Accelerating M&A transactions with smart contracts?
Digitalization is booming and the use of blockchain technology is gaining more and more foothold. New use cases for blockchain are constantly being discovered and the realm of M&A is no exception. However, digitalizing complex and tailored documents may prove ineffective. Will the M&A process become automated and will smart contracts replace transaction lawyers?
The rapid progress of digitalization has prompted many to wonder whether smart contracts will replace traditional M&A transaction agreements, in other words share purchase agreements and business purchase agreements.
The question has become particularly topical in connection with blockchain technology. It enables the generation and maintenance of a decentralized database.
At present, the benefits of decentralized technology are evident in the most well-known blockchain application, cryptocurrency Bitcoin. A third party, such as a bank, is no longer needed to verify a payment transaction, the accuracy of information, or the reliability of purchase and sale of currency. This information is available to all parties when transactions are conducted via decentralized technology. What is more, all this is taking place in a way that makes changing or manipulating information extremely difficult.
Blockchain technology enables many other uses, such as creating self-monitoring or self-executing smart contracts.
A smart contract automates paper agreements
In recent years, a variety of smart products have entered the market. There are “smart locks”, “smart apps”, “smart TVs”, and of course “smart contracts”. Some applications feature artificial intelligence – a computer program capable of performing intelligent functions or learning.
However, most smart applications lack actual AI. It is software automated functions or processes that usually put the ‘smart’ in smart products. This is also the case with smart contracts, which in simplistic terms refer to programmed contracts, i.e., contracts in a digital format.
A smart contract does not require AI to work. What makes these contracts smart is the fact that the measures agreed upon in a written agreement have been converted into a program that automatically implements the programmed contract logic. The agreement’s execution does not therefore require any actions by the parties.
Let’s use a buyer's payment to the seller as an example. Making such payment still requires a payment order from the buyer to the bank, after which the bank will transfer the funds to the seller's bank account. In a smart contract, said measures would be translated into a program that would automatically perform these actions.
If a smart contract is decentralized with blockchain technology, the need for third parties decreases. As a great added bonus, modifying or manipulating the program that implements the contract is very difficult without due authorization.
Digitalizing a tailored contract is not easy
It is difficult to see the benefits of digitalizing individual share and business purchase agreements, at least for now.
Acquisitions typically involve two parties, a seller and a buyer. They agree on the terms and conditions under which the shares of the target or its business and assets are sold to the buyer.
The structure and contents of share and business purchase agreements have become rather homogeneous in recent years, and the Anglo-Saxon way of structuring transaction processes and their terms has, thanks to international investing, caught on in Finland as well. These elements certainly help turning purchase agreements into smart contract form.
Nonetheless, each deal is an individual process with its unique characteristics and conditions. M&A transactions involve many terms that are not easily programmed into a smart contract.
Programming terms may be challenging especially when they are not structured as either–or conditions. For instance, conditions affecting the binding nature of a transaction (i.e. closing conditions) or terms relating to the seller's liabilities (i.e. seller's warranties and seller's liability) are examples of terms that would be cumbersome to code.
These terms are especially complex in larger deals. Verifying that all conditions are met requires interpretation, which in turn involves subjective and discretionary elements. The enforcement of contractual obligations, which ultimately requires a formal court or arbitration process, brings its own challenge to bringing contracts into code format.
It is therefore worth asking whether the benefits and advantages of converting a share or business purchase agreement into a smart contract are actually there when compared to the present, ‘old-school’ approach. It is likely that we have to wait a while for these purchase agreements to evolve into their ‘smarter’ forms.
The power of automation comes from scale benefits
It is unlikely for smart contracts to be at their most effective in bilateral share or business acquisitions, at least in the near future. Instead, automating the execution and enforcement of contractual obligations with blockchain technology is likely to focus on processes with clear scale benefits.
Such processes may in particular be those with multiple parties.
However, automating these processes requires overcoming many technical hurdles. Among the most critical issues are arranging a reliable identification of the parties, managing the parties’ identity information securely, and coordinating interfaces between different systems.
New applications streamline M&A processes
The M&A transaction process has already taken many steps towards digitalization over the last decade. For instance, the examination of a potential target, i.e. a due diligence investigation, has evolved from examining physical folders in meeting rooms into analyzing files in digital format by remote access in a virtual data room.
Moreover, AI applications are here to stay as data analyzing tools. It is clear that applications keep developing and that their number is constantly increasing.
In addition to legal due diligence, another subprocess that could be automated in share and business acquisitions is the so-called escrow arrangement. Escrow arrangement refers to a situation where the buyer and seller have agreed to transfer the purchase price or part thereof to the seller once certain conditions have been fulfilled after the transaction. The parties agree on depositing a part of the purchase price to a bank account where it waits for its release to the seller.
Nowadays escrow is arranged by way of written agreements between the buyer, the seller, and the bank. Furthermore, the arrangement and its execution require separate measures from all parties, such as opening a bank account, notifying the bank of the transfer of funds, and a bank transfer.
This subprocess is used in M&A transactions rather often, and it is a strong candidate for being programmed to execute itself like a smart contract. By blockchain technology, the escrow arrangement could be executed reliably not only by banks but also by other actors.
Perhaps this application already exists and we will soon have a ‘smart’ escrow arrangement within our reach.
Similarly, the release of collaterals or their transfer to another beneficiary could be automated using blockchain technology.
The blockchain and AI technology currently used in business applications only mark the beginning of future development. The limits to the use of technology appear to be only in the imagination of developers – and in the creativity of us lawyers as well. Future M&A processes will reflect the budding blockchain and AI space, perhaps not at the forefront of development but certainly at some point.
Back to News and Events »