The costs and benefits of strategic bank capital

November 2020 | SPOTLIGHT | BANKING & FINANCE

Financier Worldwide Magazine

November 2020 Issue

In recent years, banks have shifted to view FinTechs as attractive strategic partners, rather than simply as disruptive threats to their market share. Resulting partnerships between banks and FinTechs come in various forms, including a bank sourcing a FinTech’s services, contracting to offer a FinTech’s platform on a white-labelled basis, acquiring a FinTech or making a strategic minority investment. The latter option is often coupled by a vendor or partnership relationship.

Accepting a minority investment from a bank can carry significant costs and benefits for the company and its other investors. In short, accepting an investment from a bank is, in many cases, not equal to accepting an investment from a non-bank investor. Early- and mid-stage companies, FinTech or otherwise, should be aware of and carefully consider the implications of accepting a strategic investment from a bank.

Unique burdens of introducing a bank onto a company’s cap table

A bank investor will typically require rights and concessions from a company that other investors, such as funds or non-bank strategics, will not. In many cases these requirements are driven by regulatory considerations, leaving companies and co-investors little flexibility to push back against the demands of a bank investor. The result is that companies may be forced to choose between accepting a bank’s requests or forgoing the investment entirely.

In the first instance, a bank must determine how it will make the investment (i.e., directly by the bank, or instead via its holding company or affiliate). In the US, direct equity investments by a bank might require regulatory notice or prior approval and can typically be made only in companies that conduct activities that the bank would be permitted to conduct directly. There can be more flexibility when a holding company or an affiliate makes the investment, although the holding company must still structure the investment under an appropriate investment authority (in the US, under the Bank Holding Company Act, in most instances).

The form and extent of a bank’s investment should also be carefully considered by the company, as certain investment approaches could increase the risk that the company itself could become directly subject to state or federal bank regulatory obligations. In the UK, regulators will be keen to understand the rationale behind the investment and the commercial and regulatory synergies between the bank and the FinTech. Furthermore, in the UK, depending on the placement of the FinTech in the bank’s group structure, a FinTech may also become subject to the bank’s regulatory capital requirements.

In order to qualify for an exemption to permit its investment, a bank or its holding company will often need to keep its equity holdings under certain percentages, both at the time of the investment and on a go-forward basis. This may require restrictive covenants regarding the company’s ability to change its capital structure going forward. In some cases, a bank may seek provisions that would automatically convert equity to avoid crossing regulatory thresholds (e.g., converting voting shares to non-voting shares to avoid crossing a key threshold).

Bank investors may also require the right to veto certain activities. For example, subsequent to an investment the company could seek to engage in a new business line that, if launched, could render the bank’s investment impermissible. In other instances, a change in the company’s capital table could accrete the bank’s position to an impermissible level. In such instances, a bank would need the right to veto the new business line or cap table change or otherwise be provided a means to unwind its investment, in whole or in part, which might be costly for the company and all co-investors involved. In addition, bank investors may require a means of exit should the bank or its regulators determine that the investment has become unacceptable for risk or reputational reasons and ask for such provisions in investment documents that would, in non-highly regulated contexts, be off-market.

Like other significant investors, banks will often seek board or observer rights, particularly in cases where they might be interested in integrating offerings similar to those of the company into their own product suite. Bank investors will calibrate these rights carefully to avoid overstepping regulatory thresholds related to control. Banks might also seek exclusivity provisions to ensure that they are the only bank investor in or adviser to the company.

All of these rights can have the effect of making the addition of a bank to a company’s cap table more expensive for all parties. Each of these rights will likely be unique to the bank investor, requiring new negotiation by the company and co-investors and redrafting of corporate governance and investor rights documents and side letters. The company may also face requests from other investors who see the bank’s entry as an opportunity to seek new concessions or parallel rights.

Benefits of having a bank investor

While having a bank on a company’s cap table may be cumbersome and entail unique costs, it also comes with a host of benefits.

First, the presence of a bank investor can strengthen a company’s market credibility. Other investors and potential customers and partners are likely to assume that the bank undertook deep-dive due diligence before completing its investment and would not invest in a company that would impair the bank’s reputation. This can set a company apart from otherwise similarly situated competitors.

Similarly, the market, and possibly even regulatory bodies, may assume that the company’s key directional decisions will be subject to consistent oversight and higher standards where a bank investor has veto rights or a board seat. Banks are by nature conservative and will at times veto overly aggressive decisions by founders.

Bank investors also offer strong network benefits. For one, the bank may have a large client base of which the company can take advantage. Alternatively, the company may have a ready-made client base and scale in a potentially safer environment with the presence of the bank investor. While non-bank investors often offer their own benefits, there are few non-bank financial sponsors that can offer network benefits akin to banks, particular to a FinTech whose product may deepen on a bank’s unique product mix – issuing cards, moving funds and taking deposits.

The presence of a bank on a company’s cap table may also be beneficial in later funding rounds. For instance, later investors will often take comfort from the earlier of involvement of a bank, which signals that the company underwent the level of due diligence expected from a bank.

Finally, early- and mid-stage companies operating in highly regulated areas can benefit from the expertise and regulatory and compliance infrastructure of bank investors with substantial experience in the area, creating real strategic partnership value that other investors would likely not bring to the company.

Pratin Vallabhaneni and Hyder Jumabhoy are partners and John Wagner is an associate at White & Case LLP. Mr Vallabhaneni can be contacted on +1 (202) 626 3596 or by email: pratin.vallabhaneni@whitecase.com. Mr Jumabhoy can be contacted on +44 (0)20 7532 2268 or by email: hyder.jumabhoy@whitecase.com. Mr Wagner can be contacted on +1 (212) 819 7609 or by email: john.wagner@whitecase.com.

Pratin Vallabhaneni, Hyder Jumabhoy and John Wagner

White & Case LLP