Let me start by sharing that I am positioned on both sides of the market: In the last six months I participated in implementing nearly a dozen ICO projects (both as part of ICOBox and as a private advisor), and as a token holder I contributed to over 40 projects (both as a private actor and as a consultant to institutional token buyers). This is the foundation of my expertise in the field.
In this article we will be discussing ICOs and tokens, so let me give you a few numbers which will partly explain what we are doing here.
To date, over 100 ICOs have been conducted, many of them successfully. Tokens of 93 projects are currently traded on exchanges. A significant proportion of these companies are growing businesses. Multiplier of over 1: 78.5 per cent, and multiplier of under 1: 21.5 per cent.
Average price increase relative to the price at issue: 20.5*x, although there are such projects as Stratis, who reached the ratio of x782. Note that x20.5 is an average, not mean number, so it accounts for the highest and lowest numbers. Below I will talk about how to end up in the 78.5 per cent group when buying tokens, and to avoid getting stuck in the 21.5 per cent of projects whose token price dropped after they were listed and who have been unable to come back up.
The main question: How to always buy tokens at an economic advantage?
Let's first look at the two basic approaches, i.e. the goals we pursue when buying tokens:
1. Use for purpose
This will be discussed later as a factor affecting the shortage. The expertise that you need to evaluate a project from this point of view is virtually identical to the expertise you apply when buying an interesting gadget or another product on Kickstarter. If you want to use tokens you bought as a service, a discount, or for any other purpose (for instance, many useful product tokens are being issued whose user community greatly overlaps with blockchain community), you will need to make your own decisions based on your assessment of how the market situation will impact the tokens' future worth.
2. Token's value for the market and buyers
When buying tokens you may not have any specific plans for its future use other than to just support the project you like and believe to be promising. It is important to have a deep grasp of what the token offers, rather than blindly believe the team's claims. I doubt that you'd be happy if the price of tokens you bought dropped, like it happened to 21.5 per cent of previously issued tokens?
So what we really want to talk about is the strategies for selecting tokens based on the detailed analysis of their advantages, security and market prospects.
A perfect ICO: key parameters
What constitutes a perfect professionally conducted ICO? What ICO will be a 100 per cent winner? This is not so hard to figure out. To find a "perfect ICO" one can just analyse ICOs which collected the most funds and find what they all had in common.
The most important parameter is an overlap between the project's token holders and project users. The greater the overlap the higher the shortage of tokens. This is the key component, and it always affects first the user base and its potential expansion, then the shortage and, lastly and indirectly, the token price.
The second parameter is the project’s contribution to the blockchain technology, market development, and infrastructure. If the project is in fact significant and facilitates market development, brings new users to the ecosystem, and showcases new uses of blockchain technology it has every chance of winning.
The third and final parameter is economic expediency as a synergy of economic advantages of token buying and usage. Clearly, in addition to creating a shortage a project should meaningfully impact the entire industry and its token has to be economically beneficial.
Now that we discussed the key approaches and parameters let's turn to the details and nuances. As we all know, the devil is in the details, which ultimately may greatly improve or conclusively condemn the project.
Let's start with the project audit, which can be done quickly and easily.
Through the evaluation of the project’s key ideas a buyer must answer the question: Are the project’s tokens worth buying?
To arrive at the conclusion three key parameters need to be assessed:
These include the project's team, advisors – famous people helping the team with their advice based on their vast experience, and project's backers – people who are supporting the project, often also the earliest token buyers, usually through the closed presale. Each of these are the project's locomotives, the generators of both the demand and the shortage who help guarantee that the project is not a scam or a Ponzi scheme but a quality viable product.
As we know, several ICOs managed to collect over $30 million based only on the reputation of their teams. Usually, when a certain person posts about their project on Facebook their friends and acquaintances are curious. Considering that an average contribution in our industry is relatively high (around $3.5K per backer), it follows that there is no need to engage a particularly large number of people. So by bringing to the fold a thousand buyers just by word of mouth one can ensure a $30 million haul. This is why in every project the team is in charge of the quality, advisors handle the project promotion, and backers who buy tokens at presale and announce it on the web guarantee its attractiveness to prospective buyers. When each of these team members plays their role well the likelihood of the tokens selling out is very high.
At this first stage our goal is to forecast how fast the project's tokens will sell out, and to create shortage right away. If the team is efficient in its efforts, the users will transfer the money to the book building platform and will be anxiously awaiting the start of a presale.
This is a relatively subjective parameter. It is hardly worth it to try to evaluate a project in terms of your potential use of the product. But you should definitely assess the overlap between the product user community and the blockchain community. You must be clear about the potential interest the project will generate.
