Investing in or acquiring distressed assets can be a lucrative investment strategy for those with a healthy risk appetite and a roadmap for sourcing and evaluating quality assets.
Following a steep run-up in crypto asset prices and valuations of crypto-adjacent businesses in the last two years, there has been a sharp increase in companies and assets in the space looking at deeply distressed valuations, liquidity crunches or formal insolvency or bankruptcy proceedings.
Opportunities to invest in or acquire these types of assets will present a significant opportunity for those that can navigate the processes, appropriately price the assets and mitigate risk in the businesses themselves.
For those looking to treasure-hunt for distressed or undervalued crypto assets or crypto-adjacent businesses, in this piece we describe three contexts in which these investments can be made: a “down round” of financing by a business, a secondary sale of an investment position, and asset sales in distressed situations either prior to or as part of a bankruptcy proceeding. For each of these contexts, we will highlight procedures and potential pitfalls that can make or break the success of an investment.
Investments in / Acquisitions of Distressed Assets In the Market
Down Round Investing
A “down round” is a financing event in which a company raises capital—often through an issuance of preferred stock or convertible securities—at a lower valuation than in its previous round of financing. Down rounds can be triggered by various factors, such as market downturns, competitive pressures, missed milestones or reduced growth expectations. In the current digital assets market environment, all four factors (and others) have combined to have a dramatic impact on valuations.
Down rounds can have significant implications for both companies and investors, affecting their ownership, control, dilution and returns. Investors in down rounds will need to navigate an investment process that may have additional risk factors to account for. Among them:
- Uncertain Valuations: Assessing the future prospects of the business and formulating a realistic valuation will be particularly challenging for companies that may be looking to pivot their products and strategies or otherwise reverse the setbacks that resulted in the down round in the first place.
- Extended Timeline: Companies raising money in a down round are looking to jumpstart a turnaround that may be years in the future. As a result, it is likely that these companies will require longer timelines to achieve their investment objectives.
In parallel with these challenges, however, down rounds can also present opportunities for investors:
- Attractive Valuations: A down round can offer new investors a chance to acquire a stake in a promising business at a discounted valuation with an exponentially higher potential investment return.
- Enhanced Investor Rights: A down round can provide the new or existing investors with opportunities to negotiate greater investor rights and protections, such as liquidation preferences, anti-dilution protection, or board seats, that can enhance their returns or position in the event of a future exit or liquidation.
For investors with a particularly long time horizon—and an optimistic view on the long-term prospects for digital assets and blockchain technology—down round investments in these sectors may be worth the effort. For those investors looking to do so, a targeted due diligence effort is critical. While due diligence of business and legal issues is critical to any investment process, in a down round for a business in the digital assets sector there are some specific questions to ask alongside others that might not be relevant in a different market or context:
- What are the reasons/issues that contributed to the decline in valuation?
- Are these issues unique to the company, industry-wide or systemic? Have they been addressed and are they “solvable” at all? For example, a rogue employee or mishandled software release can be a significant setback, but is not necessarily fatal to the long-term prospects of a business.
- Are these issues inherent in the sector or the nature of the company’s business? Or are any of these challenges market-wide and/or short-lived? For example, legal and regulatory uncertainty is likely to continue in the United States in the near-term. In addition, even jurisdictions that have modernized their crypto asset regulations, such as Switzerland, may also be subject to future challenges by a variety of private sector and government operators.
- Is the decline in valuation due to uncertainty in the capital markets and slower exit cycles via sale transactions? Is it due to high interest rates? Or is it due to a combination of both of those elements (or others)? Exit trends tend to be cyclical and relatively short-lived when compared to longer-term, secular trends in interest rates or other policies.
- Keep in mind that multiple factors may play a part, which will lead to different answers to the follow-up questions.
- What will be the key drivers for turnaround and growth in the future?
- Are there roadblocks or impediments to the company’s use or maximization of those drivers? For example, does it have key technology and IP secured and legally protected for both its current and future or proposed usages? In particular, aspirational goals may require greatly expanded rights or capabilities that are not secured at this point.
