Before Investing In A Fintech Company: Due Diligence Steps For Foreign Investors

The economic landscape in Nigeria has changed dramatically with the growth of emerging financial technology (FinTech) companies. These FinTech companies are redefining the way financial services are delivered, offering tailor-made solutions such as digital banking, payments, lending, FinTech, insurtech, investech, and cryptocurrency investments. Their growth is fueled by many factors, including an increase in internet penetration, a shift from traditional banking services, an increase in e-commerce service delivery, and a youthful, tech-savvy population eager to embrace modern financial tools.

With over 100 million internet users [1]and a rapidly evolving market, the Nigerian FinTech industry offers opportunities for foreign investors attracted by the potential for high returns. Despite the promising nature of FinTech services, investing in these dynamic companies requires a thorough understanding of the complexities involved and great care to ensure informed decisions are made, and potential risks are minimised.

Why Due Diligence Is Crucial For Foreign Investors

In 2023, investors – majorly foreign investors - lost $70 million in investment funds to failed FinTechs.[2]  Pivo, a Nigerian FinTech serving small supply chain businesses, announced its closure just a year after raising over $2.6 million from investors due to internal conflicts among the founders.[3] Similarly, a cross-border payment platform that raised $2 million to expand its services failed due to mismanagement of resources and poor strategic planning, leaving investors questioning why these issues were not flagged earlier.[4] Another notable case is Payday, which faced turmoil only six months after securing $3 million in funding. Allegations surfaced that the founder paid himself an exorbitant salary of $15,000 monthly while the company struggled financially. Further controversies arose as customers accused the company of fraud after their accounts were restricted without explanation.[5]   Although these companies shut down for varying reasons, venture capitalists contend that many of the failed startups received funding without adequate due diligence and the fact that investment decisions were rushed.[6]

The examples reveal that inadequate due diligence of the FinTechs’ governance, risk management, technology, and compliance structures significantly contributed to the failures of these investment decisions.

Key Areas of Focus in FinTech Due Diligence

The recent FinTech failures highlight the importance of due diligence in FinTech investments. Below are some of the key due diligence steps:

1.     Legal due diligence

a.          Corporate structure verification: It is important to ensure that the FinTech company has a solid corporate structure. A review of the company’s ownership and management structure provides investors with a secure foundation. Some of the documents to review in this process include a certificate of incorporation of the main entity, affiliates, or subsidiaries of the company, founder’s and shareholders agreements, memorandum and articles of association, and any post-incorporation documents.

b.        Review Corporate Governance Structure:  For FinTech companies, compliance with corporate governance standards is important because these standards promote transparency and accountability. Investors should ensure a solid corporate governance framework that ensures accountability, transparency, problem-solving, and fair decision-making at all levels. Documents to determine the integrity of the company’s corporate governance structure include a list of board members, the board charter, company bylaws and constitution, all board resolutions, minutes of meetings, etc.

c.        Review compliance with legal and regulatory requirements: Investors should thoroughly review FinTech companies for compliance with all relevant legal and regulatory requirements to ensure compliance with industry standards, minimize risk, and take care of legal and financial matters. Investors should request copies of all licenses, permits, approvals, certificates, authorizations, applications or registration requests obtained or requested by the Company and documents related to non-compliance issues. Investors should request information regarding any breaches by employees of legal and regulatory requirements, details of potential regulatory sanctions, and information on existing or potential disputes with employees, customers, or suppliers.

d.        Review of All Material Contracts: Reviewing material contracts is essential to assess any agreements that may impact the company’s financial health, operational obligations, or legal exposure. These contracts can reveal existing liabilities, third-party relationships, and potential risks that could adversely affect your investment. Some key agreements to review include Joint venture and partnership agreements, credit agreements, material agreements with major customers or suppliers, employment agreements with executives, bonds, agreements that may have any monetary impact on the company upon termination, contracts with restrictive covenants, etc.

e.        Intellectual Property Portfolio Review: Intellectual property (IP) is an important asset for any FinTech company because it protects the company’s innovation, technology, and assets. Unless there is a special agreement, the IP usually belongs to the author, but this can cause problems when the property is developed by employees, contractors, and other third parties. For FinTech companies where technology and software are the core of the business, protection of company exclusive rights to IP is essential. Without clear IP rights, investors may face disputes over technology use, claims of infringement, or loss of competitive advantage. Some key documents to review include a list of all registrations or applications for registration of intellectual property, a list of employees, consultants, or service providers who have not signed agreements that protect the company’s intellectual property rights, Licensing agreements, assignment of inventions agreement, confidentiality agreements, obligations regarding third-party licensing or assignment, allegations of IP infringement.

f.           Review of Employment Data: Reviewing basic employee data helps investors assess a company’s willingness to attract and retain top talent, which is needed in the FinTech industry. Some relevant documents include a list of key employees and compensation data, employment policies, copies of employment contracts, details of employment disputes, documents that reflect the employee benefit plan, etc.

g.         Review of Fundraising History: Examining the company’s fundraising history and capital structure offers insights into its financial strategy and any existing obligations to shareholders or investors. This review helps investors understand the company’s liquidity, debt structure, and potential dilution risk. Essential documents to review include Agreements about the issuing of ordinary shares, preference shares, debt securities, and other investment offerings.

