Eggs, basket: The hidden and not-so-hidden risks for companies that invest in bitcoin   

Betting on bitcoin seemed like a great idea for MicroStrategy. And then bitcoin dropped again.

This article is by guest author Michael Rapoport. Michael is a business and financial journalist who specializes in stories about accounting, banking, and financial regulation and is a former reporter for The Wall Street Journal. His work has appeared recently in Institutional Investor, Quartz, and Business Insider. Michael is on Twitter as @rapoportmike. 

So far, betting on bitcoin has seemed like a great idea for MicroStrategy. The business-software company invested about $1.1 billion last year in bitcoin, and those holdings are now worth more than $2.2 billion, thanks to bitcoin’s explosive market surge. MicroStrategy’s stock has more than quadrupled since it announced its first bitcoin purchase last August.

Betting on bitcoin has also been a bad idea for MicroStrategy’s earnings. The company’s bitcoin investment dragged it into loss territory for the third quarter and first nine months of 2020 rather than posting profits.

How can both things be true? Because when it comes to bitcoin, reward and risk might as well exist in different universes. No one focusing on one wants to acknowledge the existence of the other. Bitcoin’s price has surged to undreamt-of heights in recent months, but it also has a history of stunning declines — and that volatility, even if temporary, could be damaging to a company’s balance sheet and earnings.

MicroStrategy is one of a still-small but growing number of companies placing bets on bitcoin and other digital currencies. Those moves have a degree of logic behind them, and certainly the potential rewards are tempting. But they’d better keep in mind that bitcoin has the potential to bite them, too, and not just in the obvious ways.

MicroStrategy has been by far bitcoin’s biggest fan among public companies. The company said last summer that it would put most of its excess capital into bitcoin — it even sold $650 million in convertible notes in December specifically to raise money to buy more bitcoin. The $1.1 billion it’s spent on bitcoin far outstrips all its other assets combined. Chief Executive Michael Saylor calls bitcoin “a battery charged with monetary energy.” (The company declined to comment for this story.)

Others have followed. Payments company Square indicated in October it would invest $50 million, calling cryptocurrency “an instrument of economic empowerment.” (Square couldn’t be reached for comment.) Big-name investors like Paul Tudor Jones, Stanley Druckenmiller, and insurance company MassMutual have recently invested in bitcoin as well.

“Obviously some companies are excited about it,” Matthew Schell, a Crowe LLP partner who co-chairs an American Institute of CPAs working group on digital assets. “While still not mainstream, it’s going there.”

MicroStrategy’s Saylor has turned into a leading evangelist for bitcoin. He’s holding a two-day online event in February for other companies interested in investing in bitcoin. He’s publicly encouraged Elon Musk to move Tesla’s resources into bitcoin, and the Tesla CEO didn’t dismiss the possibility out of hand (though Musk has also tweeted negatively about bitcoin.

It’s easy to understand why MicroStrategy and others want to invest in bitcoin. Most companies keep their cash in ultra-safe, highly liquid instruments like Treasury bills, but right now that’s effectively a recipe for losing money: Interest rates are close to zero, so a company’s cash loses purchasing power as prices rise. If bitcoin’s value keeps soaring and you can get better returns there, why not at least think about it?

Saylor calls bitcoin “an attractive investment asset with more long-term appreciation potential than holding cash.” Hard to argue with that, thus far — MicroStrategy says it paid an average price of $15,964 for each of its bitcoins, and one bitcoin now trades for more than $32,000, as of Thursday's New York close.

But bitcoin’s volatility also makes it an enormously risky bet — arguably a bet that prudent public companies don’t want to make with the bulk of their cash. One bitcoin may be worth $32,000 now, but it was below $5,000 as recently as last March, and its value took stomach-turning drops in 2017 and 2019.

Saylor calls bitcoin “a dependable store of value,” but how can that be the case when the price is so volatile?

And while most other companies venturing into bitcoin are just dipping a toe in the water — Square’s $50 million is less than 1% of its total assets, for instance — Saylor has done a cannonball into the deep end of the pool with his concentration of most of MicroStrategy’s available cash in bitcoin.

It’s like walking into a casino and betting all your chips on red at the roulette wheel, time after time: You might win for a while, but sooner or later, chances are pretty good you’re going to lose, and maybe lose it all.

It’s also worth remembering Saylor’s history: In 2000, Saylor settled Securities and Exchange Commission allegations that MicroStrategy inflated its earnings by recognizing revenue too quickly. Saylor agreed to return $8.3 million to investors and pay a $350,000 fine; he didn’t admit or deny wrongdoing, and he hasn’t been accused of any impropriety regarding his investment in or promotion of bitcoin. (Notably, the SEC settlement didn’t bar Saylor from being an officer or director of a public company, as such settlements sometimes do — so he was able to remain CEO of MicroStrategy.)

