What Is Happening With ICOs?
Cryptocurrencies enjoyed an unprecedented increase in value in 2017 with the value of bitcoin alone rising from $1,000 to a peak of $19,000 in December. As more and more institutional investors and retail buyers start to show interest in the market, not only have prices risen from speculation but the asset class has benefited for an increased sense of legitimacy.
With this broadening of the investor base and wider acceptance, companies are now looking at their own coin offerings (ICOs) as a credible funding source for investments in new blockchain technologies. In 2017 alone, the ICO market successfully raised $3.8bn in capital from investors (more than all early-stage venture capital) and this could easily jump north of $10bn in 2018 based on Q1’s performance and Telegram’s looming ICO.
With such a large increase in the number of ICOs worldwide and no formalized and regulatory standard for new token issuance, the market in token offerings has become something of a spray-and-pray investment landscape, sometimes to disastrous consequences. To be certain then, fraudulent ICOs are becoming increasingly prevalent. With the rising adoption of cryptocurrencies and the popularity of token offerings for raising investment capital, fraud is the easiest way to lose an investment in an ICO.
What is needed in the absence of any issuer-side improvement in offering standards, is a robust and exacting due diligence process. A full verification of the company’s claims to validate all the key investment checks and criteria needed for an ICO investment, from technical assessment of the block-chain technology involved in the project to background checks on the management team. From a full audit of the use of proceeds to verification of the rights and obligations assigned under the token itself.
With a complete perspective, you can then make an informed decision on valuation and legitimacy, with greater certainty over the nature of the business and its ICO. To carry out this due diligence process, the team at BlueFlare devised a 100+ point specialized ICO investment checklist, divided into four key areas. These checks can be used in any coin offering, and whilst they do not run to the point of exhaustion for any specific investment, they do provide a comprehensive starting point to launch an investigation into any ICO.
These are summarized in the infographic below and followed up in detail underneath.
‘Team’ refers to the executive management team of the ICO, as well as any advisory members and investment backers.
As with any investment into a project, an assessment of the ‘execution’ risk associated with it is of paramount importance to assessing the likelihood of success. Whether the team can deliver their objectives within the stated timetable and budget will have a large determining factor on the final outcome of the project but also the price volatility of the token during project’s lifetime. Announcements of delays, setbacks or conflict within the management team, will likely send the token price down heavily during production.
To assess this it’s important and research and come to a view on the management team’s track record of delivering successful projects. Investigating previous project outcomes as well as the depth and breadth of the team’s experience, both together and individually is of great import. How long have the team known each other? What have they successfully delivered on previously? What failures did they have? How much money have they returned to investors? Investors should be particularly focused on each team member’s blockchain and product expertise, to establish their competency in context to the project. How long have they been in the block-chain industry? How well known are they? Have they been involved in any successful block-chain technologies previously?
Of equal importance in respect of the management team is their reputation and professional integrity. With the ease of fraudulent misrepresentation in the ICO market, the creation of fake or misrepresented management teams has become increasingly prevalent. It is therefore important to conduct background checks on the key personnel to ensure their professional conduct historically and to validate any past claims. Are they active online? Do they have and regularly use social media? What are they talking about in relation to the project and the ICO? Do you have any related colleagues/friends that can provide more information? You can observe social media profiles, activity on online, search scam-checking websites as well as run criminal background checks.
Whilst the management team should be central to focus on here, the advisory group and major investors in the project (together the ‘backing team’) are also useful to look at. An ICO with a credible advisory team and notable investors says a lot about the management team who would have been pre-vetted if the backing team are professional. To some extent, similar questions can be asked, what block-chain experience do the backing team have? What else are they invested in? Have these projects seen success? How good are the backing team at picking winning ICOs?
‘Project’ refers specifically to the product and/or service being funded by the ICO.
The strategic value and commercial viability of the ICO’s project is paramount to ensuring funds are being used for a successful outcome for investors. With an ever widening base of ICOs on the market and the potential for broad application of block-chain technologies, many spurious offerings are coming to market which serve little value to customers. Charles Hoskinson, ethereum network co-founder, was recently quoted saying “There’s an over-tokenization of things as companies are issuing tokens when the same tasks can be achieved with existing blockchains. People are blinded by fast and easy money.”
To analyse this, investors should be realistic and sober in their assessment of each ICOs planned used of funds. In particular the key questions are, does this project need to exist? Does it have product-market-fit? Does its proposed usage of block-chain have merit and if so, what is the market value of the disintermediation it will bring? How much of that is it likely to capture? What competitor offerings are out there that will complicate things? Is this a well-regulated market that could to clampdowns on block-chain usage? This last point is crucial, in industries that are “your-money-or-your-life” (financial investments, healthcare, insurance), you should expect significantly higher regulatory scrutiny on ICOs.
Coming down for the broader picture, it’s also important to consider the current product situation. Where is the project in its current lifecycle? Is it revenue-generating yet? If so, what are the customer metrics indicating with respect to take-up? Are their reviews from customers online? Is the team working on any feedback? Is the project open-source? Its useful to see the timeline of the project to date, in particular has the project raised funding before? What was it spent on?
