Cryptocurrency and M&A Transactions
If you tuned in to the Super Bowl last year, then you probably saw Coinbase’s 60-second commercial featuring a colorful QR code bouncing around on your screen. If you are a normal person, you might have rushed to your phone to scan the QR code and look up what Coinbase is. If you are like me, after your friends screamed “free bitcoin,” then you might have thought about the increase in mainstream popularity of cryptocurrency and how it might translate to your job as a mergers and acquisitions attorney. No? Just me? In any event, over the last few years, the rate with which M&A deals have been funded by cryptocurrency has more than doubled – partially due to the COVID-19 pandemic and the shift to a remote working environment. Today, almost all major university endowments and many hedge funds now hold digital assets as part of their portfolios. As the widespread use and ownership of digital assets will only grow from here, the M&A world needs to prepare for cryptocurrency transactions – whether deals are funded by cryptocurrency or the target company owns digital assets itself.
What Is Cryptocurrency?
Though there is no single all-encompassing definition for cryptocurrency, it is generally accepted that cryptocurrency is a digital money that is not issued by a central authority and is built using blockchain technology. Blockchain uses software algorithms and a ledger-like system known as distributed ledger technology (DLT) across multiple computers to manage and record transactions. Each computer on which the transactions are stored has a copy of the main ledger and, if one copy is changed, the whole ledger is so updated. In this way, the technology works similar to a Google Doc. In simple terms, blockchain uses a Google Doc–like system to log transactions that result in changes in ownership of digital money. One example of how this all works is bitcoin, the most widely known cryptocurrency. Bitcoins are created by “mining” them. Miners (most often computers) work to solve a computationally intensive math problem and the one that solves it first is awarded bitcoin. The transaction is then linked with those of similar import, grouped together as “blocks,” verified by other users and added to the blockchain. Cryptocurrency allows for secure, peer-to-peer transactions on a blockchain, which could eliminate the need for traditional third-party intermediaries, such as banks, to process electronic funds transfers. This could provide for more efficient execution of traditional third-party processing of electronic funds transfers and may be beneficial to M&A parties who are often transferring very large sums of money.
The major benefits are easy to see, such as immediate execution of transactions, elimination of certain third-party involvement, transparency and security. Additionally, however, adding cryptocurrency M&A to your repertoire may help reach a new client base as it can appeal to digitally focused clients. Further, this could help firms prepare for a future legal landscape that could involve digital currencies issued by central banking authorities. The use of blockchain technology also offers additional efficiencies and solutions that are critical for the fast-paced world of M&A.
Considerations in M&A Transactions
If a potential client retains an M&A attorney to assist them in a transaction that either involves acquiring a target that owns or deals in digital assets, or uses cryptocurrency as part of the deal consideration, there are many matters unique to such transactions that M&A attorneys should consider. Below is a non-exhaustive list of things to consider if involved in a cryptocurrency-related M&A transaction.
- Purchase Price
If using cryptocurrency to fund a deal, parties must consider its price volatility when drafting documents and pricing the deal. Cryptocurrencies involve greater risk of price volatility than traditional fiat consideration for M&A transactions (i.e., the U.S. dollar). Large price swings in a matter of hours are still common for cryptocurrencies; thus, M&A attorneys need to consider this when representing parties in a cryptocurrency M&A transaction. Luckily, there are several options at drafters’ disposals in order to hedge the risk of price volatility for their clients.
Instead of traditional cryptocurrencies, the parties could agree to fund the deal with stablecoins, which are cryptocurrencies backed by traditional fiat currencies like the U.S. dollar. Since most stablecoins are backed by traditional reserve assets, sellers would not have the need to quickly redeem them post-closing for fiat currency. This is not to say that stablecoins carry no risk. For example, in May 2022, the price of one stablecoin known as TerraUSD fell from $1 to as low as $0.10 in one weekend. TerraUSD is an example of an algorithmic stablecoin, which relies on investor trading activity to keep its price at $1. Its price collapse was the result of a series of large withdrawals resulting in investor panic. On the other hand, the price of asset-backed tokens, another broad type of stablecoin, are much more likely to remain at $1 because they are backed in full by some type of stable asset like the U.S dollar. Therefore, if considering stablecoins as an option, parties should be aware of the risks that come with algorithmic stablecoins and may want to consider using stablecoins backed by reserve assets.
M&A lawyers may choose to include a collar to protect parties from significant price fluctuations. A collar sets the price range to which something may fall before the parties are obligated to agree to certain adjustments. In a cryptocurrency transaction, a collar could be structured to focus on either the (1) target exchange rate; or (2) purchase price. Thus, for example, if the U.S. dollar to bitcoin exchange rate or the value of bitcoin to be used to fund the transaction shifts by a certain percentage, a collar could obligate the buyer to include more bitcoin or supplement the cryptocurrency with regular fiat currency.
