December 6, 2018
By James Marshall, Deals Partner
Imagine partnering with a foreign company run by executives you’ve never actually met, or imagine crowd financing a new film even if it required a big budget? Many investors would shy away from such deals, feeling that the risks were too big or too ambiguous to take on. But given blockchain’s evolution in recent years, we’d be remiss to write off these prospects just yet.
Government and business leaders who aren’t already evaluating blockchain through a new lens need to be. The technology has been widely discussed, and much of the focus around its potential uses in M&A deals has thus far been around making the due diligence process more efficient. However, blockchain’s deeper potential use cases span beyond what dealmakers envision today. As a tamper-proof shared ledger that can automatically record and verify transactions, blockchain and distributed ledger technology (DLT) could vastly change how investors value, negotiate and execute deals. This will take years to develop, but the potentials can be found in two areas, smart contracts and tokens of various types.
Tackle trust issues with smart contracts
Smart contracts can automate agreements and self-execute when certain conditions are met. In the coming years, the technology will likely prompt investors to rethink how they evaluate if a deal makes sense.
In general, the diligence process in M&A entails ensuring that an acquirer is actually buying what it thinks it’s buying, and is not assuming any hidden liabilities or risks. Because smart contracts can be programmed to automate transactions once certain obligations and conditions are met, they can also reduce counterparty risks and enable dealmakers to enter into agreements with a higher level of comfort, regardless of whether the parties have ever met or even trust one another.
For instance, a contract could be designed such that one party doesn’t get its dividend unless they meet certain funding obligations related to R&D. This could prove beneficial for two types of deals: (1) partnerships and joint ventures, where the parties may benefit from one another’s assets or capabilities but remain independent and ultimately lack control of the other. (2) cross-border M&A deals, where investors often evaluate firms that are far away and follow very different rules, regulations and business cultures than their own.
If investors could one day apply smart contracts to an M&A deal, that could potentially raise the price of certain income-producing assets by way of lowering the variability of their returns and outcomes. Moreover, since blockchain technology democratizes access to capital in that it offers investors alternative ways to secure financing, it could theoretically attract a wider pool of buyers considering investments they previously thought were too risky; therefore, raising valuations further than today’s elevated levels.
Democratize capital through tokenization
Tokenization in a blockchain context not only supports the digital transfer of physical assets from one owner to another, it also provides a way to fractionalize ownership, giving individuals and entities the ability to invest and own parts of an asset versus the whole. From an investors’ perspective, this could evolve into a highly cost-effective way to raise capital and potentially finance projects in ways that would ordinarily be too cumbersome or cost prohibitive under traditional means.
Before delving into this further, it’s worth noting that tokenization comes in various forms, such as asset-backed or security tokens, depending on the nature of their use. When used commercially, they give holders in a transaction extra functionality and utility through rights that the issuing organization can spell out in a whitepaper and program into a smart contract. Because of these qualities, tokens present innovative ways to raise funds.
Take for instance the film industry, where liquidity is limited and barriers for investors to enter are relatively high. Through tokenization, filmmakers could potentially draw many more investors and therefore democratize early-stage investing in a way that’s similar to crowdfunding today. This could be done, for instance, by offering actors security tokens, which give holders a contractual right to cash or other financial assets in exchange for their work and talent. The difference with tokenization from crowdfunding is that investors could theoretically resell their tokens in the secondary and tertiary markets and therefore stimulate more liquidity where access to cash is limited.
This resale capability and the extra liquidity tokens could inject could also prove useful for corporations, particularly in cases where executives want to pursue a venture that existing shareholders might otherwise perceive as too risky, too ambitious or off strategy.
Through the tokenization of assets, a corporation can raise capital not just as a single entity, but rather a portfolio of individual projects housed under one corporate umbrella that investors can opt in and out of. This means two shareholders may be invested in one corporation, but their returns would depend on which projects they’re invested in. Say for instance, one investor bets that a company’s plans to expand product offerings across Asia-Pacific will be successful, but the other makes the opposite bet. Others might go long on every project at the corporation, while another group may go short. Some investors may change their positions on certain projects and decide to sell tokens linked to those endeavors – an option that brings in extra liquidity and not easily doable under crowdfunding and other traditional means of raising capital. By securitizing every project a company undertakes through tokenization, firms can apply project finance to a wider net of investors than is possible today given the transaction costs.
For this framework to work, however, companies would need to address the reporting and auditing challenges likely to arise. The compliance costs to carve up a business into hundreds of pieces from only a handful would also need to be negligible, and investors would need to feel confident that the right regulations are in place to discourage fraud. But reframing corporations as a collection of endeavors instead of just one is possible if we can imagine a world where blockchain and all ancillary and underlying technology has been adopted at scale.
A path toward wider adoption
Blockchain is still in its infancy, and it is evolving. Much depends on the ecosystem these distributed ledgers become a part of for that to be effective. It needs more players and stakeholders, including governments and businesses across different industries who are willing to coordinate and define how the platform is designed, verified, implemented and enforced. This is complex to achieve and will demand a special set of skills, particularly as some stakeholders may be competitors.
Building trust in the ecosystem will be key. According to PwC’s survey of 600 executives from 15 territories, the top barriers to blockchain adoption include regulatory uncertainty and lack of trust among users – the latter of which is ironic, since one of the appealing features of blockchain is that it allows investors to strike a deal without having to worry if they trust their counterparty. (For the full report, click here).
In terms of regulatory uncertainty, regulators remain unsettled. Many are still familiarizing themselves with blockchain and cryptocurrency and developing rules around the technology. However, it’s worth noting that governments in several countries are moving to support blockchain. Survey respondents say they expect China to be a blockchain leader in 3 to 5 years.
The opportunities in deals and other areas of business and government are wide-ranging, but their successes will demand a collective effort. Companies of all types need to develop rules and standards for blockchain; they can’t just leave it up to regulators. Dealmakers have an opportunity to make investing easier, less costly and more profitable. This will take the right technical expertise and knowledge, and it will challenge dealmakers to think of investing in new ways.