- If the company is not already profitable or cash-flow positive, is there a path to achieve either or both without additional financing? If not, an investor should consider whether it would be willing to increase its investment in a later tranche of the down round or in a subsequent financing round (and, if so, the terms on which it would be willing to do so).
- Are there legal or regulatory changes on the horizon that could impact the business plan or trajectory?
- Even in a sector where legal and regulatory risks cannot be completely eliminated, certain business models or services may be more likely targets for regulators or legal challenges than others. These include businesses that are retail or consumer facing (as opposed to B2B or institutionally-focused) or that provide services that have already been the target of regulators and enforcement actions (such as centralized cryptocurrency exchanges).
- In addition, companies can take steps to mitigate some of the legal and regulatory risk inherent in the digital assets sector. These steps include having an awareness of the regulatory regimes that apply to a specific business line, product or service and a corresponding compliance infrastructure that is integrated with the business’s culture of innovation. Companies that have both are likely to face fewer future regulatory hurdles in the future and have a correspondingly lower risk profile.
Secondary Sales of Investments
Secondary sales are transactions in which an existing investor sells its stake in a private company, funds or other illiquid asset to another investor, without the involvement of the issuer company or the asset manager. (In contrast, a primary sale is a direct sale by an issuer company of its own securities to investors.)
Secondary sales can arise for several reasons, including:
- Liquidity: The original investor needs liquidity or wants to exit an investment that has reached maturity, underperformed, or no longer fits its portfolio strategy or risk appetite.
- Diversification: The original investor wants to diversify its portfolio or rebalance its exposure to certain sectors, geographies, or asset classes (e.g., significant changes in the valuation or prospects of certain investments, either positively or negatively) can impact an investor’s outlook and appetite for holding an investment.
- Constraints on Continued Ownership: The original investor or the company faces regulatory, tax, or legal constraints that limit the investors’ ability or incentive to hold certain investments—for example, changes in law or legal challenges may make it untenable for an investor to continue holding its investment.
In the current market, investors that have seen sharp drops in the valuation of crypto-related investments and corresponding spikes in paper losses on those investments may have incentives to exit those positions. These losses are driving some investors to seek exits and a secondary sale may provide liquidity for an otherwise illiquid investment. For some investors, this may be a viable or necessary approach even if the valuation is significantly below its peak.
At the same time, a buyer in a secondary sale transaction in this market may be able to pick up an investment at a deep discount to the valuations of two years ago, even if the company is not currently fundraising or otherwise looking to market its securities.
In order to execute a secondary sale, there are a few common issues to address:
- Transfer limitations: Most shares in private, investor-backed companies are subject to contractual obligations between the existing shareholders and the company. There are likely to be transfer restrictions that require the consent of all or some preferred shareholders before a secondary sale can take place or that provide a right of first offer for existing shareholders (or both). If these procedures are not observed, any purported secondary sale could be invalidated.
- Confidentiality restrictions: Confidentiality restrictions are often required for investors, and these restrictions would limit the scope of information a prospective seller can provide to a secondary buyer. While this may seem like an issue for the seller, a prospective buyer will be purchasing a headache—and perhaps nothing else—if a company or its other shareholders object to the sharing of confidential information after the fact. As a result, any potential buyer in a secondary sale should confirm that confidentiality restrictions are well understood and observed, even at the early stages of a secondary sale process.
- Compliance with securities laws: A secondary sale transaction involving the shares of a private, US company are subject to US securities laws governing the shares themselves (which are likely not registered with the Securities and Exchange Commission) and the marketing and sale of those shares. In most cases, there are exemptions from the onerous requirements of registered securities and registered offerings, but those exemptions require the selling shareholder, the secondary buyer and the transaction itself to meet the criteria for these exemptions.
Distressed Asset Sales
Prior to a company’s declaration of bankruptcy (pursuant to Chapter 11 or otherwise), the sale or encumbrance of its assets may result in legal challenges or consequences for the company (as seller), the company’s directors and the buyer.
