Legal Briefing

Scottish fintech and VC funds: so much promise, so many pitfalls

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Finance, TMT | 18 May 2017

While fintech has generated a lot of attention in recent years, it is not actually new. From ATMs to contactless payments, technology has been influencing the financial sector and the way we interact with money for decades. So why the recent surge of interest and what has Scotland got to do with it?


In an age of digitalisation, technology is quickly redefining almost every aspect of our lives. The creation of smart devices serving as multi-functional tools enables consumer and business needs to be met easily and conveniently from virtually anywhere, provided you have an internet connection.

This development of technology within the financial sector means that traditional banks have to adapt to new technology or sometimes play catch up. With the Payment Services Directive 2 (PSD2) on the way, which is set to further shake up the financial services market, it is no wonder fintech is a hot topic.

The Scottish fintech market

Scotland has a strong tech scene, with a recent article by The Fintech Times suggesting that technology businesses now account for one in every eight firms in Edinburgh.

As the largest financial market outside of London, with a high concentration of asset management firms and banks, Scotland is in
a strong position to have a key role in the future of fintech.

With Scotland’s established financial infrastructure, fintech presents huge opportunity for the Scottish economy.

This, coupled with the wealth of leading academic institutions which are producing graduates in finance, data analytics, cyber security and from September 2017, the possibility of a masters degree in fintech itself, the talent pool that Scotland is nurturing is set to grow.

Indeed, Scottish universities have high volumes of spin-outs, many of which are in the technology and fintech sector. With Scotland’s established financial infrastructure, it presents huge opportunity and potential for the Scottish economy.

The Royal Bank of Scotland (RBS)’s recent launch of Scotland’s first fintech hub, together with incubators such as CodeBase and Techcube, should continue to foster greater collaboration across the wider market and support entrepreneurial development. This will bolster Scotland’s position nationally and abroad, helping to build better networks and encourage collaboration. While enhanced collaboration is something many developers in Scottish fintech are looking for, it is not something that is without challenges, particularly in a legal context.

Innovation

From a legal perspective, fintech is interesting – particularly when considering intellectual property and innovation. Fintech is largely about new ideas and developments in changing the way we interact with our money. The financial markets are heavily regulated, meaning that technological developments from within the traditional institutions are much slower than new tech companies, which are not subject to the same rigorous regulatory requirements that have developed rapidly over the last few years.

The vast consumer shift towards a digital world has meant that, in order to stay ahead in the financial sector and be relevant to consumers, collaboration with fintech companies is unavoidable. The tension when it comes to intellectual property is that it is often the core and most valuable business asset. So the idea of collaborating and sharing with the competition, in order to create products or services, is often approached with great caution.

It is still a chicken and egg scenario: if you are too protective of your ideas and are not willing to share, you run the risk that no-one wants to collaborate with you. If you are open and share everything with your competitors, the fear is that you put in all the work and someone else takes the credit by building something better on top of your idea.

Ultimately it is a balancing act and if Scotland’s fintech future is to be a successful one, market players are going to have to strike a balance in a way that does not stifle innovation. A lot of banks operate on legacy systems and arguably have been slow to innovate as customers have tended to have fairly sticky relationships. Fintech companies on the other hand are innovative and have disrupted this business model, and are able to effectively nibble away at the more profitable parts of the banks’ business.

A comparison can be seen in the pharmaceutical industry which has in recent years seen greater collaboration, M&A activity and even outsourcing to smaller biotech companies that have new innovative ideas, enabling more new drugs to be created cheaply and efficiently.

Turning back to Scottish fintech, it is through collaboration that banks get the benefit of accessing the innovative technology and the smaller tech firms benefit from the branding and reputation of well-established banks. Collaboration is a key ingredient which could accelerate Scottish fintech.

Open data

One of the biggest, if not the biggest, challenges in fintech is the idea of openness. Why? Because arguably the biggest and most valuable asset of the financial services sector is us as consumers, and more specifically our personal information. The financial services sector is sitting on a wealth of it, giving incumbents a competitive advantage.

