Originally appeared in Kaye Scholer's Fall 2016 Term Sheets and Tech Deals: Key Considerations Report.

Fintech startups and the regulated financial services companies (FSCs) they hoped to disrupt have realized the benefits of cooperation over competition. FSCs are seeking out the technologies, talent and business models developed by fintech startups to complement organic growth and M&A strategies, as well as to develop competitive advantages. Likewise, fintech startups wish to leverage the global product distribution platforms and compliance infrastructures offered by FSCs. For venture backers and startup founders, FSCs also now serve as primary paths to liquidity events.

As a result of the mutual interests and benefits, the volume of venture investments, joint ventures and acquisition transactions between FSCs and fintech startups has increased significantly. The following issues are often overlooked in term sheet negotiations, complicating the transaction process and placing the benefits of cooperation at risk.

Implications of “Control” Under the Bank Holding Company Act

The Bank Holding Company Act and its related rules (BHCA), to which most FSCs are subject, can complicate transactions because the BHCA provides that a FSC “controls” the startup if it holds more than 25 percent of the startup’s voting stock, controls its board or otherwise has a controlling influence (for example, contract-based negative consent rights). A fintech startup controlled by a FSC also may need to implement portions of the FSC’s compliance programs and governance practices, which could affect the startup’s culture and cost efficiencies. As a result, the structure of a joint venture or minority investment must balance the benefits of keeping the startup separate from the FSC, thereby maintaining its culture of innovation, with the FSC’s ability to protect its investment and achieve its strategic objectives. To mitigate BHCA-related issues, FSCs and fintech startups should analyze the implications of control on the post-closing business model and consider whether each party’s transaction objectives can be achieved in a structure where the FSC does not control the startup.

Potential Accounting Impacts

Transactions between FSCs and fintech startups often use earn-outs and milestone payments to bridge valuation gaps. Venture investment transactions and joint ventures also frequently include purchase options that enable the FSC’s complete acquisition of the startup. FSCs and fintech startups too often address the accounting implications of contingent consideration, consolidation, minority interests and purchase options after the valuation is set and the term sheet signed. Unfortunately, the accounting for earn-outs, milestone payments and purchase options can lead to adverse consequences for the earnings of the FSC. To minimize the risk of renegotiating material transaction terms, including price, material accounting issues should be analyzed and considered in connection with the initial term sheet negotiations.

Employment Terms and Employee-Related Closing Risks

It is not uncommon for acquisition term sheets to be signed after a high-level discussion about compensation levels for key employees, leaving material details to be sorted out later. The employment policies, practices and cultures between FSCs and fintech startups, however, often differ significantly. For example, fintech startups have reporting structures that are flat relative to the hierarchy of an FSC, so startups often liberally use equity incentives for all levels of employees while FSCs often provide meaningful equity compensation to only senior employees. Additionally, FSC compensation programs are subject to external regulations that are not applicable to fintech startups. Accordingly, FSCs and fintech startups should seek more than a high-level understanding of employment packages, incentive compensation programs, reporting lines and key employment policies (e.g., bonus clawback rules) at the term sheet stage to assess risks relating to employee retention and related closing conditions appropriately.

By addressing these often overlooked issues, in addition to valuation and other common term sheet points, FSCs and fintech startups will increase the odds of successfully completing transactions that realize the benefits of cooperation.

The volume of venture investments, joint ventures and acquisition transactions between FSCs and fintech startups has increased significantly.