Over the past decade, the fintech sector has moved from being a niche area on the outskirts of finance to being one of the core pillars of the financial services sector today. Some of the products that the fintech industry has managed to produce, from online brokerage accounts, digital payments and trading to some more recent technological breakthroughs like crypto-assets, have pretty much become a mainstream and something that the financial services sector of today, could hardly be imagined without.

This rapid growth of the fintech industry, was largely fuelled by the influx of large volumes of private capital investments in innovative fintech companies that were striving to bring more innovation to the old-fashioned world of global finance. The vast majority of these investments came from a group of investors that were particularly keen to bet on their future potential as well as bold enough to bear an above-average investment risks in this process – the venture capital industry.

Unlike other tech companies that venture capital investors have been supporting for the better part of the last two decades, fintech companies are entities that already are or are looking to become regulated financial institutions in some form. This particular characteristic of fintech targets significantly complicates the fundraising process in many ways: from the due diligence of the target, its exposure to regulatory risks, structuring of deal terms and the deal structure to regulatory approvals and ownership control procedures.

But what are some key regulatory considerations that both fintech companies raising funds as well as their investors (whether venture capital funds, family offices or larger angel investors) should be aware of? Find out in this article.

Turbulent waters of fintech fundraising

Unlike the fundraising market for other startups and scaleups, fintech fundraising market is aside from the overall market environment that influences investor’s ability/interest to invest in fintech companies (i.e. interest rates, macro-economic outlook, geopolitical tensions etc.) and obviously the business potential of the target in question, heavily influenced by the direction where the regulatory developments in a specific jurisdiction are heading.

For instance, lack of a proper regulatory framework in an area that a target is active in, creates a significant degree of legal and regulatory uncertainty for investors and raises legitimate questions about the sustainability of the business model in the long run. Same goes for the existence of a regulatory framework that is (unless a positive regulatory change is on the horizon) unfit for purpose which can heavily limit the target’s ability to operate, let alone to scale up its business operations in the long run.

The way in which financial supervisory authorities enforce applicable regulations and more importantly their overall approach to the fintech industry, is another factor that has a significant influence on the interest of investors to invest their money in fintech companies coming based in certain jurisdictions.

Finally, at the micro level, there is also a number of different regulatory-related factors that investors generally have to take into consideration when deciding to invest in a particular fintech company. Whether and to what extent the target is properly structured to begin with the business expansion and obtainment of necessary licenses (in terms of the organisational structure, headcount, technical and operational readiness etc.) what is the level of ability of the founders and other board members to keep pace with rapidly changing regulatory and market developments in a heavily regulated financial services industry as well as supervisory expectations of the regulators are just some of many questions that generally need to be factored into the investment decision.

Therefore, the regulatory dimension of fintech fundraising is by far one of the most important parts of the fundraising puzzle for fintech companies. The chapters that follow explore key regulatory aspects of the fintech fundraising process and the way in which financial regulation may influence the deal terms and the deal structures in fintech fundraising transactions.

Due Diligence

Following the signing of the initial term sheet between an investor and a fintech company, the very first step is generally due diligence of the target as part of which various areas of the target’s business operation are being analysed. In fintech transactions, regulatory due diligence that consists of detailed analysis of the regulatory status of the target and more importantly its exposure to regulatory risks, is by far one of the most important parts of the due diligence process.

Unlike other innovative companies, fintech companies are (same as incumbent financial institutions) required to comply with a number of complex and sometimes overlapping pieces of financial regulation, that define the way in which they are allowed to operate, onboard new customers, engage with business counterparties and expand into new areas and new markets. The situation can become particularly complex when a target is operating or considering to operate in more than one jurisdiction, given that in such case regulatory classification of the target’s business activities can vary from one jurisdiction to another.

Despite the fact that the European Union’s single market is often perceived (especially from the perspective of non-EU investors) as a single jurisdiction with same rules applying across the EU 27 Member States, in the fintech industry this is not always the case. That being said, a fintech company providing services that are not regulated at the EU level in a harmonised way (e.g. B2B lending, invoice trading or until recently provision of crypto-asset related services) may have a different regulatory status across different countries even within the EU.

In the post Brexit world, due diligence of the targets that operate on both sides of the Channel, requires a particular caution due to an ever-growing divergence between the regulatory frameworks in the EU and the UK.

