5 Things Venture Capital Investors should look out for when investing in crypto start-ups

As with investments in traditional start-ups, the risk of investing in a crypto start-up lies primarily in the question of whether the start-up will be successful. In the case of crypto start-ups, however, there are other factors in addition to the general framework conditions. In this article, we want to highlight 5 important factors.

1. Uncertainty under Civil Law

The hot ICO phase of 2017/2018 is over. Nevertheless, some business models of start-ups in the crypto scene involve the issue of tokens. These are issued on the blockchain (such as Ethereum or Polygon). These tokens are intended to embody a certain right. However, as long as it is not a crypto security within the meaning of the German Electronic Securities Act (elektronisches Wertpapieregesetzes - eWpG) or a crypto fund unit within the meaning of the German Crypto Fund Unit Ordinance (Kryptofondsanteilverordnung - KryptoFAV), the qualification of the token under civil law is more than uncertain. In particular, tokens are not objects that can be transferred. This raises the question of how a token is transferred and whether the rights, which the token is intended to embody, are also transferred.

During due diligence, venture capital investors should therefore pay attention to how the token is structured, what rights it should embody and what impact it would have on the crypto start-up if it is unclear who is entitled to these rights.

2. Prospectus Obligations

The question of whether prospectus obligations exist also depends on the design of the token. In Germany, there are currently prospectus requirements for securities, investments and investment fund units in particular.

If the token is intended to embody asset rights (similar to a share or bond), a securities prospectus is generally required. This always applies if the token is publicly offered in Germany. It also does not help the start-up to subject the token to a different legal system or to use a foreign company for the issue. Offers on the internet in particular quickly appeal to the German market and trigger a prospectus requirement.

The issue of a token, for which a prospectus is required, without a prospectus not only harbours the risk of intervention by Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht - BaFin) (including the naming of the start-up on BaFin's website), but is also subject to fines. In addition, investors regularly have the right to return the token at the issue price - even if the token has already lost value. Depending on the size of the issue, this can be a significant risk.

3. Authorisation Requirements

The business model of crypto start-ups is particularly at risk of triggering a licence requirement under the German Banking Act (Kreditwesengesetz - KWG) or the German Securities Institutions Act (Wertpapierinstitutsgesetz - WpIG). The authorisation requirements under the Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz - ZAG) and the Capital Investment Code (Kapitalanlagegesetzbuch - KAGB) should also not be underestimated and should be examined in a due diligence process.

The crypto custody business in particular is at the forefront of transactions requiring authorisation. Anyone who holds tokens or their private keys in custody requires a licence from BaFin if the tokens fall under the definition of "crypto asset" in the German Banking Act. This often leads to delimitation difficulties, for example in the case of unhosted wallets or staking. The brokering of purchase contracts for tokens is also subject to authorisation.

4. Owner Control

If a crypto start-up already has a licence from BaFin, an owner control procedure must be carried out for an acquisition. BaFin checks the new owners to ensure that they are reliable. Going through the owner control procedure should not be underestimated.

In particular, it must be ensured that the intention to purchase is already subject to notification. The purchase agreement should not be finalised without the approval of BaFin. Due to these special features, the owner control procedure has a considerable influence on the course of the transaction.

5. Changing Legal Situation

Regulation of the crypto sector is currently still in flux. For example, business models that are currently unregulated could be included in regulation in the future. The European Crypto Asset Regulation (Kryptowerteverordnung - MiCAR), which will be applied in stages from summer 2024, will be significant for the entire crypto sector. Crypto start-ups should prepare for MiCAR now and investors should analyse the impact MiCAR will have on the start-up's business model: Can it continue as before, or will it have to carry out major restructuring?

How does regulation affect the market in which the crypto start-up operates? MiCAR opens up the national markets for crypto service providers in the EU. Passporting will then make it possible to serve not only the domestic market, but the entire EU with just one licence. As a result, crypto start-ups will also notice competition from other EU countries more clearly.

Outlook

The situation in the crypto market is exciting. Over the next few years, changes in regulation may create new opportunities. At Bird & Bird, we have almost a decade of experience in advising on crypto business models. We also have a venture capital practice that is particularly well positioned in the start-up sector.