Tim Enneking is managing director at Crypto Asset Management. Robert Brauer and Andrew Kang are members of the Crypto Asset Management ICO Analysis team.
The number of initial coin offerings (ICOs) is growing rapidly, having raised an astounding $5.6 billion in 2017 alone. More outrageous is that, by most estimates, over half of the ICOs launched in 2017 have already failed.
In addition to the hundreds of ICOs being launched every month, our management company Crypto Asset Management (CAM), also receives around a dozen emails per day from new companies planning on launching crypto tokens to raise capital. CAM, through the various funds and share classes it manages, invests in less than one out of every 100 ICOs that comes across its desk.
Out of absolute necessity, we have developed an analytical framework for ICOs, which CAM applies to every such opportunity it evaluates.
In this article we explain what we call The Seven Pillars Of ICO Investing™, which we’ve rigorously crafted over several years of investing in crypto and other assets.
Pillar #1: Team
The critical element which we are searching for is an experienced team, ideally with a strong track record in developing and launching blockchain technology. In addition, the team should have experience in the market it is targeting. A team that is not only competent, but capable of developing, completing and/or expanding the project is paramount to its success.
A couple of additional issues to consider are:
- Does the team have a vesting token schedule that will properly incentivize it?
- Do the advisors have the right experience and are they actively engaged?
- Does the project have any notable financial backers? (VCs, other hedge funds, etc.)
Pillar #2: Idea
Without a compelling, realistic and timely idea for a blockchain-based enterprise, the investment will almost certainly fail.
A few of the key things we look for are:
- Total addressable market: How large is the opportunity? We want as large of a market as possible (See: ethereum, filecoin).
- Product-market fit: Does the business address an urgent problem? (0x, ChainLink)
- Unique value proposition: What facets of the technology enable it to stand out from the competition? How much competition is there (Wax)? Ideally, the token has proprietary technology, and as little competition as possible (Orchid Protocol).
There is clearly an interrelationship between Pillars 1 and 2. However, if we had to choose between them, we would clearly rather invest in an “A” team working on a “B” idea than a “B” team working on an “A” idea.
A talented group of people are the lifeblood of any business, and crypto is no different.
Pillar #3: Execution
In the cut-throat business world we live in, the only thing that matters is results.
A brilliant idea and great team are nice, but execution is everything. Is there a working prototype or does your idea only exist in a nebulously written white paper? We prefer to invest in a product that already exists to some degree (Presearch, Basic Attention Token, Superbloom, FunFair), whether in the crypto space or analogously in the fiat space (Wax).
Finally, we look for some sort of proof that the company will be able to hit future milestones.
Pillar #4: Legal/Regulatory
This pillar is essential given the current and growing regulatory uncertainty in the industry.
Almost every week, there is news of a governmental agency in one country or another taking regulatory action or making a new statement around ICO governance. Of course, almost as often, there is news of a different country considering crypto-favorable legislation. Comprehensive regulation in many marketplaces is on the horizon and it is imperative to ensure that ICOs vigilantly navigate the landscape to the best of their abilities.
The threshold issue is jurisdiction: in what country is or will the ICO company be incorporated and the ICO executed? This determines the rules that will apply to the company’s actions and the ICO.
Depending on the approach taken, we may apply the somewhat arcane rules of the Howey test (in the US or if US investors are targeted or allowed to invest), KYC/AML principles (which are essentially universal) and applicable securities law.
Pillar #5: Tokenization
A significant number of the ICOs we analyze do not actually need the blockchain, tokenization or a public sale of their tokens to be successful.
When this is an issue, it is usually the last - public sale - which is not necessary. (NASDAQ’s settlement system is an excellent example of where tokenization is a brilliant idea but a public market would be superfluous, or even counterproductive.) Also, they are sometimes glorified apps that could be built without creating a specific token, despite how much “utility” the founders may claim their token provides.
With the enormous amount of value exchanging hands over the blockchain and the prospect of getting “free” money without giving up any equity, it’s not hard to imagine why many industrious entrepreneurs try to identify any possible reason to launch an ICO.
That being said, one of the crucial things that every investment we make must have is a legitimate reason for “tokenizing” their business, and for creating a public market for that token (OmiseGo, Icon, Raiden Network, Cosmos).