- Considerations for Sellers: A seller needs to be mindful that the asset sales do not create insolvency. This includes reasonable confidence that (1) it is getting a fair (and appropriate) price for the assets, (2) the assets are not encumbered or secured by debts owed to creditors, and (3) the overall mix of assets after the sale provides the company with sufficient assets and operational capability to continue doing its business and servicing its debt. Where there are issues regarding the transferability of a subject class of assets (whether as a result of regulatory issues and/or claims and encumbrances against such assets), a sale through bankruptcy provides for a court ordered process free and clear of many of the legal impediments that may impact a traditional sale transaction. (More on that process below.) Situations involving sales to affiliates can also give raise to conflicts and fiduciary issues.
- Considerations for Directors of Distressed Companies: Directors also need to be mindful of the ways in which they discharge their fiduciaries duties when a company enters the “zone of insolvency.” The “zone” is a grey area where the company is at risk of no longer being able to pay its debts as they come due. This is important because courts have generally held that when a corporation becomes insolvent, the duties and obligations of officers and directors to the corporation include all residual stakeholders, including creditors. A company may pass through the zone in an instant or it may teeter on the brink for an extended period of time. Because these judgments are often made in hindsight, directors of companies that may be at risk of insolvency—and those that would transact with them—need to carefully navigate the execution of these duties. Among other considerations, detailed records of board deliberations and weighing of factors in decision making can be important and valuable pieces of evidence in claims made against directors for breaches of their fiduciary duties. Obtaining valuations from outside experts, seeking professional opinions, and/or appointing a special committee to approve a given transaction typically provides additional protections to officers and directors from a potential claims for breach of fiduciary duty where a company is operating within the “zone of insolvency.”
- Considerations for Buyers: Buyers should be mindful that their purchases of assets are not fraudulent conveyances—in other words, a transfer of an asset by a seller to delay or defraud a creditor and/or a transfer for less than fair consideration while the transferor is insolvent or is rendered insolvent. Sales of assets can be subject to look back provisions and clawback by a bankruptcy court up to two years (or in some cases, more) prior to the bankruptcy filing. Conversely, a buyer can obtain protections from collateral attack on a transaction where the deal is approved by a bankruptcy court. However, this type of formal process opens up a transaction to an auction format, and typically adds time and expenses to the deal. These factors should be weighed against the advantages in obtaining protections typically afforded to a buyer through a bankruptcy sale which provides for a transfer free and clear of any claims, liens, and encumbrances, amongst other things.
Sales Out of Bankruptcy
As noted above, sales of assets that occur as part of a formal bankruptcy process can provide certain protections to the parties involved in the sale. For example, assets that are part of a bankruptcy estate – i.e., the assets of a company (debtor) that has filed for bankruptcy – can be sold by the estate pursuant to Section 363 of the US Bankruptcy Code or through a bankruptcy plan. While these transactions do not include many of the risk allocation provisions in typical asset sales (e.g., things like indemnities and escrows), they still provide a path for seller and buyer to buy/sell assets without risk of post-closing clawbacks and liability, which can be long-term and significant. In addition, for the buyer, this type of transaction provides a chance to extinguish all or substantially all liens and claims on the assets it is purchasing (subject to limitations imposed by law or the applicable court).
A sale process under Section 363 is complex and multi-faceted. Typically a sale under Section 363 can be closed within 30-60 days depending upon the particular facts and is subject to higher and better offers. This type of sale may also provide stalking horse status to the initial buyer, which provides protections to such party, including a break-up fee if the deal does not close because of no fault of the buyer. These protections typically provide the stalking horse bidder with the inside track to acquire the subject assets, which requires another party to bid incrementally higher than the opening bid for such assets or the stalking horse buyer becomes the successful purchaser.
Many of the considerations for sellers and buyers in a Section 363 transaction are similar to those they face in the zone of insolvency, described above. For a more detailed take on navigating a Section 363 process, please see our supplemental alerts for sellers and buyers.