Bitcoin’s fans argue it’s more stable than it used to be. The recent investments from  mainstream sources have helped make it more “respectable,” they say. The regulatory guidelines for cryptocurrencies are clearer now, and the trading platforms are more reliable and established — you can buy bitcoin via PayPal.

Maybe so — but the volatility isn’t just a thing of the past. Just this month, bitcoin’s price has zigzagged wildly; it’s fallen more than 20% in the past two weeks. Some believe it might be subject to manipulation: Bitcoin’s price “is nearly certainly a bubble and likely manipulated. Investors should proceed with extreme caution,” said Alex Pickard, a vice president of research at Newport Beach, Calif., investment-strategy firm Research Affiliates, in a recent blog post.

And that’s just the obvious risk.

Despite bitcoin’s rise in value, MicroStrategy also had to take a $44.2 million impairment charge on its bitcoin investment in the third quarter that ended Sept. 30. That dragged the company to a loss of $14.2 million for the quarter, and a loss for the first nine months of 2020 as well. (Of course, the company’s non-GAAP numbers, which exclude the impairment, still show profits.)

Here’s why: Under U.S. accounting rules, bitcoin and other cryptocurrencies aren’t treated as cash or financial instruments. They’re considered “indefinite-lived” intangible assets. Companies must evaluate them periodically to determine if their value has declined — and if they have, the companies must take an impairment charge to write them down, cutting into earnings. Notably, the same isn’t true when they rise in value — under the rules, companies are supposed to record gains in value on digital currencies only when they’re sold. (The rules are somewhat different for investment companies.)

“There is a potential for impairments, definitely,” Schell said. “If you determine that fair value is below your cost basis, you’re going to land in a place where you have an impairment.”

That’s what happened at MicroStrategy. The company paid an average price of $11,111 each for its initial $425 million investment in bitcoin, but bitcoin’s trading price slipped as much as 9% below that level in early September, before it began its recent dramatic rise. That means an impairment charge was required     .

MicroStrategy has acknowledged the risk of impairments that could hurt earnings. Phong Le, the company’s chief financial officer, said during MicroStrategy’s third-quarter earnings conference call that “negative swings in the market price of bitcoin could have a material impact on our GAAP earnings.”

MicroStrategy has also added nearly a page and a half of risk factors about its bitcoin investment to its SEC filings, including impairment charges, a possible loss of liquidity, and, most of all, the potential for a drop in bitcoin’s price to hurt MicroStrategy’s own stock price, given the scale of the company’s bitcoin investment.

A big bitcoin price drop could lead to “a more pronounced impact on our financial condition than if we invested our cash in a more diverse portfolio of treasury assets,” the company said.

For Square’s part, bitcoin’s price has been on a sharp upward trend since the company invested in it, so Square hasn’t faced an impairment charge, yet. The company’s investment came near the start of the fourth quarter of 2020, and it hasn’t yet issued a balance sheet that includes its bitcoin.

The number of public companies who’ve indicated they’ve invested in bitcoin is still tiny. In fact, there are probably more companies that have sprung up involved in bitcoin mining or trading than there are companies willing to bet their own money on it. In fact, a lot of companies in the bitcoin arena seem reluctant to eat their own cooking: Many bitcoin miners and traders haven’t invested in bitcoin themselves .

And any missteps in accounting for or disclosing a bitcoin investment properly could draw scrutiny from the SEC. That’s the case even though the commission seems disinclined to go after bitcoin broadly — as The Dig recently noted, the SEC isn’t likely to pursue action against bitcoin or other cryptocurrencies that are acting as currencies rather than securities and have decentralized models, since no one organization would benefit from a spike in the currency’s price.

For instance, the SEC sent a comment letter last May to Nukkleus, a tiny financial software company that owned digital currencies at one point. The commission asked why Nukkleus appeared to be accounting for them different from other companies, and directed the company to disclose more.

Nukkleus seems to have ignored the SEC’s letter and its follow-ups — the SEC told the company in August that “you have not provided a substantive response.” (Nukkleus couldn’t be reached for comment. In its annual report filed in December, Nukkleus did add two pages detailing “cryptocurrency-related risks” and said it no longer held any digital currencies.)

Investing in bitcoin seems like the easiest of easy money these days, and certainly companies are going to continue to be attracted to the prospect of making big returns on their cash holdings. But this boomlet of corporate bitcoin investing has happened as bitcoin’s price keeps going up — let’s see what happens when that’s not the case.

Because any potential investors need to be conscious of the risks they could face by investing in bitcoin — market risks, accounting and earnings risks, possibly regulatory risks. And even if the risks don’t seem to be out front for the moment, it’s rarely a good idea to put too many of your eggs in one basket.

© Francine McKenna, The Digging Company LLC, 2020