Due diligence on digital asset projects — where to start?

Digital asset investing is still new to a lot of people and finding an entry on how to assess the many tokens out there can be daunting. To put this into perspective, CoinGecko and CoinMarketCap boast 12916 and 20708 tokens respectively (24 August 2022). Assessing Web3 opportunities often requires specialist technical and economic knowledge, which is why we get frequently asked where someone new to this asset class could start. The due diligence and research process can differ significantly depending on the exact nature and stage of a project, which may necessitate special add-on frameworks (e.g. check out our article on how to assess a DAO here). But besides sector-specific frameworks, which we employ in assessing potential pre-seed and seed-stage investments, what are more general questions one should research before making an investment decision?

Team

Obviously, without a good team, there is no product, let alone a good product. What we are looking for is the ability for teams to execute on their vision. What is their motivation? Does the team possess the experience and expertise required to build a winning product? Are they in for the long-term, focused, and are they dedicating their full time to the project? When looking at tokenomics, there should be an alignment of incentives across the whole team (including advisers, investors, etc).

Product, positioning, and potential

We are not interested in copycats; we want to see true innovation or solutions that are significantly better than their competitors. Why would a user want this product? What is the USP? Is there a value-add position to the Web3 ecosystem or is it a niche solution? Do we see potential to become a sector leader? Is there a sound go-to-market strategy? Often teams haven’t thought through all the relevant stages of their product lifecycle. Pre-launch marketing (e.g. test net), product launch (main net), token genesis event, token listings, market making, all require different strategies and solid communication to the community to keep it attractive for users. It’s ok not to know everything on day 1. But it’s important to see that the team takes constructive criticism well and acts on it efficiently.

Technology

This is where things start to get tricky and a certain level of comfort reading code will help. However, even if you can’t read code, you can go to open-source GitHub repositories and check on a project’s progress, the number and timing of commits and general activity level per team member. Keep in mind though that some projects work with private repositories, which are not available to the general public, and often only open to investors who need this sensitive access for their due diligence process.

While we are generally platform-agnostic when it comes to investing in Web3, we do have preference for certain infrastructures and reservations against others. Teams should be prepared to answer questions on infrastructure choice and why they selected a particular tech stack.

Token design

When we look at token design, there are two principal topics: token economics, which we understand as the distribution of tokens of a network to various stakeholders (e.g. founders, team, community, treasury, investors, etc); and token utility, where we look at value accrual through usage.

In terms of tokenomics, as mentioned above, we look for an alignment of incentives and sound distribution patterns. As an example, we have turned down investment opportunities because some investors were holding a too high relative share of a network (e.g. 10% or more), which poses a risk for the network and their stakeholders should that entity become distressed and come under selling pressure. It is important to us that founders think of tokenomics long-term beyond their own hands-on involvement in a project and consider how certain funds may or may not be released to certain parties, milestone-driven and through multi-sig structures held with lead investors.

While many tokens live by the marketing hype around them, we actively work with founders on finding token utility models that go beyond certain buzzwords (staking, governance, etc) and accrue value through network usage. When we look at token utility, we want to understand why you think your token should accrue value and if that is really what all your stakeholders want, as there might also be network participants that will favour a lower token price. The basis of our discussion is usually a token flow model.

Legal / regulatory

The extent of due diligence in this section highly depends on whether we are looking at an equity plus token or a token deal only. For example, some business models will require specific licenses and either you’re already in the process of obtaining such or have a good understanding of how to get there. If you’re an established business, be prepared to show deep legal documentation on e.g. corporate structure, pending / expected litigation, company assets, and more.

Financial

We will obviously want to know how the team will use the funds they are raising and how long the funds will last according to your technical roadmap and hiring needs. Ideally, you will have a financial model at hand where we can dissect the anticipated monthly burn rate. While we appreciate that the lifetime of such a financial model can be very short for various reasons, we want to understand how you plan and manage your finances to make it to the final product.

Do your own research

As indicated above, we provide here some starting points for evaluating prospective investments. Good due diligence depends on a number of factors, can take some time depending on the resources available, and varies depending on the nature and specific sector of the opportunity at hand. It is also worth noting that not every category carries equal weight — it’s a specific mix that makes positive investment decision outcomes, and the ‘ideal mix’ will be different for every investor.

SMAPE is a team of seasoned investors and industry thought-leaders investing in internet-native ecosystems that are built by value-driven founders, obsessively solving fundamental problems by shaping the future of doing business. If you want to learn more about us, reach out to us — welcome@smape.capital