Crypto and blockchain in M&A: how to address issues around volatility, validity and valuation
Published on 30th Jun 2022
The value of crypto-funded deals has doubled over the last couple of years, but there are specific challenges for parties and their advisers to be aware of when using crypto or smart contracts
Given the amount of wealth accumulated in cryptocurrency form, it was only a matter of time before we saw disruption in M&A and other corporate transactions. The current downturn has emphasised the volatility of these instruments, but not wiped out their value. We are continuing to see crypto being used in corporate transactions – perhaps because holders wish to put the residual value to use, with the lure for the investee businesses that a later boost in value will be to their benefit.
As early as 2013, two companies were purchased using Bitcoin. Historically, the use of cryptocurrencies in M&A to settle the purchase price has been limited to fintech and crypto sector deals. There are signs this trend is spreading to a wider range of transactions with the value of crypto-funded M&A deals doubling over the last couple of years. But there are a number of legal considerations to bear in mind.
Cryptocurrencies: the basics
Cryptocurrencies (starting with Bitcoin) were conceived in the aftermath of the financial crash of 2008, as an alternative to currency issued by central banks. They were originally intended to be used for peer-to-peer payments, as a form of digital cash.
Cryptocurrencies use blockchain or "distributed ledger" technology (DLT) - a digital database of transactions and assets that is consensually synchronised across the network of participants so that all can see the same data and there is no single official version of the database. Blockchain systems structure data into blocks that are strung together with cryptography. The systems are structured so that it is nearly impossible to counterfeit or double spend a coin (explained further in our past articles on blockchain and cryptoassets.)
Not issued by any central bank, cryptocurrencies cannot be subject to institutional control. Their value (stablecoins aside) against fiat currency (that is, central-bank issued currency such as sterling, euros or dollars) has proved to be very volatile, because effectively, it is decided by market forces.
The resulting potential for sharp increases in value has led to cryptocurrency being treated as an investment asset, held for its potential to deliver a financial yield rather than as an alternative form of cash. Applications of cryptoassets have also extended into being used as tokens that can represent assets or services, not just money. A token may carry a right or entitlement to something such as a share of ownership of an off-chain asset, an entitlement to a share of profits, or a right similar to a voucher. New applications such as non-fungible tokens (NFTs) are currently an area of focus.
Consideration for a corporate transaction is likely to be in cryptoassets carrying monetary value.
Cryptocurrency as consideration
The principal reasons to use crypto as consideration are:
- Flexibility as to sale price: a vendor could choose to reduce the asking price in the hope that the value of the crypto will increase in future.
- Attractive investment: a vendor may see crypto assets as a way to diversify their investment portfolio; they are often seen as a hedge against fiat currencies, and may want to invest before they become more expensive.
- Secure payments: blockchain technology is sometimes perceived (perhaps incorrectly) to be more secure than traditional payment systems.
- Chance to embrace something new: a reputation as a trailblazer may stem from transacting with crypto, though in the current market an investor could be perceived negatively as a risk taker.
Downsides of using cryptocurrencies for acquisitions
Cryptocurrency prices are extremely volatile. In one week in May 2022, Bitcoin lost 20 per cent of its value and Ethereum lost 26 per cent. In late November 2020, one Bitcoin was worth about $20,000 but by mid-April 2021 it had more than tripled. It then dropped to $30,000 in mid-July before rising to more than $67,000 in November, halving again by mid-January 2022 and falling further to below $20,000 by mid-June. Between these peaks and troughs, there was considerable instability.
For an M&A transaction this is problematic as the parties need to agree a fixed fiat currency price and agree the rate of equivalence with the chosen cryptocurrency. If the exchange rate is fixed in advance of completion, either party may make a bad bargain as the actual rate is very likely to have changed by completion, potentially significantly.
If a vendor retains a holding in crypto they may need to pay for expensive crypto custodial services.
There are potential tax and fee downsides of transacting with crypto and lack of regulation may expose parties to money laundering or other criminal activity.
Crypto is not yet a trusted asset.
Cognisance of crypto
The vendor, purchaser and advisers must be well versed in cryptocurrency and its legal, tax and accounting implications. Drafting requires knowledge of the correct terminology, and the mechanics of closing transactions using crypto.
Setting the price
There are various solutions to fix the price volatility issue:
- setting a cap and/or collar around the exchange rate to be used (if as a result of this there is a gap, this can be covered with fiat currency);
- providing for the consideration to be paid in any of a number of specified cryptocurrencies, giving the purchaser flexibility to avoid one that is particularly volatile;
- permitting a period of delay while a cryptocurrency is volatile;
- providing for fiat currency to be used as an alternative;
- a hedging arrangement or a post-closing adjustment mechanism.
Cryptocurrencies do not amount to "cash consideration" as defined in the Companies Act 2006.
