Understanding the Legal and Financial Challenges of Valuing Cryptocurrency Businesses

In a recent case before the English High Court, DAC Beachcroft LLP and Nicholas Parton from Opus Forensic Accounting tackled the intricate task of valuing a cryptocurrency business amid an unfair prejudice petition under Section 994 of the Companies Act 2006. This article shares insights from our experience as solicitors and forensic accountants who frequently represent crypto companies, highlighting the hurdles in accurately valuing these businesses.

The valuation of cryptocurrency companies is inherently complicated due to their unique nature. These enterprises often reject traditional asset frameworks and operate outside conventional regulatory oversight, leading to volatility and unpredictability. Any valuation that does not consider the unconventional context of crypto businesses is likely to be inaccurate.

At the core of every cryptocurrency business are crypto assets, which are notoriously difficult to value due to their extreme price volatility. Unlike traditional assets, cryptocurrencies can experience dramatic price swings in short timeframes, influenced by the evolving economic and regulatory landscape. This volatility is likely to persist, making it a significant factor in any valuation process.

While established cryptocurrencies like Bitcoin and Ethereum are volatile, smaller coins, known as "altcoins," can be even more unpredictable. With lower trading volumes, converting altcoins to cash can significantly impact their market price, complicating the valuation of businesses holding substantial altcoin reserves. However, altcoins can still hold significant value for those who accumulate them.

In litigation, the volatility of cryptocurrencies presents unique challenges. English law typically assesses damages based on the date of the defendant's breach. However, the extreme fluctuations in cryptocurrency values can lead to unreasonable outcomes. A recent High Court case questioned whether a defendant should face substantial damages based on a valuation of crypto assets that had significantly decreased since the breach. The Court acknowledged that assessing loss at the breach date is not an absolute rule and suggested a more flexible approach when warranted.

Moreover, crypto companies often lack the traditional management practices that facilitate valuation. While transactions may be recorded on-chain, much of the activity occurs off-chain, leading to rudimentary record-keeping. Many crypto businesses do not maintain standard financial records, resembling startups more than established enterprises. This lack of sophistication is not due to incompetence but rather a reflection of their business philosophy.

Consequently, many crypto businesses are not incorporated through traditional structures, intentionally avoiding compliance with standard regulations such as regular account filings. Even those that do not adopt a rigorous autonomy-based approach may struggle to maintain proper record-keeping due to rapid growth.

These challenges extend to basic operational issues, such as opening and maintaining bank accounts, which many crypto startups find difficult.

To navigate these complexities in litigation, parties must adopt a nuanced approach to valuing cryptocurrency businesses. Forensic accountants should consider various revenue-generating methods unique to crypto companies, including trading fees, staking rewards, transaction processing fees, and subscription services. Assessing the sustainability of these revenue streams is crucial; businesses reliant on volatile trading fees may pose greater risks than those with stable income sources.

The composition and liquidity of a company's assets are also vital in the valuation process. Most crypto businesses lack tangible assets like real estate or cash, with their holdings primarily consisting of cryptocurrencies, altcoins, or tokens. Some tokens may grant voting rights in decentralized autonomous organizations (DAOs), resembling shares in a company rather than currency. Forensic accountants must evaluate the volatility and liquidity of each crypto asset held.

Additionally, many crypto companies possess valuable intellectual property, such as proprietary technology, algorithms, and patents, which may not appear on their balance sheets. Valuing these IP assets can be challenging due to rapid technological advancements that can render innovations obsolete.

User data is another critical component in the valuation process. Operational metrics like user engagement, transaction volumes, and customer retention rates offer insights into a cryptocurrency business's performance and growth potential. A robust user base can indicate strong market penetration and future revenue opportunities.

In our experience, judges often respond positively to evidence regarding user data, whether for projecting future earnings or assessing the impact of specific events on operations.

Crypto enterprises vary widely, influenced by their goals and regulatory philosophies. The regulatory environment significantly impacts a cryptocurrency business's valuation. Some may operate as DAOs with no legal structure, while others adopt familiar legal entities for operational or regulatory purposes. Companies with traditional legal structures tied to specific jurisdictions are generally easier to value, as are those complying with regulatory requirements.

In summary, valuing cryptocurrency businesses presents unique challenges. Courts are grappling with the complexities of these valuations, making it essential to convey how and why crypto businesses operate in a distinct environment. Highlighting these differences and preparing valuations that reflect them is crucial to protecting clients' interests and preventing unfair outcomes in legal proceedings. Over-reliance on traditional comparators can undermine the credibility of the valuation process.

For parties involved in litigation concerning cryptocurrency companies, understanding these challenges is vital. Our collaborative approach as solicitors and forensic accountants aims to ensure that valuations are based on comprehensive and nuanced analyses, recognizing the dynamic and often unpredictable nature of the cryptocurrency industry.

Nicholas Parton (Partner) is a forensic accountant and Head of Opus Forensic Accounting.

Jonathan Brogden (Partner) and Alexander Bradley-Sitch (Associate) are solicitors in the Commercial Disputes team at DAC Beachcroft.