SMP
May 07, 2021 Briefing

SMP Briefing: Venture Capital Investments in Regulated FinTech and InsurTech Companies

According to the comdirect Fintech Study 2020, in 2019approximately € 1.755 billion in funding flowed into German FinTech companies in 149 financing rounds. Numerous of the most important German FinTech and InsurTech companies have their own regulatory licenses and are subject to direct supervision by the German Federal Financial Supervisory Authority (BaFin) and/or the German Federal Bank (Bundesbank). These authorities ensure that the applicable regulatory requirements are fulfilled and complied with.

Notable examples of the aforementioned FinTech/InsurTech companies are various German neobanks, neo-insurers, neobrokers, robo advisors, factoring and payment service providers as well as companies active in the lending sector. They all hold licenses to provide banking or financial services pursuant to Section 32 of the German Banking Act (KWG), payment services pursuant to Section 10 of the German Payment Services Supervision Act (ZAG), or to operate insurance business pursuant to Section 8 of the German Insurance Supervision Act (VAG).

The regulatory regime applicable to them in each case contains various regulations that must be observed in the context of venture capital (VC) transactions and that may have a significant influence on the structuring and commercial agreements of a financing round as well as the corporate governance of the relevant company.

In the context of financing rounds of these regulated companies, the typical expectations of founders and VC investors are thus always impacted by regulatory requirements, which must be reconciled with each other:

 

I. Operational Responsibility of the Founders

VC investors also "invest" in the founding team of a startup, not only in the company itself. In this respect, there is a clear expectation on the part of both the founders and the investors that the founders assume operational responsibility. Therefore, they should in principle also be the managing directors (or members of the board of directors) of the company.

However, regulatory law contains requirements for the managing directors of a regulated company in various provisions (cf. Section 25c KWG, Section 10 ZAG, Section 24 VAG). In particular, they must be "reliable" and "professionally suitable". Founders of a credit or financial services institution regularly meet the latter requirement if they can provide evidence of three years of executive experience at an institution of comparable size.

If the founders do not meet these requirements, they are initially barred from joining the management board. In this case, third parties with the relevant management experience must initially take over the management – at least for a transitional period until the founders are recognized by BaFin as managing directors.

In practice, models have been established for this transitional period in order to create at least a joint operational responsibility for the founders and thus to meet the expectations of VC investors and founders:

  • On the one hand, the founders can be granted operational powers via representation solutions under corporate law (e.g. general commercial power of representation (Prokura)). They are then often given their own rules of procedure, similar to the management, which provide for responsibilities and approval requirements.
  • On the other hand, it is possible to set up a holding company "above" the regulated company from the beginning. This holding company, in turn, is not subject to any regulatory requirements, as it does not itself carry out any regulated activities. The VC investment is then made in the holding company, whose managing directors can be the founders.


However, tendencies of the supervisory authorities can be observed to focus more on such structures and to subject comparable holding structures as so-called financial holding companies to supervision as well. This is owed in particular to the events surrounding Wirecard, as the listed holding company was not subject to BaFin's supervisory control. If the holding company is classified as a financial holding company (cf. Section 2f KWG), regulatory law also imposes special requirements on its managers (cf. Section 2d KWG).

II. Advisory Board and Composition

For the purpose of establishing efficient corporate governance, an advisory board is regularly implemented in VC-financed startups. Both the founders and the VC investors usually expect to be represented on this board. Under corporate law, the advisory board can be structured in different ways. In the vast majority of cases, it is granted veto rights with regard to special operational measures (e.g. when entering into financial liabilities, when concluding particularly important contracts, etc.).

Various provisions of German regulatory law (cf. § 25d KWG, § 20 ZAG, § 24 VAG) contain special requirements for the members as well as the rights and duties of administrative and supervisory bodies.