Another option is to include a conversion schedule in the main transaction document. The parties could stipulate various options with which to fund the deal (e.g., USD, bitcoin, ethereum, etc.) and specify agreed-upon conversion rates or purchase price values should the buyer choose to use one currency over another. This provides immense flexibility as the parties would be permitted to choose the consideration leading all the way up to closing. Parties could then choose to avoid certain cryptocurrencies if they are exhibiting abnormal price fluctuations.
Building a “pause period” into the deal would also give the parties flexibility. Since the price of cryptocurrencies can change immensely within short periods of time, giving parties the right to pause the scheduled closing for a few days to allow any price fluctuations to subside ensures the transaction will close at the agreed-upon value.
Earn-outs may also be used to help supplement any shortcomings in the purchase price. As these provisions are generally used to bridge gaps between the parties in their respective valuations, they are well-suited for a currency that may be subject to drastic price swings. For example, an earn-out could be structured to require more consideration post-closing if the value of any acquired crypto-assets skyrockets.
Additionally, a material adverse effect carve-out could be drafted to include in its definition of material adverse effect a significant change in the value or trading volume of the relevant cryptocurrency. The parties may also wish to have the ability to terminate the deal completely, which can be accomplished by including the same language in a termination provision.
Further, the parties should consider how the cryptocurrency used as payment would be handled by the seller post-closing. The seller could either keep the cryptocurrency as a store of value or immediately exchange it for fiat currency to avoid the price volatility of cryptocurrency. In any event, sellers should consider the additional obligations, including additional reporting requirements, should they choose to hold onto the cryptocurrency. The transaction document (or a separate agreement agreed to by the parties) should set forth the applicable post-closing conversion to fiat currency should the seller choose this option.
Lastly, M&A sellers’ attorneys should consider including a lockup provision in the main transaction document. A lockup provision is most often used in deals involving public companies and securities offerings to prohibit immediate sales of securities following an offering in order to prevent market disruption. In cryptocurrency M&A deals, however, a lockup provision could be employed to prohibit the buyer from trading or otherwise disposing of the cryptocurrencies with which the parties intend to fund the deal. This would give sellers additional protection since buyers would not be able to risk transaction funds on any cryptocurrency exchanges or other potential transactions, which helps preserve the purchase price.
- Due Diligence
Due diligence is one of the most important considerations in any M&A transaction, and the scope largely depends on the type of company the seller operates. The due diligence process helps both parties confirm the accuracy of information and representations, allowing the parties to be on the same page leading up to closing and ensure the transaction matches up with the parties’ expectations. In an M&A transaction involving cryptocurrency, the uncertain regulatory nature and unique considerations surrounding cryptocurrency make the due diligence process all the more important. Thus, M&A attorneys need to be extremely thorough both in the due diligence process itself and in document drafting in order to protect their client’s interests.
At a minimum, initial due diligence should tease out both parties’ involvement with cryptocurrency and/or digital assets in general. Buyers need to have complete information on whether and to what extent the selling company: (1) holds any cryptocurrency (and if so, in what manner it holds cryptocurrency); (2) has entered into any cryptocurrency-related agreements; (3) accepts any type of payment or exchange of funds in cryptocurrency; and (4) has taken all corporate action necessary to authorize any of the foregoing. Depending on the information provided by the seller, buyers will then want to make sure appropriate provisions are included in transaction documents that confirm compliance with applicable laws. Evidence of compliance may include copies of licenses, policies and procedures used to mitigate risks of regulatory sanctions or penalties.
Where the target is itself a crypto-firm, further due diligence is necessary to ensure that it has complied with all applicable regulations. First, the lack of bright-line guidance on the applicability of federal securities laws (FSLs) to cryptocurrency exposes crypto-firms to potential enforcement from the Securities and Exchange Commission. While FSLs certainly apply to digital assets that qualify as securities, it has been difficult to get a straight answer as to what those may be. As of now, cryptocurrency-related products like bitcoin and ether are not subject to FSLs, while digital tokens are treated as securities. Buyers should ensure deal documents and disclosure schedules address transactions that could potentially be considered sales or offerings of securities and draft appropriate representations and indemnification provisions related thereto.
Second, the Office of Foreign Assets Control, the U.S. agency with primary responsibility for enforcing U.S. sanctions, has taken an interest in cryptocurrency transactions. Crypto-firms face significant risk given most cryptocurrency transactions are anonymous or pseudonymous, which means firms could be unknowingly engaging in sanctioned transactions. To address this risk, acquirer due diligence should include a review of the target’s sanctions controls and policies or procedures related to gathering information on transaction participants. If the seller lacks such controls, M&A attorneys representing buyers should include longer indemnification provisions and stronger representations and warranties in transaction documents related to potential sanctions.
