Understanding FDD from Both Sides of the Table
Financial due diligence (FDD) is the process by which an acquirer develops a thorough, independent understanding of a target company's financial position, earnings quality, and hidden risks. Whether you are a fintech being acquired and need to prepare for the process, or a fintech considering an acquisition and commissioning one, understanding what FDD covers and how it is conducted is essential for managing the transaction effectively.
For the target company, FDD is frequently a more intensive experience than expected. It is not a re-audit of the accounts: it goes significantly further, examining the adjustments required to present a true economic picture of the business, identifying liabilities that may not be on the face of the balance sheet, and scrutinising every revenue assumption that underlies the deal valuation. For the acquirer, the FDD report is the primary input into the pricing model and the foundation of the representations and warranties structure in the sale and purchase agreement.
A fintech acquisition carries specific FDD considerations that differ from those in a traditional software or professional services deal. Regulatory capital requirements, licence obligations, deferred revenue treatment, and customer fund segregation all require specialist attention. This article covers the main workstreams of a fintech FDD, the working capital analysis and completion mechanics, and the red flags that lead to price adjustments or, in more serious cases, deal breaks.
Quality of Earnings: The Heart of Any FDD
The quality of earnings (QoE) analysis is the most important element of an FDD report. Its purpose is to answer a deceptively simple question: what does this business actually earn on a normalised, recurring basis, stripped of all the noise, one-offs, and management adjustments that the reported EBITDA figure contains?
The starting point is the reported EBITDA for each of the last three to five financial years. The FDD adviser then makes adjustments, with the objective of arriving at an adjusted EBITDA figure that represents the sustainable economic earnings of the business under normal operating conditions.
Upward Adjustments (Adding Back)
Items that reduce reported EBITDA but are genuinely non-recurring and will not recur under the new owner. These include: exceptional legal costs relating to a specific dispute that has now been resolved, one-off restructuring costs, the cost of a one-time system migration, founders' compensation above market rate that will be normalised post-acquisition, and excess rent charged by a related party that will revert to market rates on change of control.
Downward Adjustments (Adding In)
Items that inflate reported EBITDA and will become real costs post-acquisition. These include: below-market compensation for founders who were not drawing a market salary (which the acquirer will need to replace or fund), costs that were shared with related parties at below-market rates, and costs that were absent because the business has under-invested in compliance, security, or headcount that the acquirer will need to fund from day one.
For a fintech specifically, the downward adjustments often include regulatory compliance costs that are understated in the historical accounts because the company has been growing fast and compliance investment has not kept pace, and provisioning for expected credit losses on any lending book that may have been accounted for at rates below what the buyer's credit team considers appropriate.
Revenue Recognition Scrutiny
Revenue recognition is a persistent area of focus in fintech FDD because the revenue models are often complex and the judgements involved in recognising revenue can significantly affect the timing and amount of reported income.
Common revenue recognition issues in fintech FDD include:
- Transaction-based revenue: where revenue is recognised at the point of transaction, the FDD adviser will test whether all recognised transactions represent genuine economic activity and will look for patterns suggesting pull-forward of volume into reporting periods (for example, month-end spikes in transaction volumes that reverse in the following period).
- SaaS subscription revenue: recurring subscription revenue should be recognised ratably over the subscription period. Upfront recognition of multi-year contracts, or inconsistent treatment of contract modifications, will be identified and adjusted.
- Payment processing revenue: the gross versus net presentation of payment volumes is a significant issue. A company that presents payment flows gross rather than net of interchange and scheme fees will show a materially higher revenue number than the economic revenue earned. The FDD adviser will normalise this to net revenue for valuation purposes.
- Deferred revenue: any amounts received from customers in advance of delivery are deferred revenue and represent a liability, not income. FDD will ensure that deferred revenue is correctly classified and will assess the risk that historical periods overstated revenue by recognising deferred amounts prematurely.
Working Capital Analysis and Completion Mechanics
The working capital analysis determines the amount of net working capital that will be delivered to the buyer at completion. This matters because the deal price is typically struck on a cash-free, debt-free basis with a normalised level of working capital. If more or less working capital than expected is delivered at completion, the price is adjusted accordingly.
The Locked Box Mechanism
Under a locked box structure, the economic ownership of the target transfers to the buyer at a historic balance sheet date (the locked box date), which is typically the date of the most recent audited or management accounts. The deal price is fixed at this date, and the seller gives warranties that no value has leaked from the company (through dividends, intra-group transactions, or unusually favourable transactions with related parties) between the locked box date and completion. The buyer pays a per diem interest charge (the ticker) for the period between the locked box date and completion, compensating the seller for the economic value retained by the buyer during that period.
