ICO Due Diligence: How to Separate Legitimate Projects From Scams
New investors coming into the cryptocurrency or the digital currency market often fail to distinguish the difference between legitimate Initial Coin Offerings (ICOs) of blockchain projects to those designed to be exit scams for their founders.
New investors coming into the cryptocurrency or the digital currency market often fail to distinguish between legitimate Initial Coin Offerings (ICOs) of Blockchain projects and those designed to be exit scams for their founders.
Conceptually, an ICO is an excellent method for Blockchain companies to crowdfund in a decentralized manner, without the involvement of a mediator or a third party service provider. Conventionally, startups depend on crowdfunding platforms such as Kickstarter or Indiegogo to raise funds via online financial service providers such as PayPal. However, the involvement of two separate mediators in the crowdfunding process increases fees and the possibility of funds being mishandled.
PayPal and government
For instance, when popular privacy-focused email service provider ProtonMail ran a successful $550,000 crowdfunding campaign via Indiegogo, PayPal locked the funds raised during the crowdfunding campaign due to alleged requests from the government.
The ProtonMail team stated:
“When we pressed the PayPal representative on the phone for further details, he questioned whether ProtonMail is legal and if we have government approval to encrypt emails. We are not sure which government PayPal is referring to, but even the Fourth Amendment of the US constitution guarantees this right.”
Good for companies but what about investors?
For various reasons, an ICO is a great method for Blockchain projects and companies to raise funds with cryptocurrencies like Ether or Bitcoin for absolute transparency and financial independence.
An ICO is a great crowdfunding method for a Blockchain company as it allows it to raise massive funds in a relatively short period of time, in some cases due to the hype around Blockchain and cryptocurrencies. In fact, a large number of Blockchain projects and companies raise funds in the range of a million to tens of millions of dollars from undisclosed investors.
Most recently, Ethereum-based Blockchain infrastructure provider Melonport raised 227,000 ETH, which is equivalent to $11.3 mln and Matchpool raised $5.7 mln in the span of 48 hours, as was reported by Cointelegraph.
Gambling on the future
The issue with ICOs is that companies or Blockchain projects often prevent from demonstrating their potential based on empirical evidence or market data. Instead, an ICO is more of a gamble for investors who are essentially gambling on the future price trend of its token.
Direct listing is the closest comparison of an ICO in the public market. Most recently, music streaming service provider Spotify announced its plan to carry out a direct listing instead of an IPO, to target private investors and offer less of its equity.
In a direct listing, Spotify or any other company are asked to justify their valuation as a company. Spotify is currently being used by over 100 mln active users and the company has paid out over $5 bln to rightsholders - including musicians, composers, producers, label companies, etc. Based on Spotify’s revenues and user base, investors can come up with a justifiable valuation on the company.
With ICOs, investors are merely guessing or assuming the value of the tokens of Blockchain projects purely based on their potential. For example, when Ethereum initiated an ICO with its token Ether, no one could have possibly come up with a certain valuation or price of the token based on actual market data. Therefore, the valuation of an ICO or its tokens is solely based on the investor and the roadmap provided by ICOs.
Mistakes in management
As seen in the majority of ICOs, most Blockchain projects and companies leading ICOs often do not provide long-term roadmaps, strategies and development platforms.
With Matchpool taken as an example, its investors were not notified beforehand about the fact that $1.7 mln of its funds would be hedged to Bitcoin. Thus, many in the community believed co-founder Philip Saunders’ exit scam claims. However, if Matchpool communicated efficiently with the team and let the investors know that a large portion of the funds would be hedged to Bitcoin beforehand, such an issue would not have emerged.
As Bitcoin and security expert Andreas Antonopoulos explained at the Singapore Management University on March 20:
“I'm sure there are some [ICOs] that are very interesting but at least 95 percent of the ICOs out there have none/very few of the basic fundamentals. Does that mean we should have a regulatory agency decide which ones are good or bad? No. It will require more maturity among investors in identifying Ponzis. The best way to learn which ICOs are worth it is to lose money. Waiting for the wash-out. When these people promise great riches, they usually mean for themselves. If you have a viable product... build it first and they will come. I do not treat these technologies as investments but learning opportunities.”