Pillar #6: ICO Structure
Similar to traditional venture capital investing, the financial underpinnings of the deal ultimately determine the decision to invest. The characteristics of an ICO can have important implications on the expected upside of the token.
This can be split out into two categories - ICO mechanics and ICO deal structure.
- ICO Mechanics – Historically, ICOs with a lower hard cap tend to outperform ICOs with massive hard caps. While it is important that the parent companies be well funded and have sufficient runway to work with, ICOs need to have a convincing plan for use of proceeds as the potential upside decreases in proportion to the amount raised. The precise metric here is valuation of the token economy - a derivation of the hard cap. Both the valuation in light of circulating tokens at launch and the valuation upon release of all tokens are factors that we consider.
- ICO Deal Structure – The deal should be structured in a way so that investors are not at a disadvantageous position to the market.These are a few of our considerations:
- Distribution: The team should have a compelling structure for the distribution of tokens, fair allocation among team/advisors and investors, programs for market uptake, etc.
- Distribution Schedule: Given the fast-moving pace of the crypto market, the distribution schedule should not massively favor specific parties. While long distribution periods can be considered acceptable for high-potential ICOs, individual liquidity preferences should be considered.
- Discounts: Discounts are ubiquitous in the ICO environment, so examining the discount levels given to different tranches allows investors to understand where they stand in relation to other stakeholders.
- Equity Stakes: At Crypto Asset Management, we like to be part of the growth of the company and investing directly into the equity of a company allows us to play a greater role in that development. In the world of token sales and short-term liquidity, people often forget that the value proposition of a company can be just as great or even greater than the token ecosystem it is developing.
Pillar #7: Price Drivers
Even if we believe a team is able to create a great product that incorporates a token with an imperative use case, this does not necessarily mean that we will want to hold the token or invest in the ICO. A token must additionally have a mechanism to drive price appreciation.
A token with constant supply without any incentive to hold, will not be subject to buying pressure which significantly outweighs selling pressure over the long run (Votes). This is underpinned by the concept of price risk, in which individuals will lean towards reducing their exposure to price volatility in favor of fiat or a form of stable currency. (Kyle Samani has written an in-depth piece on this velocity problem here.)
A few of the price drivers we look for include:
- Network Volume: In almost every instance the value of a token increases as the number of transactions on the blockchain increases (bitcoin, ethereum). This is one of the most basic, yet influential, indicators of demand, and is also the reason we invest primarily in protocols rather than dapps.
- Market Leadership: We look to invest only in tokens that are clear market leaders, or have the potential to be in the near future. Usually, these tokens have a distinct and growing unique advantage over their competition (Practical VR).
- Incentives to Hold: There is a clear reason why a user would rather hold than spend the token, which can be related specifically to speculated price increases or other non-monetary rewards (Presearch, PROPS). We won’t invest in a token that’s only purpose is a medium of exchange.
- Supply Changes: This can include limiting inflation, meaning the token supply does not dilute the value of all tokens over time, or token burning, where the supply of tokens in the system decreases over time (Binance Coin, Iconomi).
- Profit Sharing: Part of the value that is extracted from the system is given back to the token holders (Augur, NEO, Neon Exchange, Ethorse).
- Staking: Having users of a network to lock up their tokens either for network consensus or as a requirement in certain processes. (Bee Network, Open Platform, NuCypher, Video Coin).
- Sufficient Liquidity: If the project isn’t proactive about getting listed on multiple exchanges, preferably top-tier exchanges, we will likely not make an investment.
Please note that, as a general rule, we are not in favor of asset-backed tokens as an investment vehicle at this time. There are no real drivers of price formation after an initial, relatively small boost for convenience (Sandcoin, OneGram) and the opportunity cost is consequently too high (there are far greater returns elsewhere).
Importantly, the effect of implementing strong incentives to hold is multiplicative. Not only will the price increase be driven by the inherent tokenomics design, but also by speculation directly related to the implementation of these drivers.
Despite the incredible number of fly-by-night operations in the world of ICOs, it is certain that token generation events are here to stay. Such events are completely transforming the traditional venture capital industry and, for savvy investors, are creating fortunes literally overnight. For unsophisticated or undisciplined investors, ICOs are a minefield that should probably be avoided. However, for those who perform proper due diligence, the odds increase for realizing breathtaking returns on your investments.
This article is an abbreviated summary of our process for investing in ICOs.
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