With an understanding of the strategic and commercial needs of the project, it’s also important to understand the technical viability of the product or service. What are the hardware and software requirements to bring it to fruition? How do these reconcile against the management team’s claims? How difficult is it going to be to deliver? Some combinations of hardware and software can be extremely difficult to integrate and deploy together. What are the likely timings and costs? How do these correspond to the team’s claims? How do they match to the team’s capabilities (discovered above)?
‘Funds’ refers to the use of the investment capital raised through the ICO.
The plans for, and usage of, the investment funds raised for the project are important to audit. In particular its crucial to establish upfront what percentage of the investment funds are going towards ‘primary’ investment (R&D) versus secondary outflow (management remuneration and selldowns). The secondary component should be far outweighed by the primary and if the management team are indicating any large outflows of the funds right away for remuneration or to pay off a liability, this can be an immediate red flag. As an investor in a high-risk growth enterprise, you want to see as much of the capital going towards supporting the project as possible.
Within the primary category, it’s important to scrutinize the line items for R&D versus marketing spend and other expenses. If the team are allocating far more to marketing than R&D and the project is barely developed, this would indicate a team that’s overlooking the investment requirements or simply looking to buy their project to success. A useful way to get a relative sense of things is to benchmark the planned use of proceeds versus other ICOs to see what the relative mix looks like. It’s also worth looking at team remuneration and benchmarking this to other management teams. Are the top management taking exorbitant salaries at the expense of funding the project?
When the use of funds has been verified, the next step is to carefully examine the governance processes in place for managing the capital raised. Raising a multimillion dollar investment pool is one thing, but ensuring it is managed professionally and spent ethically is another. Who is in charge of allocating the funds post ICO? What processes are in place to ensure no abuse of power? What checks and balances are there for changing the proposed use of funds during the project? Will investors be notified? Who oversees any management selldowns?
‘Offering’ refers to the underlying asset investors receive for their investment
The rights and obligations assigned by the underlying token are of great importance when considering what you will receive for your investment. When you buy a traditional equity share, you have voting rights and a position within the liquidity hierarchy (fairly low depending on the share type). Whilst this wouldn’t be the same for tokens (they don’t consign ownership), there are some analogous components, in particular in the event of bankruptcy or fraud on behalf of the management team.
To assess this it’s important to look carefully at what rights are assigned to investors from the token? What happens if the company goes bankrupt or fails to deliver on the project? What is the dispute resolution process if there is a legitimate claim by investors later in the process? How can I enforce my rights? Does the issuer’s country recognize ICOs and offer any regulatory oversight or protection?
Of equal import is the token’s proposed liquidity profile post ICO. It is key to ensure there will be an active and liquid secondary market on one or more exchanges post offering so that investors have plenty of opportunity to exit the investment and monetize any gains in a timely manner. In that sense, reviewing whether the token has been accepted to any major exchanges and if so, on what timetable? Are these exchanges reputable? What checks would they have done to audit the token and team? A token going on a reputable exchange infers some positives for the offering.
Another key consideration is the sell-down terms associated with the offering and its key stakeholders. In traditional equity offerings (IPOs), major investors and management are subject to a ‘lock-up’, usually for 90-180 days, depending on the size of investment. This prevents ‘dumping’ of the asset, where one or more major investors tries to sell out at once and severely depresses the price for all others. It also ensures alignment of interests, so that the ICO is not used as a vehicle for management or other investors to sell out immediately. In which case, it’s important to find out what the lock-up is for management and other major token holders? How much are the project owners holding onto? It should be a reasonable size versus financial investors to ensure an alignment of interests. Another aspect is token-repurchases. Some companies might have a token buyback program in which case this should be reviewed to see where funds are coming from for the buyback.
Immediate Fraud Flags
With a good sense of these five bases its worth doing a sanity check against some immediate red flags that are potential warnings for fraud:
“Guaranteed” high investment returns
There is no such thing as guaranteed high investment returns. Be wary of anyone who promises that you will receive a high rate of return on your investment, with little or no risk.
An unsolicited sales pitch may be part of a fraudulent investment scheme. Exercise extreme caution if you receive an unsolicited communication—meaning you didn’t ask for it and don’t know the sender—about an investment opportunity.
Sounds too good to be true
If the investment sounds too good to be true, it probably is. Remember that investments providing higher returns typically involve more risk.
Pressure to buy right now
Fraudsters may try to create a false sense of urgency to get in on the investment. Take your time researching an investment opportunity before handing over your money.
With the capital raised from ICOs likely to continue to surging in 2018 and beyond as well as talks of much larger ICOs on the horizon (a potential $5bn ICO from Telegram), regulatory oversight of the space is almost an inevitability. This is not necessarily a bad thing for investors as improved standards will only reduce the risk of fraudulent misrepresentation in the ICO marketplace.
That said, robust due diligence will remain a key virtue of any successful block-chain investor. As companies open up their books for greater transparency, so the requirement to investigate becomes more pertinent and the opportunity to place a winning bet gets greater.