How to Evaluate an ICO (a VC Perspective)
Since the start of 2017, media coverage of cryptocurrencies has skyrocketed. Initial Coin Offerings (“ICOs”) now account for more startup funding in blockchain based companies than all of Venture Capital. Almost $2.5 billion has been raised by ICOs to date, most of which occurred in the latter half of 2017. This hype has led many investors — even those outside the realm of startups and venture capital — to wonder whether investing in cryptocurrencies could be for them. If you’re interested in dipping your toe into the world of cryptocurrencies, but haven’t yet purchased a token, you might be feeling both curious and cautious. How do you know if buying a token from a company will turn out to be a great investment? How does one evaluate these types of fundraises, with no deep due diligence and without seeing any technology?
ICOs mark a fundamental shift in the investment world: developers, businesses, and individuals are now able to raise capital without giving out equity stake and without providing venture capitalists or other individual investors with answers to all their prying questions. But, as the SEC warns, “new technologies and financial products, such as those associated with ICOs, can be used to entice investors with the promise of high returns in a new investment space.”
Defining an ICO
In an ICO, virtual coins or tokens are created and disseminated using a distributed ledger or blockchain technology. You can buy these tokens using either a regular, government-linked currency (referred to as a “fiat” currency) or a virtual currency, like Bitcoin or Ether. Typically, the process is as follows: the founders will announce an ICO, distribute some information before the ICO starts, hype will be built, and once the ICO begins, people who are excited about the company have a certain amount of time to buy these tokens. The reason for purchasing these tokens is that their value is linked to the performance or expected performance of a company and they predict that the company will do well post-ICO because the tokens can be traded on a virtual exchange for either fiat currencies or other types of tokens and coins.
So, how are people developing their opinions on whether the company will perform well in the future?
Valuing the Company
As it turns out, even though ICO investors have less information than a typical venture capitalist or angel investor would receive when considering an investment, many of the key criteria for assessing a company are the same. But there are also a few major differences.
The team is one of the most important criteria for any investor when looking at a startup. What is their track record? Where did they go to school? Have they founded any successful companies in the past? Does the team have the technical chops to do what they claim? These are good questions to consider, because while many will tell you that past performance doesn’t indicate future success it certainly helps to have the experience. And while it’s not necessary for a founder to have received an Ivy-League degree, as an investor, you want to feel comfortable that the founders are well-educated and are capable of running a business in a structured way.
Advisors: Are their advisors renowned in the field? Are they advising other companies? What tangible benefit (i.e. advice or strategic connections) do they provide the company?
Partnerships: If the company has made some strategic partnerships in their industry already, this is a great sign — especially if those partners are trustworthy sources. Partnerships signal that outside companies are taking the project seriously.
Value Proposition and Market Potential
Another important assessment criteria for a VC or angel is the problem being solved and the size of the market. Is there demand for the product being built? If so, how much? This will require either experience in the field or a lot of research on your part, especially if you don’t have access to a lot of the databases that many VCs have access to. For this to be a good investment, there will need to be many people willing to interact with or use the product.
Competition and Partnerships: This might take a lot of investigating, but once you determine exactly what the company is offering, definitely be sure to identify any competition and chart the competitive landscape. Who else is doing this? What’s different about them? Are there any companies that offer similar products that aren’t blockchain companies? This should lead you to the following…
Necessity of Blockchain: One of the most pertinent questions you should be asking yourself about any blockchain company is, “does this company even need a blockchain?” Blockchain development is expensive and, when done poorly, can leave a lot of holes in the security of the system. There is no reason to invest the resources into a complicated technology when a simpler and cheaper substitute can do exactly the same thing.
Funding Structure and Uses
Previous funding: Before making an investment, VCs like to know whether there is previous investment and if there is, who the investors are. It is atypical for any company raising funding through an ICO to have any backing, but in case they do, it would be interesting to know.
Token distribution: VCs also like to know that there is a balance of where the equity is going when investing. Similarly, investors in an ICO should find out what the token distribution of the ICO will be. On the one hand, you don’t want the founding team and advisors to be getting all the tokens, because then they’ll never reach their funding goal. But you also don’t want them to have too few tokens, as then they don’t have enough incentive to work hard to ensure that the tokens increase in value.
Cap: There are two different types of caps — an open cap and a hard cap. An open cap allows investors to send unlimited funding to the project’s ICO wallet, gaining an unlimited amount of tokens. A hard cap means that there are only a certain number of tokens available for purchase. The more circulating coins, the cheaper each token becomes. Additionally, as ICOs with open caps grow larger and larger, there is less and less percentage gain for investors to accumulate.
Planned Use of Funds: This will most likely be in the white paper, but an investor typically likes to know where their money will be going to. Does their plan sound reasonable? Will you be happy about where your money is going?
Just like blockchain-free startups go through different funding rounds (seed, series-A, series-B, etc.), there are different stages of ICO and different questions to consider for each. There are three main stages for companies raising capital through an ICO:
- Idea: Do not invest if there is no white paper!!
- White paper: If the company has one, be sure to read it. Is it well written and well structured? How much of the technology do they have mapped out? What is their product roadmap?
- Proof of Concept: Do they have an alpha version of their project? Check out their github, if it’s public. How many commits are there to the project? If there are few commits and they’re claiming to already have technology built, this might be a huge red flag. If you have the capability, you should be looking through their code.
The Crypto Community
This is where a traditional investor’s assessment and a crypto investor’s assessment process starts to differ. The crypto community talks a lot and there are many forums dedicated to discussing whether an ICO is worth investing in or not. One of the most important forums — and often where ICOs get announced — is Bitcointalk. You should also check out CoinFund Slack Channel, CoinSchedule, CryptoCompare, CryptoSmile, and CyberFund.
It’s worth the time wading through the comments and seeing what the general opinion is. A lot of it could be hearsay, but be sure to check out the negative comments too. What risks are being brought up?
Evaluating the White Paper
The white paper should be thoughtfully written and comprehensive. How in-depth is the description and outline for their technology? While white papers are long and sometimes confusing, they are a huge piece of the puzzle of understanding how the company will operate.
Type of Token
There are different types of tokens that can be offered in an ICO: Blockchain tokens, dApp tokens, and DAO tokens. These three different types require different types of investigation. The main thing you want to find out in all three cases is what the purpose of the token is and what owning one gets you.
Do either national or international regulations apply to the project? Countries beginning to impose new regulations on this type of fundraising could impede a lot of progress for the company.
Signs of Fraud
Investing in cryptocurrencies limits your ability to recover your assets in the event of fraud or theft. You will most likely have no recourse here. That is why it’s so important to choose your ICO investments wisely, evaluate the company thoughtfully, and be wary of signs of fraudulent activity.
Below are potential signs of ICO fraud, as laid out by the SEC:
- “Guaranteed” high investment returns
- Unsolicited offers
- Sounds too good to be true
- Pressure to buy RIGHT NOW
- Unlicensed sellers
With that said, ICOs and cryptocurrencies are undeniably exciting to invest in and can generate huge returns. If you are interested in trying it out, there’s no reason to be afraid — just be cautious and conscious of your risks before you start experimenting.