. Issues that will need to be considered and negotiated are:
- what happens to the acquisition/investment if the collaboration or commercial agreement is terminated? What are the consequences for breach of the agreement?
- whether the established player will benefit from any form of exclusivity (see ‘Future intentions for the business and integration’);
- whether the FinTech will have exclusivity or quasi-exclusivity over supply to the established player;
- whether the established player will have any blocking rights over/impose restrictions on entry into new markets and jurisdictions (again see ‘Future intentions for the business and integration’); and
- the scope of data protection obligations (and remedies for breach) that are imposed on the FinTech in relation to the use and processing of the established player’s data (including customer data). Any data protection breach involving the established player’s data may have significant financial and reputational consequences for the established player. The established player will therefore be focussed on: (i) minimising the risk of a data breach; and (ii) there being appropriate remedies if a breach occurs.
An established player should also ensure that the valuation at which it invests in the FinTech takes into account (and is appropriately discounted for) the increased value of the FinTech as a result of entering into any collaboration or strategic agreement.
Where a PE fund is making an investment in a FinTech, it will be relying on the expertise of the FinTech’s management team to continue to grow the business and to maximise ultimate exit proceeds. Where a FinTech’s founders/sellers are continuing with the FinTech following the investment, the traditional PE incentivisation structure of requiring the founders/sellers to roll over a meaningful proportion of their sale proceeds, issuing “sweet equity” and the natural time horizon of a PE exit makes incentivising founders/sellers relatively straight-forward.
Where an established player/corporate is acquiring a FinTech the incentivisation of founders/sellers is more complex. However, mechanisms that can be used include:
- making part of the consideration payable to the founders/ sellers the subject of an earn-out:
- under the earn-out, part of the consideration will only become payable if certain financial performance metrics (most commonly revenue or profits based) are achieved by the FinTech in a period following completion of the acquisition (known as the “earn-out period” and commonly somewhere between 1 year and 3 years in duration);
- where an earn-out is utilised, the founders/sellers will clearly be incentivised to remain with the FinTech and do what they can to ensure the relevant financial performance metrics are achieved so that the earn-out becomes payable. However, the founders/sellers will be focussed on those earn-out metrics themselves and may not therefore focus on the longer term interests of the FinTech; and
- earn-outs are complicated to negotiate. The founders/ sellers will want some control over the FinTech and its business to enable them to ensure that the metrics are achieved and some protections over the purchaser manipulating the FinTech’s financial performance during the earn-out period so as to ensure that the earn-out metrics are not achieved (eg by, where the earn-out is profit based, allocating additional overheads to the FinTech to depress profits). These protections and restrictions on the purchaser’s operation of the FinTech can lead to delays in integration and achieving synergies;
- allowing the founders/sellers to retain an equity stake in the FinTech following completion:
- to ensure future liquidity for the founders/sellers and certainty for the purchaser that it will ultimately be able to acquire 100% of the FinTech, a put and call mechanism can be included; and
- such a put and call mechanism would give:
a) the purchaser the ability to call the retained equity from the founders/sellers; and
b) the founders/sellers the ability to require the purchaser to acquire their shares,
in both cases, after a certain period has expired following completion of the acquisition and at a purchase price derived from a valuation mechanism that has been agreed by the parties in advance (eg at an agreed multiple of EBITDA at the time the option is exercised). Particular focus will need to be given to the accounting principles and policies that will apply to the valuation mechanism and will be a key area of negotiation; and
- incentivising the founders/sellers through remuneration (which if the purchaser is a listed entity could include share options in the purchaser). Whether this will be an effective form of incentivisation will be dependent on the amount of money taken off the table by the founders/sellers through the original transaction (i.e. if they have taken a significant amount of money off the table continuing remuneration may be insignificant in comparison and therefore not an effective form of incentivisation).
The real value of a FinTech business is generally in its IP. A critical due diligence item for investors/purchasers will be to ensure that the FinTech owns (or has appropriate licences to use) relevant IP. Part of this due diligence will be to ensure that the IP is vested in the FinTech itself and not in the founders or its employees.
The IP due diligence will also extend to investigating the extent of use of open source software. Where open source has been used, investors/purchasers will want to ensure that such usage does not result in the FinTech’s proprietary IP having to be made freely available to others to redistribute, copy or exploit.
Understanding the strength and certainty of the FinTech’s key client/customer relationships and whether the underlying contractual framework is consistent with the claims made by the FinTech is an important diligence point. If key client/customer contractual relationships can be terminated by the counterparty at any time with no or limited consequence (or indeed no formalagreement has been entered into at all) then clearly this will need to be taken into account from a valuation perspective.
An investor/purchaser will want to ensure that there is an appropriate remediation plan in place post-completion to remedy any issues uncovered during due diligence (including any regulatory compliance issues). However, there is a balance to be struck between ensuring that there are steps in place to resolve any such issues versus imposing additional, unnecessary burdens on the FinTech which will inhibit its growth.
Established players are looking to make more and more early stage (eg Series A or Series B) minority investments in FinTechs. When considering such an investment, established players need to be aware that the FinTech will be unlikely to grant them extensive positive control rights or put and call options. At such an early stage in its development, the FinTech will be focussed on ensuring that it has the flexibility to continue to grow its business and develop without significant oversight/restriction.
The established player will also need to assess whether the proposed investment in the FinTech will result in a requirement to consolidate the results of the FinTech in the established player’s group financial statements. Whether consolidation is required should be assessed prior to the investment being made and not be an unpleasant surprise following completion.