“It is a wild wild west out there right now; there’s no framework” – Vanessa Grellet, Managing Partner of Aglaé Ventures at Permissionless 2022
The M&A scene in the crypto market is relatively young. Nevertheless, the industry has witnessed an ever-growing number of deals over the past few quarters. While the crypto M&A industry is still evolving, analysis of the current state of the industry can give readers a basic framework and thought-starters to comprehend this nascent phenomenon.
Market conditions favor a Crypto M&A boom
In the past several months, the entire crypto market has weathered storm after storm, which, although not necessarily started by Luna’s collapse, was definitely exacerbated by said collapse. Nevertheless, many seasoned Crypto Believers remain hopeful, as true innovations are born in crypto winters, learning from the past and paving the way for the next crypto summer.
As the market retreats from the high-yield gold rush, innovators must develop sustainable innovations with real use cases, such as decentralized identity solutions or blockchain security and protocol audits, making the crypto market, or the general Web3 industry as a whole, more appealing to institutional investors.
Institutional investor’s appetite for engagement in crypto manifests in many forms, including building a dedicated team to develop solutions in the crypto space (for example, KBank’s Kubix), investing in crypto tokens (an emerging area still under consideration by some regulators), investment into crypto native VC funds (such as Pantera Capital), and conducting Merger & Acquisition transactions (“M&A”).
Despite being a staple in the TradFi industry, M&A in the crypto market is a relatively new but robust phenomenon. According to Blockworks, M&A activity in 2021 tripled to 180 deals from 59 deals in 2020, and the industry already has seen over 92 deals in the first half of 2022. Many industry experts believe that industry participants will witness even faster growth of M&A activity over the next year as crypto winters present an opportunity to shop for companies or projects at a very low valuation.
Crypto M&A helps accelerate innovation within the industry
At its core, decentralization promises the elimination of intermediaries, and Crypto Believers see this as a very important evolutionary step in our civilization. With the industry being in its early days, full decentralization requires a massive attempt to build necessary infrastructures, develop appealing products and services, recruit communities, and unite ecosystems. For these to happen, innovation within the Crypto industry must occur not only for Crypto Believer’s hedonism or altruism but also for economic and financial reasons.
As many people believe that innovation is a way out of this crypto winter, M&A can accelerate the rate of innovation within the Crypto space expanding the possibility for innovators to get incentivized for their endeavors, which is especially important during this turbulent time. More M&A activities in the space create a positive feedback loop for more innovation. In addition, having M&A as one of the exit goals, innovators are required to think about the monetization, economics, and risks of their projects early on, giving the innovation landscape the ability to withstand shocks in the long run.
What types of M&A can the industry expect?
Traditional reasons for M&A typically fall into four categories, corresponding to that industry’s life cycle: capability acquisition, market access & customer acquisition, promoting economies of scale, and market consolidation.
M&A objectives by industry life stage
Source: Beacon VC internal analysis
Despite the shrinking market capitalization during crypto winter, many Crypto Believers think the market is still in the early or growth stage, meaning that most upcoming M&A activities within the crypto space will be for capability acquisition or market access.
Strategic Motives behind M&A in the Crypto Market
Strategic motives seen in crypto M&A transactions can broadly be categorized by who and whom the acquirer and target are (Enterprise vs. Protocol). To clarify, Enterprise refers to companies with a conventional equity structure (either TradFi or CeFi), managing the organization using a centralized top-down approach, while Protocol refers to Decentralized Applications (D’Apps) or decentralized autonomous organizations (DAOs) with governance tokens representing ownership in a decentralized protocol.
The list of strategic motives below is a sampling of what the market has seen, and is by no means meant to be totally conclusive.
Overview of Crypto M&A transaction motives
Source: Beacon VC internal analysis
Gateway
Given regulatory uncertainties, especially for DeFi, not all enterprises are ready to offer on-chain DeFi products or services, but many see the opportunity to capture the value created in the crypto space. Enterprises looking for a less risky way to engage with the crypto market are eying infrastructure provider/ enabler play, which is achievable through acquiring existing infrastructure, blockchain enablers, or CeFi companies. The types of services that will be provided by enterprises for the crypto industry include wallet and custodian services, auditing services, or blockchain-as-a-service, similar to what AWS does for Web2. Paypal’s acquisition of Curv is a great example of this strategy.
