Despite the recent market turbulence for cryptocurrencies and associated high profile scandals, investment in Web 3.0 assets continues as investors look to take advantage of depressed valuations and corporations continue to develop their Web 3.0 & Metaverse strategies in order to protect their brands, IP rights and business lines in this new, shared virtual environment.
We are seeing an increasing number of investors interested in acquiring rights and assets in the Web 3.0 space. In addition, as more companies become exposed to Web 3.0 as an incidental part of their main business, this is likely to become another class of assets to be dealt with as part of the M&A process.
We have identified five issues to think about when investing into Web 3.0 opportunities.
The old rules don't apply
Corporate control of the Web 3.0 projects can be a challenging concept. Unlike traditional businesses with boards of directors and clear governance structures, Web 3.0 projects are often (to a greater or lesser extent) decentralised and autonomous organisations that aim to provide underlying users with a sense of ownership and a role in decision making (weighted based on token holdings). As there is (deliberately) rarely a controlling token holder, investors should be aware that governance rights of the underlying projects (including those of the founding organisation that an investor may be backing) can be limited and the future direction of the project itself may be driven by the collective user base.
Related to this, the very nature of blockchain technology means that none of the conventional ownership and proof of title rules apply around things like state-run public registries, physical ownership of certificates of title, company books and records or evidence of transfers of title. Instead, it is necessary to dig into the underlying technology and see who or what is actually on the ledger (and respective stake sizes).
In addition, as much of the potential return associated with Web 3.0 projects will likely be through appreciation of underlying tokens, investors backing projects may consider negotiating upside by acquiring rights to subscribe for future tokens at a discount (rather than, or in addition to, traditional equity-linked protections in the founding organisation itself).
Actually, some of the old rules do still apply
Whilst the underlying Web 3.0 projects themselves may be decentralised and "on chain", many of the key players involved in these projects (including the founding organisations and early stage investors) have traditional corporate structures and investing in these entities will present many of the same legal issues affecting other types of businesses and these will also need to be addressed as part of the investment process. Examples of this will include corporate holding structures, employees, contracts with suppliers, banking and financing arrangements and so on. All of this will still need to be diligenced and usually warranted as part of the process.
Many Web 3.0 businesses and especially those involved in trading crypto currencies and other crypto assets, as well as many web-based gaming businesses, may be subject to varying degrees of regulation in the jurisdictions in which they are based and/or operate, but regulation is still playing catch-up in this space. Depending on the jurisdiction, the present regulatory position is often not clear-cut and will need to be analyzed in line with any future regulatory changes envisaged by governments and regulatory bodies. Regulators are taking an increasingly hawkish approach towards things like advertising, promotions and celebrity endorsements. Rules around data handling and data privacy will also need to be complied with.
Know Your Customer
A major challenge for investors is to satisfy laws and regulations around KYC, anti-money laundering and sanctions when investing in an asset class designed to promote anonymity and decentralization. It may not necessarily be clear and transparent as to whom you are dealing with and who actually owns the assets in question. This is further complicated when money needs to change hands and banking payments need to be made on closing a deal. There is also the issue of reputational risk and the danger of inadvertently transacting with undesirable counter-parties. In light of these risks, investors should engage advisers experienced in diligencing Web 3.0 and blockchain assets.
Valuation and Exit
Obtaining conventional valuations of Web 3.0 assets is a challenge and this, in turn, makes it more difficult to obtain conventional acquisition financing for most transactions. The issues around deducing title and ownership and the unconventional nature of the assets involved also makes obtaining effective security another issue to be tackled.
The exit process for investors can also be very different to traditional investments. In general, tokens associated with a Web 3.0 project can be listed on cryptocurrency exchanges much earlier than a traditional business would seek a public offering. However, investors will often be subject to very lengthy lock-ups (up to three years in some cases, as compared to the traditional IPO lock-up of 90-180 days). Understanding and negotiating a clear path to liquidity will be essential for any investor.
A key consideration on any transaction is the governing law of the relevant acquisition/investment agreement and the jurisdiction or forum for any dispute resolution. This is normally most relevant to any claims under the agreement, for example for an indemnity or breach of warranty and their eventual effective enforcement through the courts against the breaching party. In a world where everything exists somewhere in the cloud, these issues only multiply and need to be properly considered and structured early on, so that you are not left high and dry chasing a virtual counterparty.
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This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.
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