Acquisitions in industries related to cryptocurrency and blockchain technology exploded in 2021 in comparison with the preceding two years. Early data suggest that 2022 will be another record year for these acquisitions. This is not surprising as blockchain technology is being adapted to more business use cases. Also, take into consideration the price volatility spurring a “crypto winter,” and it is easy to see why 2022 may shape up to be a buyer’s market.
In previous articles we discussed three considerations for buyers (linked here), and in this article we highlight three things that every seller should consider when trying to sell digital technology.
Put Your Best Foot Forward
Even the most interesting digital product will only sell if it is priced correctly. It should not come as any surprise then, that companies that fail to clearly present the value proposition of their products will have a hard time finding buyers willing to pay a fair price for the product. With this firmly in mind, sellers should prepare for a sale by considering what may be attractive to a buyer or risk undervaluing their assets.
Buyers will have different expectations based on the assets’ functionality and how they will integrate into the buyer’s existing business, but all buyers will want to understand what it is that they are purchasing and will want to have confidence that the purchased assets do not harbor any hidden surprises. Sellers should be prepared with a clear explanation of the technology—how it operates, how it differs from other products in the market, and how it makes users’ lives easier. This is frequently done by preparing a technical whitepaper explaining the assets. Second, because the regulation of digital assets is not uniform across jurisdictions or asset classes, sellers should be prepared to explain why the assets have not been created or used in ways that could create a potential regulatory penalty or liability for the seller, buyer, or users of the product.
This second point is a point of tension for many digital asset creators. Often, digital assets are inspired by the desire to “cut out the middle man” or to improve efficiency. The bureaucratic state does not make a good bedfellow for this philosophy. But, sellers need to reconcile this dichotomy in an articulate way or face a lower purchase price from risk-averse buyers. That does not always mean that sellers must dedicate all of their available resources to seek out and comply with every regulation that could conceivably apply. It does mean that sellers should have a reasoned basis for their regulatory posture and not turn a blind eye to obvious compliance obligations.
One approach here is to conduct an internal audit of regulatory compliance before the point of sale to identify any material weaknesses or problems. That provides the opportunity to redress an issue (or direct the narrative around the issue) before it is raised by the buyer. Another, complimentary approach, is to document regulatory compliance activity on an ongoing basis and prepare to support positions taken (especially if the seller takes the position that a regulatory obligation does not apply), including by way of research memoranda or legal opinions, where warranted. Using this approach, a risk-averse buyer can understand what the seller has done and why, rather than fret about unforeseen skeletons in the seller’s closet.
Tax Consequences May Be Surprising
A traditional approach for sellers is to push for a company-level sale, rather than a sale of the company’s assets. This is intended to secure capital gains treatment on the sale proceeds. Often, however, buyers are leery of acquiring a company together with its historic liabilities. So, the tax consequences of a sale are usually less straightforward than simply applying capital gains rates. Instead, sellers should consider the tax consequences of selling each individual asset of the company, including the company’s digital assets.
The federal tax treatment of these assets may vary—in some instances those assets may yield capital gains, but in others (particularly where the assets are “self-created” or are treated as inventory) the sale may result in ordinary income and be taxed at higher rates.
Further, there may be state taxes applicable to the sale. Each state has its own unique set of tax laws, and a sale may be subject to income tax, sales taxes, or other transfer taxes. States generally do not impose sales tax on intangible assets, but there are exceptions. For example, Washington imposes a retail sales tax on the sale of certain digital assets, including some types of blockchain-based assets.
Sellers should work closely with their tax advisors and deal team to model the tax-effect of the transaction and avoid any surprises.
Sale Structure Should Protect Your Interests
Lastly, the structure of a sale can help put value in the seller’s pocket and protect from unnecessary risks. Under ordinary circumstances, sales can often be structured in ways to reduce or eliminate some types of tax. But, the menu of options for sellers of digital assets may shrink in some cases, particularly if the buyer intends to fund some portion of the purchase price with cryptocurrency or other digital assets.
Corporate reorganizations present an interesting example. Corporate mergers and other reorganizations can often be classified as tax-free if a significant percentage of the purchase price is composed of securities issued by the buyer. This can be a great approach for some parties, including some sellers of digital assets, but is not a great option if the purchase price includes digital assets. Digital assets can disqualify the transaction because they do not necessarily qualify as “securities” for tax purposes (even if they look like securities under federal securities laws). Further, their price volatility can also change the ratio of “securities” versus non-securities in the purchase price, depending on when the value of the assets is measured, and cause an ostensibly tax-free reorganization to be treated as taxable.
Deal structure should also protect the seller from risks. As illustrated by the recent “crypto winter,” the value of digital assets can change rapidly. If the market for the seller’s assets declines or evaporates, buyers may be prone to abandon the deal. A better approach would be to include purchase price adjustments, or even break-up fees, to prevent the deal from becoming economically unreasonable.
In short, structuring options should be evaluated closely to be sure that the deal structure actually provides the expected benefit.
This article is provided for informational purposes only—it does not constitute legal advice and does not create an attorney-client relationship between the firm and the reader. Readers should consult legal counsel before taking action relating to the subject matter of this article.