2.     Financial Due Diligence

This is one of the most important aspects of the investment process. It helps investors assess the financial health, profitability, and growth of FinTech companies, as well as the risks of financial instability. Here are some important steps of due diligence:

a.     Review the company’s financial statements: Investors should review the company’s financial statements for at least the last three years. This includes the balance sheet, income statement, and cash flow statement. [7]Key elements to watch include revenue growth, operating costs, interest rates, and cash flow.

b.    Review tax and other financial liabilities: Investors should review the company’s debt and principal obligations and investigate any issues, such as hidden debts or outstanding debts, that may affect the company’s ability to meet its financial obligations.

c.     Review financial forecasts and business plans: Investors should thoroughly assess the company’s financial forecasts, including future earnings, growth plans, and the underlying assumptions. Evaluate whether these projections are realistic, considering the company’s past performance and prevailing market conditions.

3.     Technology Due Diligence

Technology is at the heart of every FinTech company. Due diligence on the technological aspects helps investors understand the company’s innovation capabilities, infrastructure, and potential risks related to data security or technological obsolescence. Some areas to review include:

a.     Platform and software architecture review: Assess the technology infrastructure, including software architecture, scalability, and ability to manage user growth. Review specifications, code libraries, and third-party platforms or integrations used.

b.     Monitor compliance with cybersecurity measures: Evaluate the company’s cybersecurity policies, practices, and procedures, given the sensitivity of financial information. This includes reviewing past security breaches and steps taken to mitigate future risks.

c.     Check data protection compliance: Check the company’s compliance with Nigerian data protection laws and international standards to ensure it meets its legal obligations regarding user data.

4.     Operational Due diligence

Operational due diligence helps assess a company’s internal processes, management team, and ability to effectively implement its business model. Some areas to review include:

a.     Review the business structure and go-to-market strategy: Review the company’s business structure, including customer acquisition strategy, revenue generation model, and long-term sustainability plans.

b.     Management Team review: Assess track record, FinTech experience, and ability to deliver on company vision. The strength of the management team is often a determining factor in FinTech success.

c.     Company Operating Procedures Review: Review the company’s standard operating procedures (SOPs) for product development, customer service, and financial management and identify all possible deficiencies.

CONCLUSION

Due diligence is essential for foreign investors looking to invest in Nigeria’s vibrant FinTech industry. The failure of many FinTechs highlights the need to carefully consider the governance structure, risk management systems, regulatory compliance, and governance arrangements of the Company. The due diligence steps outlined in this article are not exhaustive, the industry is rapidly changing and ensuring proper monitoring of due diligence areas can significantly reduce risk and increase the potential for long-term investment success.

At La Peritum Law Practice, we specialize in guiding investors through the complex legal and regulatory terrain of Nigeria’s FinTech sector. Our team offers tailored due diligence services, ensuring that your investment decisions are informed, secure, and aligned with the highest standards of governance and compliance. For inquiries, please email us at enquiries@laperitum.com or click here to contact us directly.

[1] Statista “ Total number of internet users in Nigeria from 2017 to 2024” https://www.statista.com/statistics/1176087/number-of-internet-users-nigeria/ <accessed on November 18, 2024>

[2] Samson Akintaro “After raising over $70 million these Nigerian startups shut down in 2023” https://nairametrics-com.cdn.ampproject.org/v/s/nairametrics.com/2023/12/28/after-raising-over-70-million-these-nigerian-startups-shut-down-in-2023/?amp=1&amp_gsa=1&amp_js_v=a9&usqp=mq331AQIUAKwASCAAgM%3D#amp_tf=From%20%251%24s&aoh=17320246649904&referrer=htt”s%3A%2F%2Fwww.google.com&ampshare=https%3A%2F%2Fnairametrics.com%2F2023%2F12%2F28%2Fafter-raising-over-70-million-these-nigerian-startups-shut-down-in-2023%2F  <Accessed November 18, 2024>

[3] Ibid

[4]  Grateful People “ The downfall of prominent FINTECH Firms in Nigeria:  A cautionary tale of mismanagement and absence of GRC. https://www.linkedin.com/pulse/downfall-promising-fintech-firms-nigeria-cautionary-tale-pepple-ryxmf?utm_source=share&utm_medium=member_android&utm_campaign=share_via  <Accessed November 18, 2024>

[5] Ibid

[6] Ibid

[7] ArightCo “Preparing Your Company’s Financials For Investor Scrutiny” https://www.arightco.com/blog/prepare-company-financials-for-investor-scrutiny <accessed on November 18, 2024>