Reading a Whitepaper? Watch Out for These Red Flags
Warren Buffett once said “a pack of lemmings looks like a group of rugged individualists compared with Wall Street when it gets a concept in its teeth”. I worked on Wall Street, and I take offense to that. It’s not that I totally disagree with the Oracle of Omaha. Indeed, Wall Street is full of mockingjays spreading the same market sentiments, often in matching Patagonia vests. But, substitute “Wall Street” with “Silicon Valley” and you also get a true statement.
My personal hero John Oliver recently dedicated an episode of his hit HBO series, Last Week Tonight with John Oliver, on cryptocurrencies. As always, he nailed the debate right on the head. “I am not saying that every cryptocoin is a scam, just as I’m not saying that every blockchain company is bullshit,” Oliver said. “What I am saying is: In a speculative mania, it can be very hard to tell which companies are for real.” Hard, yes, but not impossible. Most cryptocurrencies are tokens issued to raise funds in order to develop a product. That product, and the market that product is addressing, is the most important indicator of its success. For example, as a oenophile, I don’t believe a wine-backed cryptocurrency is a good investment. I know it is difficult, even for professional sommeliers, to pick out an investment wine that 1) will not mature too fast, 2) has proper storage, 3) is in limited production, 4) can be purchased without wholesaler. Plus, wine investment vehicles already exists in the form of equities and mutual funds for wine producers and distributors.
Now, let’s say you find a token idea that you do believe in, what else should you look for? ICOs are opaque and the company selling the tokens usually do not have a product to show for. In this case, my answer is to look to the whitepaper, an informational document that describes the aspiring blockchain company’s vision and solution. Here at Lumenary, I read on average 3–5 whitepapers per week. Most of them are terrible, thus making it hard to take those crypto projects seriously. I have put together a list of things to look for in a whitepaper below to help you assess the next project you might want to invest in.
The most obvious telltale sign of a bad whitepaper is the short length. I will not waste time reading a whitepaper that is less than 15 pages long. The main purpose of a whitepaper is to explain the technology. Because at the end of the day, investing in an ICO is betting on the company’s underlying technology. 15 pages do not leave a lot of room to address a blockchain solution in detail, especially with technical diagrams and non-content pages added in.
A technical whitepaper should have at least 50% tech-related content. In addition to current technological gaps that the product is trying to address, I am looking for things like a well-reasoned protocol, logical architecture, the programming language of choice, appropriate API’s, and a feasible development roadmap.
One major mistake I see often in whitepapers is over-promising, with a product selling a plethora of complex features on an even more ambitious development timeline. When the roadmap is aggressively outside the norm of comparable software development life cycles (SDLC), it should raise a red flag. The project owners may not have any intention of actually finishing a product and are selling false pretenses.
SEC chief Jay Clayton has already said that every ICO he has seen is a security sale. It is only a matter of time before regulations descend upon us. Having worked on a trading floor when the Dodd Frank Act kicked in, the one thing I know about American regulators is that nothing escapes their far reach. It is getting less acceptable to be opaque about the company’s cash flow. The whitepaper should have a section detailing what the company is planning on doing with the funds they will receive from the ICO. Since most ICO’s function as seed-stage funding, the majority of the money should be spent on the core elements of the business. If 25% of the funding is going towards founder team’s salaries, that is not a reasonable breakdown.
4. Regulatory Compliance
Every single day, more ICO’s are getting shutdown or subpoenaed by the SEC. The whitepaper should detail either the company’s plan to register with their regulatory bodies or what type of regulatory exemptions the company is filing. In the U.S., ICO’s are a legal type of crowdfunding. Unlike traditional fundraising, there are regulatory exemptions for crowdfunding, which allow the companies to declare themselves exempt from SEC registration. By either registering with the SEC or filing for an exemption, the company will start on the right note with the regulators, which means they have a stronger chance of not getting shut down abruptly. There are 2 main types of SEC filings, Regulation A and Regulation D. They have different uses, which will be addressed in a separate blog post.
5. Token Supply
The “I” in ICO stands for “initial”. As much as I hate comparing an ICO to an IPO, similar to an IPO, an ICO should be a one-time-only fundraise. I am wary of ICO’s that say they reserve the right to future token sales if they need more money down the road. Why would I want to dilute the value of my tokens from subsequents rounds of fundraising? I am also wary of companies who say that if they do not sell all of their tokens, they will hold it somewhere (in escrow or a foundation or simply a wallet) to sell in the future.
Token supplies should be declared in the whitepaper, and the company should tell you what how many tokens are being created and what they are planning to do with unsold tokens. Maybe they will destroy the unsold tokens, or maybe they will distribute the unsold tokens proportionally to existing token holders. Regardless, be very careful if the company has the ability to adjust the supply of tokens, such as minting more for another token sale. This means they have the ability to manipulate the token price, which is not only illegal, but might also hurt your investment.
6. ICO Cap
How much money is this ICO asking for? Watch out for ICO’s with an astronomical cap — a company should only ask for enough money to take their product to market. Nobody needs $300 million dollars for a seed investment. Giant fundraising caps are practically putting a target on the company’s back for SEC scrutiny, which increasing regulatory risk. Asking for more money than is needed is a sign of the founders’ financial ignorance, greediness, or dishonesty. All of the above are major red flags for a potential investment.
If the company’s reason for their ICO cap is vague, I would reach out to the company and try to drill into their budget. As a potential investor, I want to know more than a high-level percentage break down. Ideally, I want to see tactical line item such as development cost for a functional prototype, acquisition cost of leadership and talent, business development cost of landing customers, corporate service costs (e.g. marketing, legal, rent, accounting), etc.
7. Quality of Writing
Yes, I realize this is a gimme but it only makes sense that a well-written document detailing the mission and vision of your company is coherent and professional. After all, it’s not a blog post! The reality is often on the contrary as I have read countless whitepapers that are 8 pages long in total, typed in ridiculous fonts and sizes, covered in unnecessary quotation marks, boasting of token benefits that are borderline illegal. Keep an eye out for grammar or spelling mistakes, incorrect punctuations, run-on sentences, etc.
In conclusion, you should investigate an ICO just as you would any seed or angel-investment into any tech startup. The whitepaper is a good tool to help your perform due diligence on the potential investment. And if you come across any truly outrageous ones, please send them my way, I always appreciate a good laugh!