Therefore, due diligence of a fintech target in the fundraising process, requires a deep dive into the regulatory perimeter in each market of its operation, detailed analysis of the internal organisation and governance structure of the target, any licensing exemption that the target may be relying on as well as any exposure of the target to a potential regulatory enforcement down the road. This is particularly important given that it is not uncommon for fintech companies to scale quickly without adjusting their internal processes, procedures and controls to applicable requirements, creating a hidden risk profile.

The failure to complete a proper regulatory due diligence of the target in a fundraising transaction, can lead to some very unpleasant post-closing surprises, ranging from implementation of costly and unplanned business model changes, regulatory investigations, monetary sanctions and even potential cessation of the business operations of the target altogether. To that end, conducting a proper regulatory due diligence is an essential and important part of the fundraising round that shall be aimed at forming an understanding of investors where the regulatory pitfalls in the business of the target may lie, how they may affect scalability and valuation of the target, and whether the target has the stability to scale up as planned.

Transaction Structure

The structuring of the transaction and the deal terms is usually the most complex part of the fundraising transaction, especially in the case of more mature scape-up fintech companies that have already managed to list a number of different investors in their cap-table. The financial regulatory requirements that a target is subject to in its jurisdiction of origin, also have an important impact on the deal structure and deal terms, where the level of contractual liberty of the parties is to the certain extent limited.

Regulatory capital

Fintech companies that are regulated financial institutions (like investment firms, payment institutions and in the case of some more mature scale ups, credit institutions) are subject to own capital requirements requiring them to always maintain a specific amount of regulatory capital. For this purpose, these entities must comply with prudential requirements under applicable regulations (like the Investment Firms Regulation (IFR) or Capital Requirements Regulation (CRR) in the EU) which require them to maintain their own funds in a required way, including by maintaining minimum levels of the so-called Common Equity Tier 1 (CET1) capital.

Impact of the structure

Fundraising transactions backed up by venture capital investors, are commonly based on structures that involve a combination of ordinary shares and one or more classes of preference shares of the target. With the aim of balancing the interest of a proper corporate governance, fair division of power among different classes of investors and investors’ financial goals, preference shares are generally tied to some specific rights of their holders, like specific dividend payment rights or a non-voting status. However, the use of this structure, if not carefully implemented, may have unintended consequences on the regulatory capital of the target. Under the applicable prudential regulatory requirements in both the EU and other major markets like the UK, only shares that are fully paid-up, unsecured, subordinated to all other claims against the company and which do not grant their holders preferential rights to distributions are eligible to qualify as CET1 instruments. Preference shares, particularly if granting their holders any preferential rights (which generally is their main purpose) generally do not qualify as CET1 eligible instruments.

Practically speaking, where a venture capital investor invests EUR 20 million, only the portion of this invested amount that is allocated for the purposes of acquisition of shares meeting criteria to qualify as CET1 instruments, will strengthen the target’s regulatory capital. Where a target is at the point of fundraising, near the limits of its regulatory capital, poor structuring of the transaction without a proper consideration of the impact of the transaction on the regulatory capital, may present a material regulatory issue for the target.

Other relevant deal terms

The same goes for some other, less common instruments, such as convertible notes or instruments subscribed for under simple agreements for future equity (SAFE) which do not qualify as CET1 instruments until conversion (and even upon conversion, can only qualify if the allocated shares meet the relevant CET1 criteria). When it comes to liquidation preference rights embedded in share terms these can likewise disqualify an instrument from being CET1 eligible, particularly where they create a senior ranking or fixed claim on assets of the target.

Another common deal terms that can have a negative impact on the regulatory capital of the target may be indemnity clauses that the company agrees to in the investment agreement. Where agreed indemnities are significant and likely to be triggered (where the risk is very likely to materialise e.g. part of the business operations lacks a proper license) the indemnities may be treated as contingent liabilities of the target i.e. the amount of liability that they may lead to needs to be reduced from the amount of target’s CET1 capital.

Ownership control procedure

Once the deal is structured and the commercial terms have been agreed on between the parties, fintech fundraising transactions are subject to regulatory approvals that are quite uncommon in other industries. Unlike firms in other industries that may be subject to foreign direct investment (FDI) or merger clearances by antitrust authorities, fintech companies are required to secure an approval from their financial services supervisory authority of any corporate transaction that results in an acquisition of a qualifying holding (in the EU) change in control (in the UK) as defined under the applicable law in their jurisdiction of origin.

