How Fintech companies can get the best from Private Equity Investment

‘Eventful’ would be a good one-word summation for 2020. It certainly applies to Fintech companies. Challenges and opportunities have abounded as COVID-19 has upended industries across the board and changed the way both business and individuals carry out financial transactions. Look no further than the recent GameStop – Reddit - Robin Hood situation to a prime example.

BDO has developed the RETHINK framework that can assist companies, including Fintechs, react to the fallout of COVID, increase resilience and best position themselves to realise their full potential.

Outsider funding, for example from private equity firms (PEs) may be needed to reach that potential - or a favourable exit. In the BDO Global Fintech – Private Equity investment guide you can find a detailed walkthrough of the steps and considerations needed to secure optimal investment from a PE. This article presents an overview of these steps.

What Are You Looking to Achieve – and When?

Meeting COVID-related challenges, taking advantage of growing demand or pursuing an exit are just a few of many possible reasons for Fintech companies to consider external investment.

Defining goals and strategy for securing investment starts with looking inward. Your current situation, market, and solution, along with prospects, strengths, weaknesses, threats, and opportunities – as well as near, medium, and long-term goals – will all need to be objectively analysed.

Advisors capable of meeting you at eye-level with an understanding for your situation, market and solutions provide a good sparring partner for such a process.

Private equity is a good source of both extra capital and collaboration that can help you reach your goals. There can be many upsides to working with PE firms. Focus on growth, strong experience streamlining business processes, and understanding how to expand your operations are some reasons why PE can be a good funding avenue.

What PE Investment Enables

Private equity firms are increasingly frequent investors in the Fintech space, which in 2019 saw investments worth $137.5 billion. Deciding whether a PE is the right choice relies on knowing what PEs can do for a company.

Note that potential benefits vary between PE firms, as do their size, focus, and expertise. General advantages from working with a PE include:

Market expertise: PE firms have a track record of growing portfolio companies’ sales and customer base.
Networks: PE firms often have vast contact networks including business experts and new customers.
Operations: Supporting optimisation of your internal business processes is an area where PE firms often shine.
Profitability: As illustrated by BDO UK data, the likely result of PE investment is revenue and profit growth.
Exit options: PE investment can be an opportune avenue for founders and management teams looking to exit the company.

How to Leverage Financial and Tax Support

PE firms can be of great assistance to Fintech companies with financial issues.

This may sound counter intuitive. Fintech founders and management teams often include finance experts. However, they tend to be banking and financial operations focused. Fintechs often face complex legal and regulatory landscapes – especially when expanding into new markets or offering new solutions. Continually developing rules governing Fintech operations, audit requirements and tax risks insight into current and coming applicable rules’ influence of business operations.

Apart from regulatory aspects, Fintech management teams will not necessarily be experts in financial areas like tax and VAT/GST, corporate income tax exposure, operational taxes, transfer pricing, employment taxes, share incentive schemes, and the founders’ own tax position.

Creating an efficient and explainable group structure –with assistance from either financial consultants or the PE - is vital to the business’ success.

Know What a PE Firm Expects

Fintech companies from scale-ups (and in some cases perhaps even start-ups) may be in some PEs’ investment sights. A rule of thumb is that companies who are past Series A funding might find interest among some PE firms.

PE firms differ from other investors by having a very strong focus on creating growth within a set period. Usually, the goal is to either double the value of their investment in three years or triple it within five years.

With a strong focus on achieving growth, PE firms will, when looking at investing in Fintech, be very focused on your scalability. In other words, they will expect your company to be able to expand rapidly. This can be tied industries (vertically or horizontally), geographically, through building out solutions, bundling through bolt-on acquisitions, through rollups, and more.

Competent management and strong collaboration between the parties will be other expectations.

Know Your Worth

Many Fintech companies’ value proposition is on the rise as contactless payments, alternative banking and lending are becoming more widespread. Counterbalancing the development is COVID-19’s impact on projections of future earnings and growth.

Defining your value and thereby the starting point for deal negotiations includes looking at your solutions, code, R&D, patents, customer base, sales, and future potential. An inexhaustive list of other areas affecting valuation include your technology stack, industry trends, revenue metrics, growth potential and runway.

Generally, revenue or EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples are used as yardsticks. Note that historical average multiples may not apply because of COVID-19’s influence on global markets.

Staying within the parameters of ambitious but achievable projections for growth will be important during negotiations and subsequent collaboration. Unrealistic valuations may lower trust in your management team and lead to more difficult negotiations.

What PE Firms Are Looking at

PE firms will be locked in on growth scenarios and the growth potential of your company and solutions. During the initial stages of deal preparation, a company should work to create detailed plans and strategies for achieving short to medium-term growth goals without risking long-term potential.

During negotiations, PE firms often focus on areas similar to those that determine your value, but with greater focus on details. This is true of areas such as:

Management/employees: Ability to deliver on business goals, overcome challenges, and create and update solutions.
Customer relations: Customer base connection and brand awareness among specific, relevant customer demographics.
Investments: How the raised capital is going to be deployed.
Exit strategy: Viable exit options for the PE firm (future sale or IPO), as well as your potential exit plans.

Prepare for Due Diligence Questions

Due diligence involves potential investors closely examining and evaluating areas including your software, code, architecture, and products – as well as financial and managerial aspects of your business.

Some of the questions that a PE firm will ask include:

Sales and forecasts: What are your sales channels? Do you rely on a few large customers or many smaller ones?
Products, product strategy and portfolio: What solutions do you currently offer? What are their competitive advantages?
Market situation: What is your current market? Are there other areas or verticals where you can increase sales?
Technology: How do your solutions scale? Are there third-party dependencies?
Taxes and legal: What are your non-income-based taxes? What is your potential exposure?