For example, a meaningful ICO in the art industry, with its hundreds of thousands of participants, will certainly attract the attention of the art market and will receive wide support.
This is the type of analytical thinking that can help you assess the project in terms of shortage, probable time it will take it to sell out, etc.
You have to understand how the project's token works. For instance, if it burns up in the course of the system's operations this results in its depletion, i.e. shortage. Alternatively, the token price may go up, which improves its benefit and also causes shortage. Any detail which improves the token's worth is important.
A great many product ICOs employ the model in which the token is used as a legal tender within the service, or an access key, or a discount system, and one can observe over time (and this is part of the very basic mechanics of the project) that the token's worth is creeping up. This expands the project's horizons, widens its user community, and creates the shortage we are aiming for.
Other important parameters:
Distribution. This is another very important parameter which should be addressed in the project's White Paper, landing page, and all other marketing materials, so that potential token holders could understand to whom and how many tokens will be allocated. If any group, whether they are the project's team, partners, or advertising agencies, is given a large number of tokens, there is a significant risk that these tokens will be dumped, which will cause a noticeable price fluctuation.
Listing. First of all, token listing has to be based on something. Secondly, any token holder may then legitimately ask when will the token end up on an exchange? Oftentimes the projects and exchanges offer an ambiguous answer, and this is not a bad thing. As you may have noticed from completed ICOs, when a company announces its exchange listing date in advance, it almost always causes a serious drop in sales during the ICO. The price of tokens listed early, within 2-3 months of their issue, always drops to below its listing price. In most cases it bounces back later.
This decrease in sales during the ICO occurs because the potential user and token holder communities are waiting for the time the token is listed on an exchange so they can buy it cheaper than at presale or during the main book building stage.
Companies conducting their ICOs should clearly substantiate the need for the listing. In many ways, it is an issue of regulation. Because our goal here is to buy risk-free product tokens this matter is very important.
The reason for listing may never be speculation but only that the project needs a wider user base. Alternatively, it could be that the project could not reach a wide enough audience during its ICO but its service works best with a large number of users, or that a certain ratio needs to be maintained between various groups of users. Consequently, all of these can serve as grounds for entering an exchange. Token listing should be a tool to develop the project, to channel it appropriately, and to bring benefit.
So far we have been covering just the basics. Let's now take a closer look at the project's audit.
In-depth audit: ICO production process
ICO production process always contains three components:
· Legal support;
· Marketing; and
To conduct due diligence or an audit one must understand all three of these components.
Let's start from the first component, legal support, whose importance many may not realise. I believe it to be the key not just because I live in the US, but because the vast majority of risks are to be found in the legal field. Let's examine them.
· The risk of the primary demand crash
Tokens which have been structured incorrectly, incompetently, or in violation of the law will be problematic to sell in the USA, Europe, and Asia. One must understand that these risks affect the business itself, jeopardising it. They are also not determined by the backers' or project's country of residence.
· Secondary market risks: potential issues related to listing
Recent events involving the US regulator Securities and Exchange Commission demonstrate that market participants are advised to work with exchanges rather than engage with token issuers directly, which will naturally result in tighter regulation of said exchanges. Unsurprisingly, that will make exchanges much more cautious about listing tokens, causing them to study offered tokens very carefully to avoid being subject to securities market regulation. Consequently, if a token fails to meet certain criteria and cannot be deemed purely and simply a product, it will have insurmountable problems getting listed, and essentially will be unsellable.
As I said earlier, the regulatory aspect applies regardless of where the issuing startup, its potential token holders, or founders are located.
In-depth audit: legal support
How can this important issue be addressed? The token must pass three relatively simple tests which allow to determine if it is or isn't a product, and what are the risks. These tests are:
1. Howey Test (primary);
2. Family Resemblance Test; and
3. Risk Capital Test.
Here's a brief summary of the questions these tests address:
1. They give an idea of the interconnection between the ICO escrow use, the token issue, and its availability for use. For example, if the ICO did not use escrow accounts, that is, the money went directly to the issuer before the tokens were issued, this immediately qualifies tokens as securities. This is a gross violation which is virtually incapable of being cured!
Let's imagine that ICO did use an escrow account, the tokens were issued and distributed to token holders at the very end of the ICO, and the funds were released to the project. In the meantime the tokens were not ready to be used. The result will be similar to the one above: the tokens cannot be listed, the business will be under fire, all potential US users will have to be excluded, and the resulting legal claims will plague the company for the rest of its life.
