ICO 2.0: A framework for due diligence

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2017 may have been hailed as the year of the ICO, but that doesn’t mean they’re off the agenda for 2018. With over $3.5bn raised through these events during the year, they really have taken the crypto-economy by storm.

However, while every story of a new crypto-company accessing the funding they need should be hailed as another major step towards bringing blockchain into the mainstream, there are still too many people being burnt by flawed ICOs.

There’s no doubt that every individual that decides to involve themselves in this world needs to be aware and take responsibility for the risks involved. However as an industry, I believe we can do more to help steer them towards the projects that we can all benefit from and away from the charlatans that are giving our industry a bad name.

For anyone that has operated in this industry for some time, there are some obvious signs that a particular ICO should be avoided. Without a regulatory body to oversee these events though, less experienced participants have little to go on.

That is why, as part of Peer Mountain’s commitment to building a better crypto-economy for all, I have outlined a framework for ICO due diligence that all prospective investors can use. Known as T3CG, it builds on the work that Jeremy Epstein has already done in relation to assessing crypto projects. Crucially though, T3CG is specifically tailored for use when such projects undertake an ICO, when the area of governance becomes so important.

Here is an overview of the main elements that all investors should assess when weighing up whether to invest in a new ICO.

Team

There are three elements to the team assessment, the executive team, the advisory team and the backing team. The executive team are responsible for delivery the strategy of the project, so you need to know they have the required skills to do so. For example, limited blockchain experience in the team should suggest that the technology has been bolted on rather than being an intrinsic part of the project. You also want to understand if they’ve been a functioning team for some time (at least 6 months) and how successful their previous ventures have been. Finally, find how they’re being paid and whether they’re willing to be paid in coins rather than fiat. This is a sign that they’re in it for the long run.

For the advisor team, you need to really understand what advice they are providing. Celebrities or well known names might attract attention but is that all they are there for? If you’re taken in by a big name, you’re probably the reason the project sought that ‘advice’ in the first place. Like the executive team, check the advisors’ credentials for similar projects, as well as whether they’ve worked with the executive team before.

You should also find out who the financial backers of the project are, including any VCs, private equity or credit institutions, as you don’t want the ICO you’re getting involved in to be a socialization of their bad investment. For all the teams you’re assessing, you also need to check whether anyone who’s been convicted of a serious crime, such as accusations of fraud, money laundering, connections to organized crime or any other potential financial crime issue.

Technology

It’s important to understand the full technology stack involved in any project, so that you’re not just focusing on the blockchain elements. Software systems are complicated to build, new hardware built for existing software is also challenging, but new hardware that demands new software is crazy hard to scale up commercially. Ask yourself whether the executive team are keeping the project simple by utilising existing components where they can or building everything from scratch.

Also, one of the most important things to understand about the technology is whether it’s live and working. A spec or proof of concept is a very different proposition to a platform that has already been used and tested by market participants.

Token

You want to understand how the token economy of a project really works, in terms of the value exchange between different parties and whether there’s enough incentive for them to use it. Crucially, you need to understand whether a token is actually required and whether a token that already exists could fulfill the same purpose.

The number of tokens in existence will obviously affect the price of a single unit and so you also need to understand what the ‘forking’ strategy is. Things can change after an ICO but the post issue holding is a good thing to watch at the time. If the project holds too many, they become the token ‘central bank’, which is also not good. As a rule of thumb, between 30% and 70% of tokens should be sold.

Finally, you should understand how the token will be classed in terms of its legal status and how liquid it might be future, in terms of which exchanges it will be available on.

Community

Following on from your understanding of the value of the token, you should also try to understand whether others in the community agree with your assessment of its potential. Try to estimate the size of the community and track their engagement with it.

Keep an eye on how actively the project team are engaging with the community, as this will give you a sign of the active user base after the ICO is complete. Check out telegram, slack and content channels like Medium to see what’s being said, both by the project participants and the community assessing it.

Governance

As mentioned earlier, the T3C elements that I’ve already outlined can be used to assess any crypto-project but the governance element becomes crucial during the ICO stage. There are two elements to assessing governance, the organisational governance and the token governance. Always though, you should look out for specific reference to the project team’s commitment to respect and protect the buyer’s interest.

Organisational Governance

The project should have an explicit commitment to provide transparency. A useful thing to find is a commitment to recognized initiatives, such as the EU ICO Charter and Project Transparency. Also, make sure you know who is in charge of what and how resources will be allocated and managed. This should be clear before the funds are raised, as should who is responsible for appointing others, setting strategy and committing project resources. The board, or other supervisory group, should have a regular meeting and review schedule.

In addition, the project should clearly indicate the arrangements to safeguard project funds and ensure use for the purposes indicated in the plan. It should have a clear communication policy for addressing token holders, with well-defined channels that are easily accessible. There should also be a clearly articulated policy for how it maintains neutral third-party audits of the project resources and a code of conduct that the project leaders have committed to.

Token Governance & Compliance

Even though ICOs are not, on the whole, regulated, investors can still look out for best practice steps being taken. For example, it’s worth understanding if the board has ensured that laws and regulations are respected. Anti-money laundering applies to all finance not just securities, so the ICO should conduct KYC on the token purchasers and have an anti-money laundering policy in place. It should also be transparent in describing the risks of the token. Depending on its nature, the project should draw on investor protection or consumer protection best practices to formulate clear policies.

The project should clearly state when tokens will be delivered from the sale. This policy should also state if and when the project may issue more tokens in the future and the factors that will contribute to any such decision. As mentioned, forking can be a form of hidden token issuance and the project should clearly state what the forking policy is, as well as where and when the token will be listed for exchange. Finally the project should explain its own policy for buying and selling tokens on exchanges.

Conclusion

For anyone interested in using the T3CG framework for due diligence, I’ve included an example checklist using the data for the Peer Mountain ICO as a guide.

As the number of ICOs has increased exponentially during 2017, the need for clear guidance on what participants should do to assess projects has only increased. As an industry, we should be helping individuals to make the right decisions so that the momentum of support for credible and potentially revolutionary blockchain projects continues.

Learn more about Peer Mountain, PMTN, and Smartcap in our white paper.

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