If the advisory board of a VC-financed company is to be classified as a supervisory or administrative body under regulatory law, this has, among others, the following consequences:

  • To the extent that the founders are already acting as managing directors of the regulated startup, they are generally precluded from having a seat on the advisory board.
  • All members of the advisory board must, among other things, be "reliable" and have the "necessary expertise" to perform the supervisory function.
  • Veto rights in favor of the advisory board are only permitted to a limited extent.

In practice, it was therefore observed for a long time, that VC-typical advisory boards were set up in such a way that they did not fall within the scope of the respective regulatory regime. However, there are signs of a tendency on the part of the supervisory authorities to act more strictly when classifying such arrangements as administrative or supervisory bodies under regulatory law.

As a result, the regulatory criteria must be taken into account at an early stage when implementing advisory board structures – especially in order to check and coordinate with the supervisory authority which persons meet the regulatory requirements and can therefore assume an advisory board mandate. Since membership in a supervisory body can also entail special duties - and corresponding liability in the event of a breach of these duties – the question also arises for representatives of VC investors as to whether and, if so, who is willing to assume these duties (and any liability).

III. Incentivization of Founders and Team - (V)ESOP, Vesting etc.

An essential part of the investment of a VC investor in a startup is the sufficient incentivization of the founding team and the employees. Thus, almost every startup has a corresponding employee participation program in the form of virtual stock option programs (VSOPs) or straight equity programs (ESOPs). In addition, founders are often also granted further shares or options in later company stages via special arrangements (e.g. Hurdle Shares, negative liquidation preferences).

Regulatory law also contains special requirements with regard to the remuneration of managers and employees of regulated companies (cf. e.g. Section 25a (5) German Banking Act in conjunction with the Intitute Remuneration Act (InstitutsvergütungsVO), Section 25 German Insurance Supervision Act). For example, variable compensation at credit institutions and some financial services institutions may regularly amount to "only" 100% of the fixed remuneration. This can be increased to 200% of the fixed remuneration by means of a corresponding shareholder resolution.

The VSOPs and ESOPs usually implemented in VC-financed companies will regularly be regarded as variable compensation. Therefore, these typical incentive programs, as well as all other incentive programs appearing in VC-financed startups, should be reviewed timely with respect to their compliance with regulatory requirements.

IV. Urgent Need for Liquidity and Equity – PrimaryEquity financing rounds for startups are frequently associated with high time pressure. Often, only a few weeks pass between the day the term sheet is signed and the signing of the long form documentation. This time pressure is often caused by the startup's urgent need for liquidity.

In the case of regulated companies, a certain urgency for equity financing may also arise from regulatory capital requirements. However, if an investor wants to acquire more than 10% of the shares or voting rights in a regulated startup in a financing round, they must regularly go through a owner control procedure with BaFin (Inhaberkontrollverfahren – cf. Section 2c German Banking Act, Section 14 Payment Services Supervision Act in conjunction with Section 2c German Banking Act, Sections 16, 17 German Insurance Supervision Act).

The law provides for an assessment period of 60 working days for this procedure with BaFin from receipt of the complete notification of the acquisition of the equity interest (cf. Section 2c (1a) German Banking Act). However, depending on the complexity of the investment structure and the type and origin of the investor, such a owner control procedure can take between three to nine months. If the FinTech company is a CRR credit institution (credit institution that conducts deposit and lending business pursuant to Section 4 Capital Requirements Regulation ((CRR)) and therefore requires the involvement of the European Central Bank (ECB, the procedure can even become significantly longer.

Since the financing round cannot be completed before the supervisory authority gives its approval, the duration of the proceedings must be taken into account when it comes to liquidity and equity planning. In order to not always having to wait for the outcome of the owner control procedure before receiving the investment that may be urgently required, arrangements have become common market practice that enable early (partial) financing of the startup with equity. In a first step, investors often acquire a stake of less than 10% as part of the primary and pay the corresponding share price to the company. The remaining shares (from the primary tranche and/or secondary tranche), which lead to the final stake of more than 10%, are only subscribed to in a second closing after the owner control procedure has been completed.