The ability for businesses to store, analyse and process data as a result of digitalisation means that the financial services sector is sitting on a gold mine of data, waiting to be utilised by those who see its rich potential. Until fairly recently, the traditional financial services model has enabled banks to retain full control of the market. But as consumers become digital in their approach to financial matters, fintech companies can be agile in their response to market, and with PSD2 on the horizon, their potential to overhaul the way the market operates cannot be understated.

The UK’s Open Banking initiative and PSD2 will open up the market so that banks will no longer be competing solely with other banks. Under PSD2, banks are required to provide third parties with access to their data and infrastructure through open application programme interfaces (APIs), meaning that they can essentially build services and products on top of the banks’ infrastructure and data.

It is clear that those operating in the fintech market have a lot to be thinking about, particularly when it comes to data. With a little over a year before the General Data Protection Regulation (GDPR) comes into effect, the overhaul of the data protection regulatory environment is another key area that fintech market players need to be thinking about. As digitalisation of the financial sector increases so too do issues such as cyber crime and security, consumer protection, as well as anti-money laundering and market integrity for all those involved in the fintech sector (including the regulators). Notably, where any mishaps involve personal data, the hefty financial fines that are attached to breaches of the GDPR are something to be noted. Banking is built on trust, and a major data breach will substantially undermine an organisation’s reputation with its customers.

Change is afoot in Scotland. HM Treasury has recently announced proposals for RBS to facilitate an independent fintech fund for challengers entering the sector.

This could present major economic change and challenge to the traditional financial institutions. Traditional business models need to be adapted and change is appearing on everyone’s radar. Change is definitely afoot in Scotland; in addition to the creation of the RBS hub HM Treasury has recently announced proposals for RBS to facilitate an independent fintech fund for challengers entering the financial services sector. This is to be welcomed. Despite having quite a vibrant eco-system, many start-ups leave the Scottish market to benefit from a bigger pool of funding and investment. However, there is a range of investment and funding options out there that fintech businesses should be thinking about.

Incentivising venture capital investment in fintech

Venture capitalists typically invest in start-up or early stage businesses with high growth potential. Clearly it is a risky business – data released by fintech firm Ormsby Street in August 2016 suggests that while over 90% of small businesses survive their first year of trading, only 40% will still be standing four years later.

In order to whet investors’ risk appetite, venture capital investment comes with some attractive tax incentives, some of which are enhanced when you invest in the technology sector. Investment can be through venture capital trusts (VCTs) or other venture capital funds, or investors may choose to invest directly.

Venture capital trusts

Launched in 1995, VCTs are designed to boost investment in early stage companies by offering various tax benefits to compensate investors for the risks of venture capital investment. VCTs are usually listed on the main market of the London Stock Exchange, and investors subscribe for shares in the VCT, which invests the capital in qualifying portfolio companies.

Current tax reliefs for investors include income tax relief on their investment at a rate of 30% on subscriptions for new shares up to a value of £200,000 in each tax year, providing that the investment is held for five years. Exemptions from income tax on dividends from the VCT shares are also available, as well as exemptions from capital gains tax on disposal of the shares.

The VCT itself does not pay tax on dividends received from its investee companies but will be taxed on any interest received. It is also exempt from tax on chargeable gains on the disposal of its investments.

At least 70% of the VCT investments must be in qualifying investee companies. This is where the advantages of investing in the technology sector in particular come to the fore. For example, one of the requirements for a qualifying investee company is that the shares are issued within seven years of the first commercial sale of a product or service; however, this time limit is extended to ten years for ‘knowledge-intensive companies’. After seven to ten years of trading, a fintech company could be fairly well established and less risky than a start-up, but still qualify for VCT investment (subject to other limits on, for example, gross assets and number of employees). The detailed characteristics of a ‘knowledge-intensive company’ are specified in legislation, but virtually all early-stage fintech companies will meet the requirements.