CeFi companies can also be acquirers, especially large CeFi exchanges looking to enter new jurisdictions. The target would likely be existing CeFi exchanges with local licenses and hopefully good relationships with regulators. FTX’s acquisition of Liquid Group, then rebranding it to FTX Japan, reflects this strategy.
Innovation Leapfrogging
Innovation happens fast, often faster than blockchain-native CeFi companies can keep up. Acquiring frontier protocols allows companies to leapfrog their competition. In fact, many industry experts expect that CeFi exchanges to be the most active acquirers. Coinbase, for instance, has made more than 20 acquisitions since its inception, accounting for over $800 million in acquisitions.
Traditional enterprises are also developing a clearer picture of their long-term strategy and crashing the protocol acquisition party to accelerate innovation. For example, eBay recently acquired NFT marketplace KnowOrigin as a part of its ‘reimagine eBay strategy’.
Real-world Capability Cultivation
Successful decentralized protocols rely heavily on their communities to push out innovations and build infrastructure. As these projects tend to scale rapidly, many lack sufficient resources to handle the ecosystem.
Many successful protocols that are cash-rich may take crypto winter as an opportunity to develop internal capabilities for the next crypto summer, by acquiring traditional companies to develop real-world capabilities. The acquisition target for these protocols would likely be an existing vendor or supplier to that protocol, as the community already has buy-in for the value that the target is able to generate. Sandbox’s recent acquisition of Uruguayan tech firm Caulit is a great demonstration of the attempt.
Synergy Building
As previously discussed, successful projects place high importance on their communities and the platform’s ability to maintain the community. During crypto summer, investor goodwill is high, and funding is easy to come by. When investor money is tight, however, projects and their communities turn to each other in the hope of sharing resources and growing their footprint in a more cost-efficient manner.
The acquisition motive for synergy can take many forms. One can be product-driven similar to Uniswap’s acquisition of Genie, an NFT marketplace aggregator, to complement its existing NFT liquidity pool – Unisocks. Another could be efficiency-driven similar to the Rari-Fei protocol merger to create a mega $2B liquidity pool.
Possible Structures of Crypto M&A
There is still very limited disclosed information on the deal structure, therefore the structures described below are solely based on market observations and internal analysis. In addition, there are still several challenges in executing a crypto M&A, and there is no standard playbook. In general, however, the Equity/ Token Direct Acquisition is the default method of M&A for its relative simplicity for all types of M&A motives, while Token Swap and Token Merge happen exclusively within Protocol-Protocol acquisition.
Level of control associated with transaction structures
Source: Beacon VC internal analysis
Equity/ Token Direct Acquisition
The direct acquisition method involves purchasing a controlling stake of the target’s equity or governance token, usually aiming to acquire total operational and directional control of the target. The process is executed similarly to traditional M&As, where both parties agree on the transaction price, draft legal documents, execute the agreements, and transfer the securities (or tokens).
Unlike traditional M&As, there are still several challenges in crypto M&A such as token valuation, legal recognition of governance tokens as an acquirable asset, governing jurisdiction, and the absence of a legal entity for many crypto protocols. With these complexities, it is not surprising that the deal structure for direct acquisition will vary greatly, depending on the specific challenges of the deal.
Token Merge
Token merge happens when the acquirer and acquiree merge to form a new entity and issue a new token. Under this structure, both parties have approximately similar bargaining power, knowing that each party cannot succeed without the other party’s strength. The aforementioned Fei-Rari Merger is a great example for this case. Token holders of Fei and Rari would exchange their respective tokens for a new TRIBE token, under the project name FeiRari.
Some other remarkable token mergers include the WRAP-PLENTY token merge into PLY to provide a more comprehensive all-in-one DeFi experience on the Tezos blockchain. More details on the merge mechanics are available here.
Token Swap
Token swap usually happens when the acquirer has a larger market capitalization compared to the target, and is looking to acquire smaller projects to complement or help complete its current product or service suite. Unlike total acquisition, the acquirer wants to allow the target company autonomy to operate and innovate. To put it in simpler terms, as Cointelegraph has put it, token swaps can be viewed as a crypto partnership on steroids, to drive the stickiness of the main ecosystem. TNC’s, a blockchain network company, announcement of 4 token swap transactions is an example of this pursuit.
