Cryptoassets: What to look out for in your next M&A process

Cryptoassets are part of a growing asset class where a 40% valuation swing barely raises eyebrows. In this environment, what potential pitfalls should M&A professionals be aware of?

Now, more companies than ever are choosing to hold, transfer or trade cryptoassets. Although no longer new, cryptoassets remain a relatively novel feature of the mergers and acquisition (M&A) process. They can be highly volatile and the associated challenges are not always immediately apparent.

In this blog we discuss how the presence of cryptoassets in an M&A process can give rise to disputes, as well as the key considerations to make when they are held by a target company.

Where are they from and what are they for?

Cryptoassets are a digital representation of value or rights which can be created, transferred and stored electronically. However, one of the biggest challenges posed by these assets is the variety of forms they can take. Two defining features appear to dominate their classification as a cryptoasset – they are based on blockchain technology, and are cryptographically secure – i.e. encrypted. Well-known examples include non-fungible tokens (NFTs) and cryptocurrencies, like Bitcoin and Ethereum.

Given this volatile combination of a fluctuating value, married with a variety of forms, it is vital for the parties in the M&A transaction to consider several key factors throughout the M&A process:

• The source of the cryptoassets - This is of paramount importance to ensure businesses don’t fall foul of any laws or regulations. For example, buyers don’t want to be caught out by finding out a target company’s assets were linked to money laundering or any proceeds of crime.
• Why the target company owns cryptoassets - How are the cryptoassets used by the target business? Answering this can ensure businesses remain compliant with any relevant regulatory bodies and tax authorities. For example, if a UK target is involved in the trading of cryptoassets, it must be registered with the Financial Conduct Authority.

Valuing cryptoassets in M&A transactions

The headline price in any transaction, while often based on theoretical valuations, is the result of commercial negotiation between the parties. The actual purchase price payable is usually the result of the values of certain assets and liabilities (which can be based on measures, such as: what was reported by the target company; in accordance with financial reporting standards; or at a pre-set value as agreed between the parties) adjusted against the headline price. It is the same when the target company holds cryptoassets.

As an emerging asset class there isn’t a financial reporting category that serves as a ‘natural fit’ for cryptoassets. The International Financial Reporting Standards (IFRS) does not yet include any specific guidance on accounting for cryptoassets and nor is there a clear, widely accepted industry practice.

Depending on the form and use, cryptoassets can be recorded as:

• Cash or cash equivalent, though this is unlikely under the requirements of IAS 7;
• Financial asset other than cash, under IFRS 9;
  
• Inventory, under IAS 2;
  
• Intangible assets, under IAS 38;
  
• Prepayments.
  

Depending on the specifics of the Sale & Purchase Agreement (SPA), cryptoassets may appear in the transaction as cash, debt or working capital, with their value accounted for in a variety of ways.

So what can go wrong?

On top of the usual disputes and risks faced by the parties in M&A transactions, the nature of the cryptoassets may introduce further risks. These include disputes stemming from:

1. The variability in accounting of the cryptoassets

The variability in classification of cryptoassets in accounting can lead to different interpretations of the nature of the asset itself.

If not properly mitigated in the SPA, this can give rise to challenges both before and after signing. Parties in the M&A transaction should consider:

• Is the asset to be classified as net debt or working capital?
• How should its value at closing be recorded in any completion accounts?
• How should the complexities of IFRS 9 and its inherent judgements be navigated?

2. The volatility of cryptoassets

This asset class has largely been defined by massive fluctuations in value. The last 12 months has seen the value of 1 Bitcoin fluctuate between a high of £50,000 on 10 November 2021 and a low of £20,000 on 19 May 2021. Furthermore, there was a 48-hour window in May 2021 where the price of 1 Bitcoin plummeted by 41% - from £33.7k to £20k, before rebounding back to £26k.

This volatility calls into question the reliability of traditional valuation methods, such as Mark to Market.

The complexity in valuing cryptoassets is compounded by the fact that the fluctuation in the assets' value can happen despite there being little or no actual change in the underlying business.

3. Increased regulatory scrutiny

Target companies holding cryptoassets may attract increased regulatory scrutiny, over perceived links between cryptoassets and nefarious activities. Failure by the seller to disclose issues of this nature may trigger a warranty claim.

4. Compromised security and loss of assets

The rise of cryptoassets has moved lockstep with a heightened risk of security and the potential loss of assets. These risks range from large scale cyber-crime efforts from a sophisticated group of hackers, to misplacing the one-time private key for a digital wallet. Once lost it’s difficult to recover the funds in the account.

A few practical steps to take

The risks associated with cryptoassets in the context of M&A disputes are not insurmountable, and steps can be taken to minimise them. Parties engaging in deals involving cryptoassets should:

• Ensure they have a clear understanding of both the use of the cryptoassets in the target company and an agreement on how they should be accounted for;
• As always, draft the SPA clearly, detailing the agreement of the parties on how cryptoassets will be accounted for in any purchase price adjustment mechanism, as this avoids many disputes. This is particularly important given accounting standards and widely accepted practices are still emerging, so consistency with the reference accounts defined in the SPA may not be appropriate or even possible;
• Consider specialist support, either around accounting or the SPA drafting, particularly if experience in dealing with cryptoassets in the deal team is limited; and
• Obtain warranties that are linked directly to value, either of the assets themselves or purchase price to mitigate some of the issues around uncertainty.

That said, here’s one final point to remember: warranties are useful for flushing out additional disclosure from the seller— but the usefulness of such warranties are diminished, if breaching them would be insufficient to change a buyer’s view of the value of the target company as a whole.

Contact us

If you’d like advice on any issue around cryptoassets in your next M&A process, we’d be happy to help. Please contact Claire Jolly and Emily Dent.