Third, the U.S. Commodity Futures Trading Commission considers cryptocurrencies commodities under the Commodity Exchange Act, triggering its anti-fraud and anti-manipulation authority. Therefore, buyers need to confirm targets have appropriate policies addressing matters regulated by the commission. Fourth, the Financial Crimes Enforcement Network (FinCEN) has taken the position that its regulations regarding “money transmitters” apply to administrators or exchangers of virtual currency that accepts, transmits, buys or sells a cryptocurrency for any reason, excluding for the purchase of goods. Therefore, due diligence should also include an analysis of whether the target’s activities apply to and require licensing under FinCEN regulations and any other state money transmission laws. Additionally, under FinCEN regulations, money service businesses (MSB) (including those offering currency dealing or exchange) are required to maintain an anti-money laundering (AML) program. Therefore, buyers may need to conduct AML due diligence to determine whether: (1) the target is an MSB; and, if so, (2) its AML program is sufficient; and (3) it complies with any applicable regulations at the state level. For example, the New York State Department of Financial Services has promulgated both AML regulations and a cryptocurrency-specific licensing regime known as the “BitLicense” for New York virtual currency businesses. M&A attorneys representing buyers should strongly consider including AML and licensing-related representations and warranties in transaction documents.
Lastly, due to the mining required to acquire certain cryptocurrencies, buyers’ attorneys should consider conducting environmental due diligence on target crypto-firms. As mentioned earlier, cryptocurrency mining is extremely energy-intensive. Proof-of-work cryptocurrencies, such as bitcoin, require the use of large computers to solve complicated math problems in order to acquire cryptocurrency. This incentivizes using computers that generate higher levels of power, which results in a greater amount of electrical waste. Thus, if you are purchasing a target company that holds or transacts in cryptocurrency assets, environmental due diligence may be prudent to determine whether it has been involved with any mining activities or environmental sanctions or enforcements.
- Storage and Security
As cryptocurrencies are digital assets, they are often stored in digital wallets. These digital wallets can be either “hot,” which are storage sites offered most often by online exchanges like Coinbase, or “cold,” which are not linked to online exchanges and house cryptocurrencies offline (e.g., flash drive). Blockchain transactions in which one party receives payment in cryptocurrency can be identified by the parties’ wallet addresses. Thus, it is imperative to obtain accurate information about the wallets to confirm successful payment.
Additionally, if you are representing a buyer who is purchasing a company that owns digital assets, you will want to make sure you get specific information about how and where all digital assets are stored and whether there are adequate safeguards in place to protect against the loss, theft or tampering of those assets. Since hot wallets are stored online, they are likely more susceptible to hackers and other malicious actors. In this case, target companies should either have sufficient insurance to cover any loss to these assets or make stronger representations and indemnities to cover the same. Parties should also seek out information on any limitations on hot wallet storage and withdrawal, which can be accomplished in the due diligence period.
Moreover, digital wallets may only be accessed through public and private “keys” (i.e., passwords). Unfortunately, if these passwords are lost, it may be impossible to access the cryptocurrency stored on the wallet. Not only will buyers (if purchasing a company that holds crypto-assets) and sellers (if receivingfunds in cryptocurrency) need to conduct further due diligence on whether these keys have been shared with parties outside the scope of the transaction, but they will also need ensure the keys are securely maintained. Representations can be built into transaction documents that confirms the: (1) keys have not been widely disseminated; (2) keys are saved on backup drives to prevent total crypto-assets loss if one copy of the key is lost; (3) identity of any custodian of the crypto-assets (if not being stored with the target company). Further, due diligence should also focus on the accuracy of all information regarding digital wallet addresses and public and private keys so that sellers make sure they will be paid at the end of the transaction, and buyers can confirm they will be able to access the digital assets post-closing.
- Ownership of Digital Assets
Since the traditional exchange of wiring instructions and bank account information may be replaced with exchanging digital wallet addresses, parties should consider including a representation that confirms the wallet addresses are correct and the cryptocurrencies and wallets are owned by the respective parties. The wallet addresses must be accurately stated – one small error and you will not be able to access and use the cryptocurrency connected therewith. Another option to ensure the ownership of digital assets is to utilize certificates of verification. Similar to incumbency certificates, these could be used by the parties to verify the accuracy of digital wallet addresses and should be signed by an executive officer of the company making the representation.
- Tax Implications
According to the Internal Revenue Service, digital assets including cryptocurrencies are treated as property, not currency, for federal tax purposes. Thus, all tax considerations applicable to property apply to cryptocurrencies. Depending on the structure of the transaction and the classification of the digital assets, buyers should be aware of potential transfer tax liabilities that may arise as a result. If the value of a party’s cryptocurrency increases before closing, then a gain must be recognized on the acquisition, measured by the difference in tax bases of the cryptocurrency and property received. Further, cryptocurrency is a capital asset, making it subject to capital tax rates depending on the length of ownership.