A further advantage to VCT investment in the technology sector is that, while most companies are limited to £12m of relevant investments, the limit is extended to £20m for knowledge-intensive companies.

Other types of venture capital funds

A variety of other venture capital funds have invested in the Scottish fintech sector. In terms of legal structures, these will often follow the classic private equity model, which typically uses Scottish, English or offshore limited partnerships. These are set up as tax transparent private funds, meaning that no income, corporation or capital gains tax is payable by the fund itself. Instead, the UK tax authorities look through the partnership structure and partners are taxed on their share of partnership income arrived at in accordance with their profit-sharing ratios (which can be different from the ratios in which capital has been contributed). For capital gains tax purposes, partners are treated as owning fractional shares in the underlying assets. These funds can usually only be marketed to certain categories of high-net worth and sophisticated investors.

Enterprise Investment Scheme

If individuals invest directly in qualifying companies, they will also qualify for income tax relief of 30% (mirroring the VCT scheme) up to an annual investment limit of £1m, substantially more than the £200,000 limit in the VCT scheme. The investor should hold the shares for at least three years and cannot hold more than 30% of the ordinary share capital, issued share capital or voting rights in the investee company. As with the VCT scheme, investors will also be exempt from capital gains tax on disposal of qualifying shares. It is worth noting that this scheme is not available to anyone who is connected to the issuing company, eg employees or paid directors.

Risk capital in Scotland rose in 2014 to £244m, representing 90% growth over the previous five years.

Similar requirements to those which apply to VCT investee companies apply to EIS investee companies. Again, the age limit is extended from seven to ten years of trading and the lifetime fundraising limit from £12m to £20m for knowledge-intensive companies, thus incentivising investment in the technology sector in particular.

The Seed Enterprise Investment Scheme offers even more attractive tax incentives for investment in start-up companies, including income tax relief of 50% of the sum invested.

VC investment in Scottish fintech

According to a Scottish Enterprise report in December 2015, risk capital in Scotland rose by 20% in 2014 to £244m, representing 90% growth over the previous five years. Scottish Enterprise is an importance source of venture capital in the Scottish market. Its investment arm, Scottish Investment Bank (SIB), offers a number of types of fund investment to start-up, early stage and expanding businesses. A range of SIB funds offer between £10,000 and £1.5m of equity finance, typically committing on a co-investment basis alongside other investors. This represents an opportunity to attract private sector and international investment to Scotland; indeed, according to the last SIB annual review, it worked with over 50 corporate and VC funds based outside Scotland in 2015-16.

However, SIB is not the only VC investor in Scotland. Business Growth Fund, the result of collaboration between five of the big banks, has offices in Edinburgh and Aberdeen, with dedicated investment teams focused on Scottish targets. Other independent funds exist too, such as Pentech Ventures, which invests exclusively in technology companies. It has an Edinburgh base and has in recent years backed companies including Metaforic, a Scottish-based provider of security software to industries including mobile payment and mobile banking.

In addition to the traditional sources of funding, crowdfunding opportunities abound too. There are several examples of Scottish companies achieving great success with crowdfunding and online platforms will continue to play an important role in the start-up sector.

Nevertheless, despite positive indicators about the availability of early stage capital, only 3% of SIB investments in 2015-16 were in fintech (compared to 21% in renewables) so, although it has been the buzzword in financial services for the last few years, there is evidently still room for growth.

Conclusion

Scotland has a varied fintech sector which is still developing. Banks, VC investors and start-ups are recognising the potential the Scottish market has to offer and the creation of the fintech hub will hopefully be the missing piece of the puzzle, to help accelerate alternative finance in Scotland.

Funding is already available, with the promise of more to come as the government backs plans for RBS to become an independent fintech fund for new market challengers, and the existing tax incentives will continue to attract investors keen to capitalise on growth in the sector. As stakeholders look to enhance collaboration with a view to driving development forward, it looks set to be an attractive investment. Fintech in Scotland is definitely an area to watch.