Most companies will benefit from undertaking a vendor due diligence process or similar sell-side due diligence activities.

Know PE firms’ Software and Fintech Concerns

Fintech companies are attractive investment targets. Interest can, at times, be tempered by the challenges and risk factors that investors see in the space.

Respondents in BDO’s 2019 private equity study pointed to growth opportunities (42%) and finding and retaining management teams (33%) as some of the biggest challenges when acquiring target companies. This may also apply to the Fintech industry.

Other areas of concern include competitor resilience, and regulatory and technological risks. Changing regulations make Fintech companies particularly susceptible to the latter. The same applies when entering new markets, which often equals new compliance demands for data, financial reporting, and capital reserves.

Technological developing is another area that PE firms may see as an opportunity – or look at with concern. It can mean shorter product life cycles and narrower windows of opportunity. Your company should have clear, well-documented strategies and policies in place for addressing such risks.

Knowing Your Potential IP Issues

Who owns the rights to your software, code, solutions, patents, and other IP? The answer may not be as straightforward as you think. Your code, products, and services are central to PE firms’ interest in your company. Ensuring that they are acquiring IP rights when investing in a main focal point for PEs.

There may be risks that subcontractors, as well as current and previous employees, hold rights to your IP. Your IP may also be reliant on third-party solutions, including open-source code libraries. Figuring out what your potential IP exposure is before negotiations begin is crucially important.

PE firms may look to hire external technical and judiciary experts to review your IP, code, and solutions early on during negotiations. As for legal matters pertaining to IP, you may want to engage independent third parties to ensure insight without risk of perceived bias.

How Covid-19 Has Changed the Deal Process

The global pandemic has changed M&A negotiations and specific contract terms. Whether things reach a ‘new normal’ soon is yet uncertain. In the meantime, regulatory approval times have been extended.

Reduced face-to-face interaction, limited travel and remote working have all increased the average deal negotiation times. Deal and payment structures may also have changed, seeing altered capital structures and earnout targets.

Other areas of deals and negotiations with a PE that can have been affected by COVID-19 include:

Due diligence: Projections, business plans, continuity plans will likely see increased scrutiny.
Risk exposure: Increased privacy, HR, and cybersecurity risks may have changed.
Negotiations: Negotiations and access to off-site document may have slowed substantially.
Changed Interim Operating Covenants (IOCs): Changes to IOCs to ensure smooth company operations between deal signature and closing.
Earn-outs: Earn-out targets may change, and earn-out times be prolonged.

Define Your Earn-out Goals and Targets

A PE deal can be a time for funders and management teams to reach a desired exit while ensuring continued, successful company development. In such cases, you will likely be negotiating earn-out clauses and targets.

Earn-outs are usually divided into fixed and variable components. Fixed parts are often paid out upon deal completion. Variable components are paid out over time and may be tied to milestones, such as earnings or growth targets. In the technology sphere, it is not unusual for up to two-thirds of deal value being tied to earn-out targets.

Earn-outs may have material tax consequences dependent on deal terms, earn-out payment methods and applicable legislation. The most important area to sellers are often income tax and how earn-out payments are treated. Earn-outs defined as compensation for services rendered may be viewed as taxable income and could lead to extra tax liabilities.

Start Preparing Early

PE firms’ requests for detailed data and information may come as a surprise to Fintech companies. This is often particularly true for financial matters.

Creating the best possible foundation for a successful, smooth deal negotiation should start well in advance. If possible, a year of internal preparations is recommended.

Often, a good starting point is looking through what historical and current data is available and how it is structured. The next step would be how to structure and present data, information, and documents to a PE firm during negotiations.

PE investors will also want to know how you plan to deploy raised capital and how you see it leading to increased growth and profitability. Detailed plans covering such areas should also be laid and presented – but also take into consideration that a PE firm will likely want influence over this process.

Plan for Your Collaboration

Establishing the fundamentals of that post-deal collaboration can begin at the negotiation table.

Defining your goals for the short, mid, and long-term and being open about expectations for the partnership is a good starting point. The same goes for working with the PE on defining how collaboration should look in practical terms.

PE firms may spend 50% of their time growing a company and the other half on figuring out how to divest. Having a clear idea of what the end goal is and working together to achieve it will be a core aspect of your collaboration.

A general rule of thumb is that PE firms will be much more involved than the likes of VCs. You and the PE should strive to continually ensure that actual involvement aligns with planned and agreed-upon involvement.

Set Clear Targets

Agreeing on realistic targets and goals for both yourself and the company, post-deal, is important for all the time you will be working alongside a PE.

Shaping the conversation around targets and how to measure them is a continuous effort. Parts should be formalised in the contract while others should remain more fluid and informal.

The exact communication form and frequency will vary, the below are rules of thumb that apply to most situations:

Be proactive: Communicate clearly ahead of making bigger business decisions.
Define decision-making: Establish clear guidelines for how major decisions that could affect targets are made.
Ask for help: PE firms can offer valuable insight and assistance. Ask for a second opinion when needed.
Set communication schedules: Agree with the PE and other potential parties on a schedule and format for communication.

Get the Right Advice – and Advisors

This guide is only an overview of some of the aspects that a Fintech company should look to cover during deal preparation and negotiations. The key takeaway is that preparation is vital. The same goes for setting clear goals. Once you have decided to sell, you need to spell out what your role and responsibilities will be post-sale – or how you wish to exit the company. Otherwise, you will end up in a process that is unnecessarily frustrating and challenging for both sides.

In most cases, objective advice from outside experts, such as financial advisors will be key to reaching the best possible outcome of your investment efforts.

BDO has developed other guides, industry overviews and articles for Fintech companies. Our goal is to assist companies navigate business operations, tax, funding for growth and much more to achieve the optimal results and reach their full potential.

Our publications include:

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