Blockchain technology is shaping and creating a new type of business model in a number of sectors. The advantages this technology provides seemed to be countless: but can blockchain facilitate deal-making in the area of mergers and acquisitions (M&A), especially now in the context of overall economic disruption, confinement and social distancing due to propagation of COVID19?
Blockchain was invented in 2008 by Satoshi Nakamoto (a pseudonym for a person or a group) and allows storing data without the need for a central authority and control, implying that the data will no longer be stored in a central database but distributed to several computers that store data locally, in so-called blocks. For this reason, blockchain is called distributed ledger technology (DLT). Each block contains a record of the transaction/data together with the time/date stamp of when the corresponding block created, and each block has a unique identifier that allows the distinction between the blocks. The blocks are bound to each other using cryptography, resulting in a growing chain of information.
Since its conception, the blockchain technology was quickly adapted in finance, insurance, intellectual property protection, energy trading and supply chain management. Interestingly, since there been numerous opportunities identified for the use of blockchain technology, the financial industry has spent billions of dollars on the development of blockchain applications. Notwithstanding the continuous investment, there has not been much evidence that the blockchain has practical, scalable use.
As the popularity of blockchain grown drastically over the past few years, there are hundreds of blockchain evangelist and enthusiast trying to sell the idea that the blockchain can help to reduce transaction costs (especially the legal costs), gain time and provide transparency and trust in the M&A process. This article will examine whether, in the context of an M&A transaction, blockchain brings any added value.
M&A is the term used to describe the action to consolidation of companies by means of different types of financial transaction vehicles, including mergers, acquisitions, consolidations, purchase and swap of assets, share transactions and management acquisitions etc. Thus, the M&A process is complex, time-consuming and costly as it involves not only the acquiror and seller teams but also several external entities such as bankers, equity partners, auditors, strategic and specialist advisors, regulators, institutional investors, arbitragers and government. Another layer of complexity to an M&A transaction is a variety of payment options available. Finally, in an M&A deal, the acquiror and the seller are likely to have a significant distance between them; thus the evaluation of the target must take into consideration that the target might be subject to entirely different legal requirements in terms of operation rules, regulations and even business culture than the acquiror. Effectively, not one M&A deal is exactly the same as the next one – each company is unique, and the objectives of the deal are unique.
A typical M&A process starts with a definition of an acquisition strategy and organisation of the process, followed by targets identification and screening and approaching shortlisted candidates (can be on either seller or acquiror side). Then the due diligence of and negotiation with the target take place, and the process finalised by the integration of the target and management of warranties and earn-out provisions.
During target screening and identification of potential entities of interest between 100 and 1000 prospective targets can be analysed for one M&A transaction. Through assessment of the business and exclusion based on specifically defined characteristics, this number reduced to 10s. From that list, a shortlist defined for presentation based on a detailed analysis of prospective targets’ business, attractiveness and potential realisation of synergies. Then the recommendation for the most attractive target/s is made – usually between 1 to 3.
As the target screening stage involves an analysis of a large amount of data, use of a blockchain does not seem to be fitting. However, the use of an Artificial Intelligence for the initial target screening can be argued quite solidly, from the perspective of time reduction and taking into consideration the amount of the data that would need to be gathered and analysed – particularly bearing in mind that information for initial screening would be publicly available data.
The next labour intensive and costly stage of the M&A process is the due diligence: a process permitting the acquiror to verify, investigate or audit of the seller in order to confirm all the relevant facts and the financial information and to be in a position to valorise the target. If the target used blockchain for the registration of their intellectual property that can assist with the valuation of the target, however, such application of the blockchain is not directly linked to the actual M&A process and more on the incidental side.
As blockchain is fundamentally a database, the blockchain evangelist like to argue that this technology can be deployed for data sharing during due diligence stage as a replacement of the virtual data room. Based on this argument, the parties to the M&A transaction will have all the data exchanged stamped to guarantee when and how this data was transmitted. Now the ultimate question should be asked: does this add value to the transaction? From the perspective of anti-corruption compliance, the blockchain can add value in stamping the due diligence documentation and work as a proof for the information provided if the target operates in an industry prone to bribing or sensitive sector. In such case, blockchain becomes somewhat of a safeguard in the case the acquiror inherits some issues and has conducted proper anti-corruption due diligence. Once again, to have the due diligence virtual data room shared through a blockchain only adds the certification to the data, the acquiror still need the data analysed. At this point, it is important to highlight that the various case studies of the major failures of M&A transactions provide that the failure of M&A deal or post-merger integration is attributable to the failure to conduct in-depth due diligence or rushed due diligence process. Thus, blockchain adds value in terms of certifying the documentation but from a practical perspective carries little added value since this information still needs to be analysed by the acquirer. Related: Space Robots Could Help Colonize Mars
The next aspect that needs to be considered is the time required for setting up a blockchain supported virtual room: that process can take up to 12 weeks, as not only the information would need to be compiled by the seller (a case of ordinary virtual data room) but the structure for the blockchain defined, blockchain platform selected, access rights defined, nodes etc. designed. Average time for due diligence is 60 days, thus up to 12 weeks to set up a blockchain in order to have a certification of data transmission simply makes no sense from neither acquiror or seller perspectives nor carries justifiable added value. Remember: M&A is a time-driven fast process, and no time should be wasted.
