Fintech M&A: Minority investing - some key pointers
14 August 2017
As we set out in our first article on fintech investments and M&A strategies, investing in fintech (and particularly those companies with novel technology or that are pre-revenue) demands a particular approach.
This can be unfamiliar territory for big corporate and financial institutions, more used to big-ticket M&A transactions with public companies or well-established private enterprises than making minority investments in small private companies.
Here the founders of the company – often a key asset – will typically be significant shareholders and be the key managers of the company. Employees, friends and family and angel investors might be part of a relatively large number of shareholders, and depending on the maturity of the business, other institutional investors and venture capitalists might be on the register.
It is becoming increasingly important for corporate and financial institutions, which often lack the investment committee structures of the VC and PE funds, to make sure that they have the right internal governance procedures in place, including efficient processes for gaining approval for a deal. Unnecessary delays here could see a good deal go begging. Lax controls are, equally, likely to be a recipe for ill-judged investments or result in agreeing unsatisfactory deal terms.
A buyer’s ability to negotiate transaction documents and amend existing corporate documentation may well depend on the size of the investment.
Investment terms will focus on voting, veto, consent and information rights, together with investor protections including anti-dilution mechanics, pre-emption rights as well as drag and tags. Significant or key investors will expect a seat on the board, and institutional investors typically require the timing of an exit to be agreed in principle, whether that’s through an IPO or M&A transaction.
Thought will also have to be given to the long-term relationship between the investor and the fintech. There may, for example, be a natural temptation to seek exclusivity over the IP and products of the company but that might not be the best approach for the institution. If, for example, the fintech’s technology is reliant on market-wide adoption, it will need to sell its product to businesses which may be in competition with one or more of the investors. Corporates which are considering such investments must therefore be wary of applying traditional deal thinking to their fintech investments.
Establishing the true long-term value of an early-stage company is also necessarily tricky. Often convertible preference share or loan note structures will be used as they can push the question of valuation down the road and in the case of loan notes, guarantee a periodic return to investors.
This is a structure that some strategic investors may be unfamiliar with, yet putting the terms in place will be crucial in ensuring that all the initial investors in the business – including key personnel who may be critical to the success of the venture – get a fair return.
Contracts with employees will need to be carefully scrutinised in the diligence process and buyers will need to make sure that they have strong clauses in the shareholder agreement covering founders leaving the company, including restrictive covenants and good and bad leaver clauses. Key members of the team may be crucial to the value of the company, so taking care to incentivise team members as part of the bigger organisation can pay huge dividends.
Share plans are common place in growth stage companies and careful due diligence will be needed to establish the potential size of any scheme and how much of that has already been allocated to employees. Failure to do so may see investors’ stakes shrink on a fully diluted basis if further increases to any option plans are required.
While due diligence on larger transactions will look very closely at material contracts this may be less of an issue here, early stage companies are often focused on product development rather than revenue generation, and as a result, there may be few or no customer contracts to review.
Instead a critical part of the diligence process will concentrate on kicking the tyres on the regulatory position and looking closely at IP to make sure that the innovation actually belongs to the target business and that systems are securely owned and patented rather than, in some cases, relying on open source technologies. Great care will need to be taken in structuring warranties around this IP.
The diligence will drive the warranty package covering the standard risks including litigation, tax and accounts, as well as areas which are particularly relevant for fintech deals, such as IP, employees, regulatory compliance and the company’s business plan. Founders should expect to sign up to the warranties for the first few rounds, and as the company grows into an established and credible enterprise investors may accept warranties from the company alone in later rounds.
Establishing a strong sense of trust between buyer and seller will provide an important foundation for future partnership and something to which it is worth dedicating time and effort.
There is inevitably an inequality of bargaining power and sellers are under pressure to disclose substantial amounts of commercially sensitive information. Buyers often have the upper hand in dictating terms. Taking full advantage of that position can be a questionable strategy if retaining key people is an important objective of the deal. The fintech community is a tight-knit one and reliant on a comparatively small group of skilled personnel. Word gets about pretty quickly if a buyer is seen to be behaving unreasonably or if it gets a name for poaching ideas and people.
The best strategies we’ve seen for established financial services players making investment in fintech are rooted and grounded in investors identifying targets that match their strategic interests while also coming within agreed financial investment parameters. Due diligence is key to achieving and balancing these objectives. Meanwhile, an understanding of the market norms in structuring minority investments and having in place a good governance structure for investing is key to maintaining the nimbleness and agility to stay ahead of the competition and make the best deals.