Since federal tax rules place limits on how much non-equity funds a seller can accept before a deal must be classified as a taxable event, it may be difficult to satisfy such requirements if sellers receive payment in cryptocurrencies, whose values are subject to extreme volatility. Because cryptocurrencies are treated as property, an M&A deal funded by cryptocurrency could be treated as a sale of property – not just selling the seller’s assets, but also the buyer’s cryptocurrency. Additionally, the U.S. Department of Treasury announced last year that businesses must report all transactions involving cryptocurrency that exceed $10,000 to the IRS. Thus, both parties must loop in tax attorneys to determine the extent to which they need to report details of and recognize capital gains or losses on the transaction, and to ensure they are complying with applicable tax laws.
As stated earlier, the term “blockchain” refers to the technology and Google Doc–like system used to track, manage and record transactions involving cryptocurrency. Primarily, blockchains are either public or private (with some other variations as well). A public blockchain is open to anyone with internet and has no restrictions to access. A private or “permissioned” blockchain includes permission restrictions and is usually only accessible by specific persons within an organization. When and if parties to an M&A transaction involving cryptocurrency hire a software team, they should also consider what type of blockchain to utilize. Permissioned blockchain DLT, which is often used for commercial applications such as banking, may be preferred for M&A transactions because only certain individuals with the requisite permission may access the ledger of transactions.
- Smart Contracts
Smart contracts, also stored and executed using blockchain technology, are a combination of software code, legal text and transaction parameters that self-execute obligations derived from outside agreements. The “drafter” still must outline the parties’ obligations in the smart contract, but once all parties confirm all conditions have been met, the contract executes certain obligations (e.g., payment) without the need for third-party intervention like a bank confirmation of wiring instructions. Smart contracts are useful for all situations except those in which require a large amount of human judgment; for example, the payment structure of a promissory note, post-closing movement of proceeds and offer letters are all ideal situations in which a smart contract would be beneficial. However, major documents such as purchase agreements are still better suited for human drafting. Further, only certain cryptocurrency blockchains allow for the use of smart contracts. Thus, if parties are dead set on utilizing smart contracts, M&A attorneys should be aware that this will limit the cryptocurrencies available to the deal.
Importantly, parties to an M&A transaction need to consider potential vulnerabilities of underlying smart contracts and draft around them to better allocate the risk associated with cryptocurrency M&A transactions. If the parties are interested in employing persons to code smart contracts for their transaction, attorneys will want to make sure they draft ancillary agreements for the coders to sign to allocate the risk to them in the event their smart contract(s) go(es) awry. Such ancillary agreements should include: (1) a provision requiring the smart contract to undergo an independent third-party audit; (2) a fail-safe mechanism so that the parties can terminate the smart contract and regain access to the cryptocurrencies if issues arise; and (3) strong indemnification provisions protecting the parties in case of a data breach or cybersecurity event. Since the development of smart contracts will be mostly out of M&A attorneys’ hands, it is imperative to consider drafting traditional, ancillary contractual agreements to mitigate adverse outcomes for the parties involved.
- Cybersecurity and Data Privacy
The state and federal landscape of cybersecurity and data privacy legislation is changing every day. Laws often give consumers various rights with respect to their personal data, and, in a blockchain transaction, parties would likely need to agree on a data sharing agreement before anything can be processed on the relevant blockchain. If such agreement is unable to be reached, blockchain participants will need to rely on strongly drafted representations that consent to having their data processed on the blockchain was obtained. On the other hand, using a private, permissioned blockchain could remedy these potential concerns. In any event, it would be wise to bring in cybersecurity and data privacy attorneys for both the due diligence and document drafting processes in any cryptocurrency M&A transaction.
While cryptocurrency’s usage in M&A transactions has grown exponentially over recent years, it still involves a great deal of risk, especially for larger transactions. Since every M&A deal is unique, there is no one-size-fits-all solution for cryptocurrency-related M&A deals. However, the current regulatory landscape and intricacies of cryptocurrency provide attorneys with a starting point for planning how to protect their clients’ interests. As more clients venture into the crypto space, more attorneys will have to acquire knowledge of the industry, and, as of now, it looks like cryptocurrency is here to stay.
Dustin M. Dorsino is an associate attorney for Bond, Schoeneck & King in Syracuse, New York. His practice focuses on assisting corporate clients with transactional matters, including mergers and acquisitions, and cannabis-related regulatory issues. This article appears in a forthcoming issue of NY Business Law Journal, a publication of the Business Law Section. For more information about this Section, please go to NYSBA.ORG/BUSINESS.
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