As the token industry continues to mature, so do the opportunities for token project M&A. In particular, strategic buyers are increasingly active in this space as they seek to expand their operations and pivot toward new business lines. As is characteristic in highly regulated and emerging industries, though, there are numerous legal issues that ought to be considered and resolved in order to make an M&A transaction in the token space successful.

Interest in M&A grows

While it may not have been clear to token industry participants in 2017, it should now be abundantly clear in 2018 that US federal and state securities regulators are of the view that token offerings, given the typical fact patterns under which many are conducted, are generally securities offerings. This is particularly so for token offerings that are conducted to raise capital in lieu of more traditional equity or debt financings.

Despite greater regulatory pressure, the token economy continues to grow. While token projects are reported to have raised US$5.6 billion in 2017, they have raised US$6.3 billion in just the first quarter of 2018 alone and this is gradually translating to an increase in M&A transactions. According to PitchBook Data, the emerging blockchain industry has produced 88 completed M&A transactions since 2010.

M&A among exchanges and alternative trading platforms has been particularly active this year, as they push to become fully regulated crypto exchanges under the FINRA and the SEC. In February, US payments start-up Circle announced that it is acquiring cryptocurrency exchange Poloniex for US$400 million and, in June, US cryptocurrency exchange Coinbase announced its intention of acquiring securities dealer Keystone Capital for an undisclosed amount.

Given the highly regulated nature of token project business models, many of the financial regulatory considerations that accompany M&A transactions involving a financial institution may apply. These considerations range from conducting focused regulatory due diligence to obtaining appropriate regulatory licenses, registration and approvals.

Due diligence faces complex issues

Token projects that are acquisition targets present a host of complex issues when it comes to due diligence. Many projects were founded by entrepreneurs and technologists who, while often highly innovative and technically competent, are not as steeped in the complex legal, compliance and regulatory challenges that face fintech companies. Furthermore, their risk-reward calculus as start-up founders may have led them down a risk-taking path that a mature company would not have pursued.

Acquirers should be sure they understand the culture of innovation upon which many start-up token companies were founded and conduct due diligence appropriately. Fintech start-up targets are often not without their regulatory issues, but a token due diligence investigation should be calibrated to fully assess whether these issues are both quantifiable and manageable in light of the potential upside of an acquisition.

Regulatory hurdles

In the context of regulatory authorities, there are numerous registrations that may need to be made, or licenses, charters, non-objections or approvals that may need to be obtained prior to conducting business in the token space. For example, many token companies may be operating as money transmitters under federal or state law. This may require them to register with FinCEN or obtain money transmitter licenses from one or more states.

Some states, such as New York, have virtual currency-specific licensing and regulatory regimes.

In other contexts, some token businesses may involve the extension of credit. As with money transmission, the licensing regime for lending outside of the bank or credit union context is administered by state regulatory authorities that, in various instances, may require a particular token project to obtain lending licenses.

Strategic buyers try a new approach

Strategic buyers in the token space may also pursue other structures to accelerate, but still manage, their exposure to the token economy. One increasingly popular approach is to form a joint venture whereby a mature corporate contributes capital to the joint venture and a start-up fintech company contributes intellectual property and talent.

Joint ventures can be structured in numerous ways and can include subsequent fundraising by way of debt, equity or tokens, or options for either party to acquire equity from the other party's parent entity. Parties contemplating a joint venture should be mindful of conducting due diligence and reverse due diligence, and consider fully the regulatory implications both for the joint venture and the controlling parent companies, prior to forming a joint venture.

M&A outlook

As the token industry continues to mature, opportunities for M&A transactions will continue to abound. Start-ups will seek exits, and infrastructure players in a fractured market will be consolidated and absorbed by more efficient market leaders. And in a bid not to be left behind, established market players will leverage their existing client bases to pivot toward token exposure.

In navigating these transactions, however, it is important to remember that token technologies, while novel and potentially revolutionary, are not immune from the fundamental legal, regulatory and compliance frameworks that apply to business, and in particular financial services business, more generally.

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