South Africa has a highly developed financial services system generally serving the middle to upper end of the market.
However, the low penetration of these services at the lower end of the market coupled with the customer opportunities presented by the high penetration of mobile phones as well as the underserved SME sector, has created a fertile space for fintech innovators to disrupt the larger, traditional financial services providers.
Ryan Rodkin, PwC transaction services director, says: “As the fintech industry in South Africa matures, high-growth companies which have proved to have a viable concept and track record have become targets for acquisition by both financial services trade buyers and financial buyers.
“As a practice, we have seen an increase in the number of fintech transactions in recent years, including the investment in Entersekt by Rand Merchant Investment Holdings and Nedbank and Investec Asset Management’s investment in the wiGroup (Entersekt and wiGroup were the joint winners of PwC’s Vision to Reality Awards for high growth emerging companies in 2014).”
Some of the key risks to be considered in making a fintech acquisition include:
* Frequently the intellectual property (IP) of the business is held in a separate offshore entity and licensed for use in South Africa. Therefore, it is important to gain an understanding of the corporate structure of the target to ensure that you are acquiring the underlying IP.
As relatively small companies, many fintech companies are still reliant on a few key individuals (generally the founders) to continue driving the business forward. Deals need to ensure alignment with these individuals in terms of driving value and the ultimate objectives for the transaction or investment (for example: exit) as well as there being a need to address the risk presented by this reliance in terms of succession planning.
As start-ups, many fintech companies still have a high level of client concentration risk. Losing any of these key clients is likely to have serious implications for the profitability and liquidity of the company in the short term, which in turn could threaten its longer-term sustainability. There is also a risk that the company may be overexposed to a particular industry.
As with many small companies, fintech companies are often not fully compliant with the country’s tax legislation. This can range from minor areas of non-compliance, such as errors in calculating employee tax, to more significant breaches. The impact of this non-compliance needs to be considered in pricing and structuring any deal.
Since many fintech companies are in the early stages of growth, they do not have a sufficient staff complement to adequately implement a system of internal financial controls, increasing the risk of errors and fraud. The buyer should consider the cost of having to implement these controls.
Some fintech companies are part of a larger group and have been set up to develop a specific solution or application. The product could be housed in a legal entity, but some of the operating costs could be covered by the parent company or another related party (i.e. there could be shared office space, finance and human resources teams and management’s time could be split between a number of entities). Therefore, it is important for the buyer to gain an understanding of the cost structure of the target as a stand-alone entity and how it would operate once independent of the vendor.
Fintech companies often do not adequately comply with the requirements of IFRS. Among other things, they may not have appropriately treated the development costs of the IP. Depending on the treatment, either the development costs in the statement of comprehensive income or the capitalised IP on the statement of financial position could be overstated.
Due to the lack of historic track record and the changing nature of a young business, it is difficult to prepare reliable cash flow forecasts, making the use of the discounted-cash-flow (DCF) approach in valuing the business challenging.
Tertius van Dijk, PwC corporate finance director, explains: “These issues with fintech companies add to the complexity of pricing the transaction. Ordinarily, our preferred approach to value a company is to place primary reliance on the income approach and to apply a DCF model to the company’s forecasts. However, for fintech companies (which are still in the high-growth stage of their business life cycle), the level of uncertainty in longer-term cash flow forecasts is very high. It is equally difficult to formulate an appropriate discount rate taking into account the inherent risks and uncertainties in the business.”
The other two generally accepted approaches to value a company, the net assets approach and the market approach, present their own challenges notes Jeffrey Levin from PwC Transaction Services. “The net asset approach does not adequately consider the fintech company as a going concern and still in its high-growth phase and consequently does not capture the goodwill in the business. The market approach can be problematic because many of the companies are either not yet profit making or their current profit levels are not reflective of their level of future expected profits. Consequently, using a profit multiple may not be meaningful.”
In practice, a revenue multiple is often applied to value a start-up or high-growth emerging fintech business, especially where the business is not yet producing a mature level of sustainable profits, even though this approach has its own challenges. A key to applying this approach successfully is to gain a proper understanding of the comparable companies and transactions in the market that you intend to use in determining the market multiple and to ensure that they are as closely aligned to the company being valued as possible.
The following are considerations that impact the adjustments to the observed market multiple applied in a valuation:
* Strength of the management team and their experience in the financial services/fintech industry;
Level of client concentration / key client dependency, strength of relationships and clients’ own outlook;
Distribution channels and the current and prospective routes to market and its ability to effectively address and tap into these different channels;
Barriers to entry into the specific service offering. For example, high development costs, capital expenditure and working capital requirements or regulatory barriers;
Level of competition, uniqueness of the technology and global scalability; and
Ability to reliably forecast higher revenue growth rates and the supporting cost base (which is largely fixed).
Rodkin notes that an important step in valuing a fintech company is to perform a thorough due diligence of the company and the market in which it operates to gain a proper understanding of its specific business drivers, risks and opportunities. Thereafter, proper advice in terms of negotiating the transaction and structuring the legal and commercial aspects of the transaction to ensure alignment between all parties is crucial.