Effective signals for investing in an Initial Coin Offering

An exploratory study investigating signals for ICO investment

In 2017 the Initial Coin Offering fundraising mechanism has allowed crypto-ventures to raise a staggering $2.18 Billion (as of Sept 2017). The amount per say is not surprising, but the mechanism of ICO fundraising is very interesting. It decentralises the whole fundraising in respect to the VC fund raising model and in comparison to crowdfunding provides an access to a substantially high amount of seed funding.

However, there are quite a few serious aspects of this fundraising model that raise concern. The model is currently unstructured and unregulated. This provides ventures to explore various models and innovate with the fundraising strategy. However, in some cases it also leads to unethical behaviour, scams and bogus ICOs. The recent steps by different local governments- US SEC ruling on DAO, China banning ICO and Canada creating a regulatory framework highlights this concern.

Blockchain ICO funding outweighs venture capital by 3x in total deal size and quantity.- CoinDesk’s Q2 2017 State of Blockchain

As a part of a research project I conducted an exploratory research, interviewing 6 stakeholders from different aspects of the ICO ecosystem (founders, traders, investors and economist). The goal of the interviews were to understand and identify some tendencies that might help people to invest with proper due diligence.

You could read the complete report here. (the methodology, the assumptions and the interview structure) or just scroll down to read through the key insights from the research.

Link to the research

Note- The research is exploratory in nature and do not claim any statistical or scientific validity. It’s only an initial exploration and is meant to start a discussion and exploration in this sector. Please use your own judgement while investing

Synopsis of key Investment signals for investing in an ICO-

  1. Local government’s attitude towards the blockchain technology

With the rise of acceptance of blockchain technology by the people, the governments are also shaping regulations for this space. The recent SEC ruling, declaring DAO tokens as a security (hence ICO liable under taxation) shows some ways the government regulations can impact the ICO. Hence as an investor or entrepreneur, it is quintessential to monitor the currently “evolving stance” of the local government; while investing or raising crypto-capital.

2. The duration of existence of company before the ICO

In the current market, the ICO model is considered to be the most effective way to raise capital quickly without proper due-diligence or regulation. This has led to companies raising far more money than actually required, which might lead to a strong market correction; spoiling the whole blockchain economy.

The duration of existence for the project/company could be a good indicator of the team’s commitment to the project’s goals and vision. Also, it is a good demonstration of the team members could effectively work together.

An investor/trader could use this signal to base her token holding time.

3. Liquidity of tokens post the ICO

One of the key aspects of ICO model being so successful in comparison to the equity crowdfunding is the possibility to trade the tokens right after the ICO. Unlike equity-crowdfunding, this gives the investor the freedom from a lock-in period and an option to exit the project at will. However, for an entrepreneur, this could be tricky as often the valuation of the token is heavily based on crowd sentiments and not entirely the project development outcomes. Hence, the fake news could instantly affect the crowd sentiments leading to crash in token valuation or in some extreme cases death of the whole project early on. The entrepreneur should be aware and careful of this aspect. Depending on the motivations of the entrepreneur it might be smartly used to filter out speculators from investors. For example, if a holding period of 3 months is designed after the token sale; restricting people to trade. It could repel speculators and only get investors believing in the product vision; probably resulting into more market-valuation stability. Another key decision that an Entrepreneur could base in this signal could the amount of crypto-currency to be converted to fiat currency after the ICO.

4. Distribution of the token holdings

The distribution could be analyzed based on two major categories: 1)Distribution of ownership of token holdings and 2)Distribution of demographics of investors/traders

  • Distribution of ownership of token holdings

With venture funds and hedge funds entering into the crypto space, sometimes a large portion of tokens are owned by a very small group of people. This affects the dynamics of financial control of the project. As an entrepreneur it should be one key consideration- whether she would prefer the distribution of tokens with a distributed crowd of investors (which might also expose to fluctuation due to crowd sentiment) or manage less number of financial decision-making stakeholders(which might expose to a centralisation of financial control). For an investor researching about the token ownership distribution could give an idea about how the decision could be made in the company?

  • Distribution of demographics of investors/traders

This is a bit tricky. Some countries with a major share in the crypto-investments have strict government regulated financial policies. A key reason for the investors from these demographics might not be entirely based on their investment on the expected growth of the projects. Hence once the crowd-sale is complete the entrepreneur could use the information about the distribution of demographics of investors/traders to design her strategy about the

split of the fundraised money into cryptocurrency versus fiat currency safely.

5. The sentiments of the crypto-community around the projects

This is one of the most important signals in the blockchain ecosystem. Along with this, it’s also the most dangerous signal as well. The whole blockchain ecosystem runs on community engagement. An active and growing community showcases the positive interest of people into the project. One interesting aspect could be the openness of the project developers within the project community to provide the assessment of the technological risks (as the technology is not completely mature).

Several investors/traders consider only the community sentiments as the sole signals in their investment decision. However, it is important to note;

online forums and chat channels are people without major credibility at stake.

Hence, the advice sometimes might not be of highest quality. Along with this there is an add on business entirely based on providing services to improve the crowd views around an ICO. Therefore, this signal is highly effective if used carefully or in conjugation with other signals.

6. Promotion bounties and paid promotion

Bounties are often used by entrepreneurs to get done small tasks cheaply. Like translation of whitepaper, visual design or proof reading. However, sometimes bounties are used for a social promotion that might look like an organic sentiment.

The identification of promotional bounties or using services for paid promotion of an ICO is often considered a very negative signal to the investors.

7. Information quality in the project White paper

Since the initial Bitcoin whitepaper by Satoshi in 2008, almost all the crypto projects release their project core-focus, vision, and roadmap in form of a white paper. As often the projects are using blockchain projects, the key focus is explaining technology (which in some projects might be glorified). With the expansion of the type of people entering the crypto-community; it’s of paramount to present the whitepaper from the point of view of the potential investor/trader. Based on the research, few of the key parameters that might help in effectiveness of white paper-

  • Clear explanation of the problem and providing a logical justification for the worth of the problem.
  • Providing a concrete financial roadmap with a more detailed explanation on the allocation of the funds (maybe a sample balance sheet).
  • Demonstrating the understanding about the target users: their goals and motivation with respect to the project.
  • Acknowledging the technical risks and presenting them in a neutral way along with a possible action plan.

The above-mentioned insights hold a high degree of subjective to the analytical thought process of the researcher. Hence while using the above-mentioned signals, it highly advised to use one’s own judgment and the signal could just act like a set of reference guidelines.

Conclusion

Currently, in the bull market of crypto-currencies, there is a very high amount of volatility primarily due to lack of proper due-diligence. As seen in history again and again; if the projects are not able to provide a real value to the business cases then a market crash is inevitable. Based on the current volatility, there is a common consensus in the community of an expected market correction in next 12–24 months. Depending on the extent, this market correction could be very bad for the whole blockchain economy as the regulators might use it as a signal to impose strict regulations on this technology.

Note- The research is exploratory in nature and do not claim any statistical or scientific validity. It’s only meant to start a discussion and exploration in this sector. Please use your own judgement while investing.