If the investor is not from the EU, the foreign direct investment (FDI) law should always be taken into account in financing rounds of German FinTech and InsurTech companies (this also applies to non-regulated startups). This is because an acquisition of more than 10% in a German startup that, for example, develops industry-specific software in the financial and/or insurance sector as defined by the Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung, AWV) always requires notification to the German Federal Ministry of Economics (Bundeswirtschaftsministerium, BMWi). Moreover, the acquisition by the non-EU investor may only be completed after clearance by the BMWi.

V. Liquidity of the Asset - Secondaries and Exit

VC investors regularly expect to be able to quickly sell their stake in a startup via the means permitted in the shareholders' agreement (secondary, drag-along right, portfolio secondaries etc.) and in compliance with the respective restrictions (rights of first refusal, tag-along right etc.).

If such a sale leads to the purchaser acquiring more than 10% of the regulated company, the aforementioned regulations on regulatory ownership control procedures and FDI law must also be observed and taken into account in the context of such secondaries or exit transactions.

VI. Liquidation Preference

VC investors generally secure their investment through so-called liquidation preferences. In the event of a sale of the company – be it by share deal, asset deal or other corporate arrangement such as mergers etc. – as well as for other events leading to distributions to the shareholders (e.g. liquidation of the company), it is agreed that first the VC investors will receive back the amount of their investment and only then the remaining amounts will be distributed to the other shareholders.

However, Art. 28 CRR prohibits additional and advance dividends with regard to the Tier 1 core capital of credit institutions. VC-typical liquidation preferences are therefore only permissible to a limited extent for credit institutions. The agreement of "classic" liquidation preferences can rather lead to the fact that the investments already made to the startup are not recognized as Tier 1 core capital for regulatory purposes.

Since a breach of the equity requirements may result in severe regulatory sanctions and in order to sensitize the VC-typical expectations of investors at an early stage, the structure of the liquidation preference arrangement should be considered in time and discussed with the existing and potential new shareholders.
 

VII. Selection of Investors

Every founder wants as broad a base of potential investors as possible. Founders of regulated FinTech and InsurTech companies, as well as startups considering applying for regulatory license, should be aware in this respect that, for example, the participation in their company by another bank as a strategic investor may be accompanied by implications for the investor itself.

For example, a bank's qualifying investment (more than 10%) in a company in the financial sector (e.g. credit institution, financial institution, insurance company) regularly represents a deduction for the bank's own Tier 1 core capital as an investor (cf. Art. 43, 36 CRR). A bank's investment in a regulated FinTech or InsurTech company can thus have a direct impact on the capital adequacy of the bank itself. The investing bank will take this into account in its investment decision as well as in the amount of its investment and can thus have an indirect impact on the investor selection of the regulated startup.

 

VIII. Notification Obligations

Various of the issues discussed above trigger notification obligations to BaFin and/or the Bundesbank on the part of both the regulated company and the VC investor. For example, the intention to appoint a new managing director pursuant to Section 24 (1) No. 1 KWG by the regulated startup or the intention to acquire a significant stake (usually, i.e. more than 10%) in a regulated startup by a VC investor pursuant to Section 2c (1) KWG must be notified to BaFin as well as the Bundesbank.

Since the notification obligations regularly become virulent even before the respective state is established, it is mandatory to take an early look at the regulatory requirements and advisable to seek dialogue with the supervisory authority in good time.

 

IX. Conclusion

The aforementioned topics show that in the context of financing rounds of regulated FinTech and InsurTech companies, various regulatory provisions must be focused on at an early stage, as they have a significant impact on the structuring and commercial agreements of the financing round, the liquidity and equity planning of the company as well as the future corporate governance. An early dialogue with the supervisory authorities and investors is recommended on a regular basis in order to discuss and agree on structuring possibilities as well as to explain VC-typical peculiarities and to be able to influence expectations.