Executing token swap transactions requires multiple smart contracts to manage both parties’ tokens staking into each other’s platforms, or through a shared wallet. The swap itself is a smart contract design problem, but the real challenge happens pre-transaction, similar to the token merge structure, as successful conclusion of the deal involves an extensive community buy-in program for both parties’ stakeholders, not only to align at the financial level, but also to align on project directions.
Some Areas with Still More Questions than Answers
There are still many questions in the crypto M&A space that need to be answered. Most remaining questions are related to the execution of transactions, since there is still limited understanding of blockchain economics, and an unclear regulatory framework surrounding the space. Below are some of the biggest questions by stage of transaction that deal practitioners are trying to answer.
Pre-transaction
Valuation: How to value the project as a basis for acquisition?
At the moment, there is no definitive approach to value crypto-based companies for general investment or M&A, creating tremendous difficulties at the negotiation table.
Some of the methodologies being used to uncover ‘fair value’ of the project include:
- Market Approach – use comparable tokens and respective market price/ capitalization ratios;
- Cost Approach – approximation of input cost to create that specific token or project as a lower bound of valuation range;
- Income Approach – discount the future economic benefit or utility of such protocol at an ‘appropriate’ discount rate; and
- TQM or Quantity Theory of Money approach – approximation of equilibrium market capitalization value in the future, discounted to estimate the present value of the project.
These approaches are inherently subjective by nature, and the characteristic of tokens in each project also brings tremendous complexity. For a deep dive into crypto valuation, follow the link to EY’s report on the valuation of crypto-asset or Crypto.com’s guide to crypto valuation.
Utilization of on-chain transparency: How to best leverage the abundance of on-chain data for deal-making?
On-chain data promises to help investors make smarter and more well-informed decisions. However, only a handful of investors really understand how to mine insights from the blockchain. Most investors lack the right tools to conduct on-chain due diligence, and further development of the market requires investors to explore how best to leverage on-chain data.
During-transaction/ Deal-making
Agreement drafting and enforceability: How to ensure that the transaction is legally enforceable and minimizes counterparty risk?
The difficulty of enforceability arises from the discrepancies in how different jurisdictions recognize digital assets or DAO entities, or the lack of recognition in several jurisdictions. Cambridge Judge School of Business provides a deeper analysis of the legal and regulatory framework of different nations. In addition, many institutions are subject to anti-money laundering regulations, requiring that any transactions or activities be free of potential money laundering activities. As decentralized blockchain transactions are anonymous in nature, such institutions may be unable to participate in these transactions.
Legal practitioners and deal makers have been trying to popularize provisions, which protect both parties, including adverse materials, definitions of digital assets, and agreement termination clauses. Bloomberg Law has published a great analysis piece on crypto drafting trends.
Means of payment and volatility hedging: How to shield parties from the volatility of digital currency as means of payment?
While there is strong demand to use digital currency as means of settlement for crypto M&A (either for tax, transaction speed, or any other reasons), the high volatility within the market prompts both acquirer and target to question how to best shield their position. At the current stage of the market, there aren’t many cost-effective hedging options available, even for institutional investors.
Post-transaction
Integration of technologies and communities: How to ensure successful post-merger community and technology integration?
Many M&A transactions ultimately fail due to a lack of compatibility between entities. Integrating two blockchain projects and work processes is a major problem, as currently there is no standardization between projects. Another problem is how to best handle the two communities, whose interests and passion for the projects may not fully align.
Closing thoughts – the beginning of beginnings
With the industry learning more about crypto M&A, we hope that industry participants are working to close the industry’s understanding gap in good faith and for the sake of innovation, and not in an exploitative mindset.
While many people hope that decentralization would become one of the most prominent turning points of mankind, there are several pieces of evidence suggesting that M&A activities can adversely affect the rate of innovation in a monopolistic or oligopolistic market environment. Acquirers must strive to remember that these transactions must be done for the sake of value creation for all stakeholders, and in pursuit of the betterment of society. Only with the joint hands of institutions and innovators to lay the groundwork and create meaningful solutions, the pursuit of decentralization dreamworks can be realized.
Author: Woraphot Kingkawkantong (Ping)
Editors: Krongkamol Deleon (Joy), Wanwares Boonkong (Pin)