Cryptocurrencies, digital assets, and blockchain-based technologies seem to show up everywhere. As the market for these products matures, new markets are emerging. Competitors, new entrants, and investors are acquiring the technologies and platforms themselves, or the businesses that developed them. The opportunity to acquire a new product or technology is exciting, but before signing the dotted line, buyers should consider the following three ways digital assets influence a potential acquisition.
Due Diligence
All types of digital assets present complex practical and legal issues. As a practical matter, integrating the target technology or product into the purchaser’s business structure is vital to the long-term success of the acquisition. With digital assets, this is easier said than done.
Commentators generally refer to the blockchain as if it were one standardized system. Yet, there is no universal technical standard applicable to digital assets. Each blockchain has its own standards and procedures, meaning that products and services build on different blockchain technologies are unable to communicate with each other. Buyers should carefully consider how acquired technology will integrate into their existing technology stack.
As with many new technologies, blockchain and associated innovations do not fit perfectly within legal and regulatory structures designed to address the problems of the brick-and-mortar economy. Regulatory regimes lag behind the advances made within the technology sector. In some cases this means uncertainty or unexpected compliance requirements. Buyers should carefully evaluate a target company’s past actions to identify areas with particular risks of regulatory noncompliance.
Key areas to consider are:
- Federal and state securities regulation;
- Commodities regulations;
- Banking and financial regulations, including money transmission laws and anti-money laundering;
- Intellectual property;
- Data protection and digital security;
- Privacy; and
- Tax.
An in-depth discussion of these areas is outside the purview of this article: follow us to receive future articles. [David Brandon; Bryce Parkllan]
Each acquisition transaction is unique. Buyers should consult with counsel to determine the appropriate scope of diligence based on the particular circumstances of the transaction. A well-drafted letter of intent will help identify and provide access to the right information, and a well-drafted purchase agreement can protect the buyer from the target’s past indiscretions.
Asset Valuation
Volatility is a hallmark of many cryptocurrencies. It is common for prices to fluctuate by 15 percent or more in the matter of hours. A sudden drop in value can undermine the expected value of a target company. Acquiring a company with cryptocurrency assets is not for the squeamish. But, there are ways to protect the value of a proposed investment. For example, robust provisions allowing for price adjustments can ensure that the purchaser is not overpaying. Alternatively, a purchase agreement may permit termination of the acquisition if the price drops below a stated level.
Another issue arises with digital assets that are difficult to value. Non-fungible tokens (NFT’s) are unique assets and are not always traded on an open market. Similarly, unproven or novel technologies are notoriously difficult to value. Purchasers may need to increase their diligence efforts to understand the value and commercial viability of these types of assets.
Transaction Structure
There is no “one-size-fits-all” approach to buying or selling a company. But, there are a few universal structuring choices. For example, should the transaction be structured as taxable or tax-free? As an equity sale or an asset sale? The answers to these questions dictate the federal income tax results for both buyer and seller.
Tax-free transactions are generally used where the sellers are not cashing out, but intend to continue in some role with the purchaser. This is usually accomplished by issuing equity in the purchasing company to the sellers. Federal tax rules limit the amount of non-equity compensation the sellers can receive in a tax-free transaction before it becomes taxable. It can be tricky to satisfy those requirements if the sellers expect to receive payment in digital assets or equity whose value derived from ownership of digital assets. Volatility in the value of the digital assets make it difficult, but not impossible, to determine whether the transaction will qualify for tax-free treatment.
In taxable transactions, conventional wisdom tends to bias sellers toward equity sales and purchasers toward asset sales. That convention likely holds true in most cases involving acquisition of companies holding digital assets, but the incentive for buyers may not be as strong in situations where the assets being acquired are not depreciable or amortizable (for example, cryptocurrency or NFT’s).
Traditional tax considerations are skewed further when the parties want to pay the purchase price using digital assets. Because cryptocurrencies are treated as property, a purchase made using cryptocurrency is treated as a sale of that currency. So, a taxable sale could result in a taxable gain or loss for the buyer, not just the seller.
Of course, non-tax considerations are at play here too. Poor corporate hygiene or regulatory noncompliance may cause a buyer to demand an asset sale, rather than inherit the skeletons in the target company’s closet.
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