The Completion Accounts Mechanism
Under a completion accounts structure, the deal price is adjusted after completion based on the actual working capital, cash, and debt delivered at the completion date. The SPA includes an agreed accounting policy for preparing the completion accounts, and any deviation from the target working capital level leads to a price adjustment in the buyer's or seller's favour.
For fintech companies, the choice between locked box and completion accounts is meaningful. A fast-growing fintech with volatile working capital (large and lumpy receivables, significant customer prepayments, or regulatory capital movements) may prefer locked box because it gives certainty at completion. A more stable business may be indifferent.
Debt and Debt-Like Items in a Fintech
The identification of debt and debt-like items is one of the most important and most contested elements of fintech FDD. The starting point is straightforward: bank loans, lease liabilities under IFRS 16 (or FRS 102 Section 20), and drawn revolving credit facilities are clearly debt. But in fintech businesses, the list extends considerably further.
"Debt and debt-like items in a fintech acquisition routinely surface surprises. Deferred revenue is cash received but not earned; regulatory capital requirements are a structural cost of the licence; deferred consideration from a prior acquisition is a genuine liability. Each is a legitimate price chip if not identified early."
Fintech-specific debt-like items that FDD will examine include:
- Deferred revenue: amounts received from customers for services not yet delivered are liabilities. In a fintech with upfront subscription payments or pre-sold transaction bundles, deferred revenue can be material.
- Regulatory capital requirements: an FCA-regulated entity (payment institution, e-money institution, or investment firm) must maintain a minimum level of own funds. This capital is locked in the regulatory entity and cannot be freely distributed to the parent. The FDD will assess the regulatory capital position and identify whether the entity is adequately capitalised at completion.
- Customer funds obligations: payment institutions and e-money institutions must safeguard customer funds, either through segregation or insurance. The safeguarded funds are not assets of the company and should not be included in the enterprise value. If the FDD identifies any shortfall in the safeguarding obligation, this is a material finding.
- Deferred consideration from prior acquisitions: any earn-out obligations from acquisitions previously made by the target company represent debt-like items that reduce equity value.
- Pension obligations: for mature fintech companies, defined benefit pension obligations or legacy defined contribution arrears may represent hidden liabilities.
- Tax provisions: unresolved HMRC enquiries, deferred tax liabilities, or uncertain tax positions are debt-like items that will be assessed in the tax due diligence workstream.
Typical FDD Report Structure
Red Flags That Lead to Price Chips or Deal Breaks
Experienced acquirers and their advisers have a well-developed sense of the findings that are likely to affect deal pricing versus those that are structural deal-breakers. Understanding the distinction from the target's perspective helps CFOs decide which issues to disclose proactively and how to frame them.
Issues that typically lead to price adjustments rather than deal breaks include: accounting policy adjustments that change the reported EBITDA (these are expected and manageable), working capital shortfalls at completion if they are within the normal range of seasonal variation, and modest contingent liabilities that can be covered by appropriate indemnities in the SPA.
Issues that more frequently lead to material price reductions or deal breaks include: evidence of revenue recognition practices that overstate the economics of the business, a regulatory capital shortfall that requires the acquirer to inject capital immediately post-completion, customer fund safeguarding gaps that create regulatory liability from day one, a significant undisclosed HMRC enquiry or tax liability, and material related-party transactions that were not disclosed in the data room. The common thread in deal breaks is not the issue itself but the discovery that information was withheld or misrepresented: buyers will forgive problems that are disclosed and priced; they will not forgive surprises that emerge in due diligence.
Key Takeaways
- FDD is not a re-audit: it is a buyer-commissioned analysis focused on earnings quality, working capital, and hidden liabilities. It covers more historical ground and more operational detail than a statutory audit.
- Quality of earnings analysis adjusts reported EBITDA for non-recurring items, related-party distortions, and management compensation anomalies to arrive at a normalised, sustainable earnings figure.
- Fintech-specific FDD considerations include regulatory capital adequacy, customer fund safeguarding obligations, gross versus net revenue presentation, and deferred revenue classification.
- Debt and debt-like items in a fintech extend well beyond bank loans: deferred revenue, regulatory capital requirements, IFRS 16 lease liabilities, earn-out obligations, and tax provisions all reduce equity value.
- The locked box mechanism gives price certainty at an early stage; completion accounts provide post-completion adjustments based on actual delivery. The choice depends on working capital volatility and deal timeline.
- Buyers will forgive disclosed problems; they will not forgive undisclosed surprises. Proactive disclosure and, where resources allow, vendor due diligence significantly improve deal outcomes for sellers.
- Red flags that lead to deal breaks include undisclosed HMRC enquiries, regulatory capital shortfalls, safeguarding gaps, and evidence of revenue overstatement.