Control

Where an acquirer of shares or other interest in a regulated target meets specific criteria, it can be deemed as an acquirer of a qualifying holding/ controller (hereinafter “controller”) and hence subject to a specific assessment ran by the financial supervisory authority aimed at checking their suitability to be a controller of the regulated entity (i.e. checking their business activities, financial and reputational solidness etc.). Thresholds for the ownership control procedure typically start at 10%, with further regulatory significance gradually rising at 20%, 30% and 50%. The ownership control procedure is also triggered whenever an existing investor exceeds another threshold for notification, (for instance when investor holding 15% of shares acquires additional 9% and thereby exceeds the 20% threshold).

It’s worth mentioning that control in this context is not solely triggered by share ownership over the above-mentioned threshold by an individual entity/person. Structures that are based on the allocation of different voting rights that are disproportionate to capital participations or specific veto or board appointment powers of investors as well as structures involving different layers of investment vehicles, nominee companies, trust-arrangements and/or special purpose vehicles (SPVs) require careful assessment and identification of relevant controllers since the controllers’ status in these structures may not be as obvious as in some more simpler structures.

Importance of a proper structuring

In the same vein, from the investor perspective, proper structuring of the acquisition tree can make things much easier in the process in terms of the scope and the complexity of the ownership control procedure that inevitably has an important influence on the transaction timeline. Further, proper structuring of the acquisition tree from the outset can also have important impact on some future regulatory exposure of the investor themselves: for instance, where a majority investor (like a family office) invests in one or multiple targets that are or may become in the future financial entities, it may end up being classified as a financial holding, a mixed financial holding, or investment holding company under the applicable provisions of the EU IFR/CRR regulatory framework. This could lead to an unintended consequence that the acquirer that may primarily look to act as a passive holding company, ends up triggering a license or supervisory consolidation requirements due to the large allocation of its investment participation in the regulated sector in the beginning.

Cross-border complexities

Cross-border fundraising transactions, where an entity raising funds is a parent undertaking of two or more regulated subsidiaries operating in different jurisdiction, add additional complexity. In such case, single fundraising round may require parallel approvals of a number of different financial supervisory authorities not all of which apply the same rules and more importantly the same criteria on the identification and assessment of controllers. To that end, carefully structured acquisition tree that was supposed to reduce the regulatory burden in one jurisdiction may not serve the same purpose in the other (or may potentially trigger a scrutiny of some further subjects that were not in the picture in the first place).

In this scenario, where poorly structured in the condition precedents in the investment agreement, the transaction timeline may be negatively influenced by a conflicting pace at which different financial supervisory authorities are processing notifications, divergences in their approach to the assessment of relevant information as well as applicable requirements their orient themselves to when it comes to supporting documentation.

Notification and approval

Financial supervisory authorities require advance notification of a proposed acquisition of a qualifying holding/change in control and the submission of a number of supporting documents about the involved entities, related persons, members of their management boards etc.

The process can take up to 60 working days, is however sometimes extended for time required for the submission of additional documentation, information or discussion of specific complex parts of the acquisition structure with the regulator.

The failure to notify or obtain approval from the competent financial supervisory authority supervising the target can lead to quite severe sanctions. Based on their powers stemming from sector specific pieces of EU legislation (e.g. MiFID II, PSD2, CRD) as implemented into national law, financial supervisory authorities across the EU (e.g. German BaFin) are empowered to impose monetary sanctions, suspend investor’s ability to exercise voting rights in the target or file for a court order, ordering the investor to sell/transfer its shares to a third party (i.e. in a trust account). In the UK, under the Financial Services and Markets Act (2000) the failure to notify or obtain approval for the change in control from the FCA, also constitutes a criminal offence.

Conclusion

Against the backdrop of everything abovementioned, it would probably be an understatement to conclude that the structure, the terms as well as the timeline of fundraising transactions in the fintech sector are heavily driven by the financial regulatory requirements that target entities are required to ensure compliance with.

Unlike some other areas of law that are likewise a common part of the due diligence process and related contractual negotiations, the regulatory dimension of the fintech fundraising transaction has a far-reaching impact on areas of the transaction that may not be as obvious to either the investor or the target (e.g. hidden effect of standard liquidation preference or indemnity terms on the regulatory capital of the target, without which normal operations are not possible). The complexity of the deals with a cross-border element that require specialised expertise in more than one jurisdiction and experience of working with different financial supervisory authorities at the same time is another part of the fintech fundraising puzzle that makes these transactions particularly challenging.

Nonetheless, with the proper structuring of the acquisition and transaction structure from the outset, both investors and fintech companies raising funds can ensure smooth execution and closing of the transaction later on, without falling into some common pitfalls. Therefore, when entering the next fundraising round involving a fintech company, on either side of the negotiation table, don’t forget to mind the regulatory gap(s).