Nonetheless, there are some solutions already available on the market for a blockchain based data room applications such as FIRESTARTER (a Belgium start-up) – but then again it is not clear how well this application is in use since at the time of writing this article the social media of this company has not seen new posts for a few months.
LEXIT (an Estonian based start-up) had, what it seems, an interesting idea for a start-up in terms of creating a platform based on blockchain as a marketplace to trade intellectual property, code and facilitate M&A for a start-up. But the idea was short-lived – created circa 2017-2018 all the social media seems to stop being active mid-2019.
If the overall process of M&A considered, then another popular subject that blockchain evangelist like to discuss is the adaptation of smart contracts in the context of M&A. In the recent years smart contract has also gained popularity: for example, at this moment several Canadian law firms are working on a “smart contract” project using blockchain in collaboration with OpenLaw, a tech law firm(the project includes law firms such as Bennett Jones LLP, Blake Cassels & Graydon LLP, Davies Ward Phillips & Vineberg LLP, Fasken Martineau Dumoulin LLP, Norton Rose Fulbright LLP and Stikeman Elliott LLP).
A smart contract is fundamentally a software code in which the terms of an agreement defined, actions assigned to the parties to the contract and enforcement of the negotiation and execution of the contract is thru digital verification. The code and agreements exist cross a distributed blockchain network. The blockchain evangelist like to put forward the argument that automation of the overall M&A process, through adaptation of smart contracts, can lead to a reduction in the errors in the execution and provide better monitoring of milestones and achievement of deadlines.
As the M&A deal takes its course, the parties engage in an intensive exchange of marked-up contract and the actual execution of the contract. A smart contract can assist the parties to an M&A deal in the way that it provides reliable traceability for such mark-ups. A smart contract can be programmed to cover the whole M&A process, i.e. the signature of a non-disclosure agreement or a letter of intent during so-called “setting the stage”. Then as the negotiations progress, the smart contract can follow up through the definition, for example, of the share purchase agreement or an asset purchase agreement. Finally, the smart contract can assist with monitoring of achievement of earns out (i.e. seller will receive additional compensation if the sold asset meets certain financial goals).
But the arguments presented by blockchain evangelist for the use of smart contracts in M&A process do not take into consideration that a smart contract is a program that is written by a human and it is not free from errors in programming in the same way as a paper-based contract is not free from drafting errors. What is also is not taken into consideration by the blockchain evangelist is the complexity of a share purchase agreement or an asset purchase agreement. It is quite simple to code a condition that is an “either” or “or” condition. But what about codding seller`s warranties and liabilities conditions? That would be quite complicated. Also, the blockchain evangelist typically overlooks that verification that all the conditions are met in a complex contract requires interpretation which, in turn, requires subjective and discretionary thinking and analysis.
As it was already mentioned, M&A transaction is a time-driven process and blockchain evangelist very much present that smart contracts will reduce the time for the transaction. However, it is necessary to consider that in order to create a smart contract, first, it is necessary to have the contract on paper, so to speak. And then the “paper” contract would need to be coded – thus adding additional time to the process that is already time conditional.
Depending on the complexity of a contract, on average, it can take about 2 weeks to write a code for a smart contract. However, before the coding, the party responsible for the creation of a smart contract would need to spend time on the preparation and planning phase for code structure, i.e. studying the physical contract and understanding the subject matter of the contract and the intentions of the parties, which can take between few days and a week. Then, once the contract is coded, it would need to be quality tested – which can take about a month on average. So, in total, we are looking at between 1.5 and 2 months of work required to implement a smart contract. According to Gartner a mid-size M&A deal takes an average of 106 days to close and a large deal an average of 279 days to close. The large proportion of this time spent on due diligence which is on average, is between 40 to 80 days depending on the size of the target and complexity of its operations. So, if we take into consideration a medium-size M&A deal with the duration of 106 days, there is absolutely no value at all added if the deal to be executed through a smart contract, as the smart contract set-up will add 2 extra months to the overall duration of the process.
Effectively, the blockchain solution for M&A transaction will need to demonstrate that it will create value - currently, from the perspective of complexity and time required to implement such solutions, the blockchain simply is not compatible with the time element that drives the M&A processes. Secondly, even though a seller might propose the use of a blockchain solution for an M&A, say in the context of a data room, it might not easily integrate into information technology infrastructure of the acquiror. Thirdly, for blockchains to operate they require a significant amount of energy which might be against the operational targets set by one or both parties to the transaction. Lastly, there is also a question of adoption of blockchain. The blockchain initially was developed as a basis for bitcoin, but the rise in bitcoin scams and hacking put in question how well the blockchain technology itself is regulated, should it be regulated and how foolproof the technology is.
By Polina Chtchelok and Luis Colasante
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