The global financial services industry is undergoing a major shift as technology, regulation and consumer behaviour combine forces to demand wholesale digital transformation. Banks are being forced to change fast with fintech competitors hot on their heels.
Yet the startups initially seen as another threat are becoming a powerful asset for financial institutions that struggle to deliver innovation. As the game switches from competition to collaboration the race is on to partner with the best innovators.
Our new economic study Close Encounters found that financial services firms, both at home and abroad took part in 1,861 deals with UK SMEs in the last four financial years, largely in the form of minority stake purchases, alongside mergers and acquisitions. More than £31bn is known to have been invested in these deals between the 2013/4 and 2016/7 tax years.
This puts financial services far ahead of any other UK industry in volume of deals between large companies and SMEs.
The popularity of these asymmetric deals mirrors the industry’s strategic investments in accelerator funds, startup events and incubators, which has created an ecosystem for collaborative innovation between fintech innovators and financial corporates.
How can collaborating benefit both fintech startups and banking giants?
At first sight there is little common ground between multinational financial institutions and fintech startups. One is well-established to the point of antiquity, powered by financial strength, brand loyalty and scale. The other is refreshingly free of legacy systems or expensive property, built for optimised digital development and attractive to millennial talent, yet held back by lack of regulatory expertise, access to a large customer base and infrastructure.
In the highly regulated and deeply trust-dependent world of consumer financial services each side’s strengths are also weaknesses. As such these polar opposites have much to gain by working together.
The need to make the most of each other’s very different capabilities can be seen in the way in which financial services firms are choosing to collaborate. Our research found large financial services organisations are increasingly choosing to opt for minority stakes in SMEs rather than full buyouts. Over the last four years 75% of financial services deals with UK SMEs were minority stake purchases while 25% were mergers and acquisitions.
This may reflect a desire to avoid the difficulties of integration that often come with M&A. Bringing a small company into line with the larger partner’s systems on everything from HR to IT can cost vast amounts and the end result often falls far short of a well-oiled machine. Integration can be particularly challenging when large corporates acquire startups as the two function so very differently. While some institutions may want to acquire a startup without integrating it into the main firm this is difficult when accounting regulations force larger owners to treat the newly purchased company as part of the wider group, and in doing so enforce the same restrictions, processes and corporate governance that make in-house innovation so challenging in the first place.
When the ultimate aim is innovation minority stakes may be a more effective way of incentivising both parties. Rewards generally depend on capital growth, but there’s no reason why earn out couldn’t alternatively be based around achieving innovation goals such as development milestones or successful product launches.
And the secret to success?
Our study identified five key points of tension between startups and corporates when it comes to negotiating a successful collaboration. Balance these for the best chance of motivating both parties and delivering valuable innovation:
The extent to which an SME can keep its original culture versus how much it must be controlled by the larger partner is a fraught issue that cuts to the heart of collaboration. This goes much deeper than a clichéd clash of corporate suits and startup hipsters and is about how working culture function at its best.
For those startups who are not yet regulated, approaches to risk can be very different, with the compliance responsibilities of large organisations in conflict with the approach of the most dynamic SMEs. However many slightly more mature startups have already realised this can put them at a disadvantage when it comes to working with corporates and have comprehensively considered the regulatory issues impacting their business before they approach banks for investment.
Over and above the obvious need to negotiate a fair financial settlement consider how any conflict in motivation can play itself out down the line. For example one party may be seeking a fast turnaround while the other is interested in long-term value.
Understandably for an industry still recovering from trust issues sparked by the 2008 financial crisis, one of the biggest sources of concern over startup collaboration comes from risks to the larger party’s brand. Reputational threats add an extra dimension to all other risks - escalating the drama of a data breach or regulator’s fine in the way that only a PR crisis can.
The need for central brand control suggests a degree of conformity that goes against the desire to retain an SME’s autonomy. For fintech consumer brands, loss of independence and conflicting alignment with the new parent company can also undermine hard won identity and goodwill.
On the one hand the larger company will want to maximise the tax efficiency of its investment by claiming R&D relief and to do this will push for a bigger stake. In contrast the SME’s individual shareholders will want to retain a sufficient equity interest for each of them to qualify for Entrepreneur’s Relief.
Reconciling these two conflicting objectives can be particularly challenging when there are a number of individual shareholders, for the simple reason that there is less equity to go round.
Recent years have seen a considerable shift in exit strategies. Fast-growth tech-powered startups are no longer designed to build up to an IPO, but a corporate sale, as seen in the decade’s lowest global IPO rate in 2016.
The popularity of minority stake purchases, rather than full acquisitions, might suggest financial institutions are getting wise to these short-term exit strategies, and understandably wanting to buy continued development potential, rather than IP alone. However for an entrepreneur, minority stakes are not designed to replace an attractive exit. One solution may be to structure earn out around sustainability of the company and succession planning, rather than trying to lock individuals in for an unenforceable time period.
The potential benefits of collaboration could scarcely be clearer. Since 2008 fintech startups have sprung up to solve the needs of an industry in flux – advanced analytics to transform everything from payment technology to risk management.
Combined with the experience, customer loyalty and financial power of established financial institutions collaborations between the two have the potential to create valuable innovation that spills over from individual firms to the wider economy, helping UK financial services stay ahead when it can ill afford to fall behind.
Other industries facing disruption could do well to learn from this tale of joining forces with the competition.