If shares are being subscribed for with crypto in a public company, a third party valuation report would need to be produced valuing the digital assets.
In all cases, the directors of the vendor, purchaser or issuer (having regard to their duties) will need to be satisfied with the value of the crypto. At a time when values are falling, this can may be more difficult, in which case the various mechanisms to deal with price volatility may be needed.
Documenting receipt and checking validity
Payee bank account details will need to be replaced with their cryptocurrency wallet address and a process established to verify the wallet.
It is important to note that transferring a wallet would not be appropriate. A wallet contains the private key that gives access to a crypto holding, rather than holding the crypto itself. The nature of keys (which in practice are a string of numbers and letters) means that the vendor could have kept a copy of it, and could therefore still access the purportedly transferred crypto. A transfer should always be of the cryptocurrency holding to the new holder, which will generate a new and unique private key in the recipient's wallet.
Taxes, fees and accounting
Fees for crypto transactions need to be built into transaction funds flows.
The tax treatment of, and accounting for, the disposal of the crypto asset should be considered but, in general terms, the disposal would trigger capital gains tax (for individuals) or corporation tax (for companies) on any chargeable gains realised.
For stamp duty purposes, HMRC's current view is that cryptoassets do not amount to either "stock or marketable securities" or "chargeable securities" meaning that no stamp duty or Stamp Duty Reserve Tax (SDRT) will apply to transfers of cryptoassets. However, where cryptoassets are given in consideration for the purchase of shares or chargeable securities this would count as "money’s worth" and a charge to SDRT would arise on the sterling value of the cryptoassets on the date that the charge arose.
How else might crypto impact M&A?
Due diligence: If the target holds crypto assets, due diligence will need to be undertaken to ascertain what assets are held, how they are stored (for example, hot/online or cold/offline wallets or using custodial services), their tax treatment, the terms of the storage provider such as withdrawal and transfer fees, security protocols for wallet keys and any insurance cover. Where the target is a crypto firm, due diligence should ascertain that it has all the required regulatory approvals (in the UK, all firms offering cryptocurrency services must register with the Financial Conduct Authority) and appropriate policies and procedures.
Warranties: Crypto assets may be covered by specific warranties in the sale and purchase agreement, including warranties relating to anti-money laundering and anti-corruption.
Material adverse change: If there is a MAC provision in the sale and purchase agreement, this may include a carve out for material changes in the value of cryptocurrencies.
Completion accounts: If there is a purchase price adjustment and balance sheet assets include cryptocurrency, consideration should be given to the accounting policies that will apply.
Funding conditions: If the transaction is being funded by cryptocurrency, the purchaser may want to withdraw from the transaction if the cryptocurrency's value drops below a specified level.
Smart contracts in M&A
Smart contracts are electronic instructions stored on blockchain and automatically performed (for example, payments made) when predetermined conditions are met. They have been mooted as suitable for use for earn-outs, loan note instruments, escrow arrangements and some transaction closings.
Smart contracts can be combined into more complex decentralised finance (DeFi) structures. Again, these have been proposed for use to fund acquisitions (for instance with a smart contract which can monitor the loan and release collateral when it is repaid). Entities (such as newco purchasers) could be set up using blockchain-enabled entity formation.
Advocates of these innovations cite benefits including removing human error, making transactions more secure and auditable, automating and expediting deal processes and reducing their costs. However, automating processes brings its own risk, crypto transaction costs are also subject to volatility, and the immutability of blockchain means that locked-down smart contracts need very careful design to ensure they will operate as intended, and potentially to allow for the unexpected with mechanisms such as a "kill switch".
With DeFi, the lack of involvement of a financial institution or intermediary from which to seek redress should things go wrong, combined with the absence of regulatory oversight or protections, may be a risk too far for some M&A parties.
As with all innovation, the potential benefits need to be balanced against the new challenges for transaction parties and their advisers.
Osborne Clarke comment
While we do not expect use of crypto to explode in terms of usage in M&A and other corporate transactions in the short term, not least due to the recent drops in value and global economic uncertainty this year, we do anticipate that there will continue to be a steady flow of its application for businesses in the crypto sector. That said though, a recent crypto target's sale was completed by Osborne Clarke with traditional share consideration.
Other sectors may slowly become more open to its benefits over time as trust in digital assets improves and if volatility reduces.
England and Wales is likely to become a leading jurisdiction and governing law for smart contracts and cryptocurrency financing, including in M&A, as demonstrated by the government and legal sector's commitment to these through the LawTech Delivery Panel's UK Jurisdiction Taskforce's consultation on crypto, DLT and smart contracts in English law (about which, see our Insight).
The UK Treasury has also announced an ambition to make the UK a global crypto hub so additional tax and regulatory measures are expected in the coming months.