In reality, everything has to be done in a completely different order. First you create the situation in which tokens can be used. Then you issue and distribute tokens, and only then the funds can be released from escrow.
If a company conducting its ICO needs money sooner, it can divide its tokens into batches and issue these batches one at a time, with the funds to be similarly released from escrow in batches. This is not just an example of one of the ways this problem could be tackled – this is THE only correct way to do an ICO. All three factors – escrow, token issue, and its availability for use – have to line up just so.
Things are simpler for tokens which do not carry any economic benefit. But tokens that do bring economic benefit, even if they are just product tokens, beg a question: What does one do to derive this benefit?
If the answer is nothing, then this is a direct indication that the token is a security. If no effort is required, then this is passive income, meaning it is a security – which signifies major headache ahead.
If the answer is to put in an effort and receive reward equal to my share, it will most likely qualify the token as a security. I would advise against contributing to such ICOs, because sooner or later the regulator will get around to enforcing the laws against them.
If the answer is to put in an effort and receive an individual reward not linked to any share but tied to the amount of effort which may be limited by the token, it points to a true product token. The bottom line is that each user receives his or her own amount of reward based on what specifically he/she did with the token. It is advisable that in a 3,000-user system no 10 users are ever alike.
· A token must not grant any ownership rights or shares in a legal entity;
· A token must not grant rights to shares in a legal entity's profits or assets/liabilities; and
· A token must not grant its holder a status of a creditor or lender, or a right to the refund of the purchase price.
When reading a project's White Paper and reviewing its token's underlying economic model all of these issues have to be taken into account. I provided a slightly simplified version of the above-mentioned tests (in total, they contain about 20 questions), but the listed items represent about 90 per cent of the tests' requirements. Overall, the application of these tests allows a regular buyer to determine if the tokens they are considering buying are securities or a product.
Now we can move on to the next ICO component, marketing. It is much simpler. It only moderately affects our key issue: shortage. However, one does need to understand that marketing helps promote tokens during their sale, i.e. it ensures both the primary and the secondary market shortage, and as a result impacts the price drop risk on the secondary market and the surplus risk on the primary market.
In-depth audit: marketing component
To analyse the marketing component of an upcoming ICO one does not generally need any special skills.
1. Assess the team's marketing team (project's website should contain links to their profiles), whether internal or external.
2. Study marketing agencies' website and/or LinkedIn profiles of the team members, establish their experience promoting blockchain projects and participating in ICOs.
If a team has no experience conducting ICOs or promoting blockchain-related projects this is not so good because the basic principles of marketing in this case operate very differently than in regular marketing. SMM, PR, celebrities engagement to advertise the team, and cooperation with mass media are all implemented in a different way than when conducting marketing campaigns in other industries.
3. Investigate the regions to be covered in a marketing campaign:
· The project's marketing strategy in key countries should be implemented through internal effort or with the help of external agencies. The markets to be covered should include the US, China, Japan, South Korea, the startup's country of residence.
· Marketing in other countries may be implemented through referral or bounty programs and by other means which do not require significant labor contribution.
4. It is good if a project engages 2-3 agencies – for instance, one that specialises on blockchain, and two that are not blockchain-related. Each agency will require a budget of around 20-30 thousand US dollars.
Now we can proceed to the technology component, which allows to sell a technology understandable to the backers, and handles the project's own money loss risks and the tokens holders' money loss risks.
In-depth audit: technology component
One should review the following features:
1. Smart Contract;
2. Book Building Platform;
1. Production standard: Ethereum ERC-20.
This is a platform and a standard on which tokens are based. By now backers have a clear grasp of Ethereum and ERC-20 standard, and they are most comfortable when the technology solutions are implemented using this combination. It is uncommon to depart from these standards, although many new platforms are being developed these days, and it is possible that the situation will change in the future. But for right now this is a very weighty argument: Several ICOs failed to attract large institutional backers only because they utilised alternative standards for their technology solutions.
2. Publishing the smart contract code on Github ensures its transparency.
3. Availability of instructions to the code. Token holders find integrity and openness highly attractive.
4. Smart contract's conformity to its description in the White Paper and website.
The latter is a rather involved question. While in previous steps it was sufficient to note the existence of smart contract and accompanying instructions, here one would need to dig deeper and may prefer to engage an expert in the field. This audit should not be costly, since you don't need a written opinion, but should just answer a question of how exactly the project operates. Having received your answer, you will be able to compare it to the description in the White Paper and draw your own conclusions.
5. Availability of links to external auditors or evidence that the smart contract was created by seasoned professionals experienced in conducting major ICOs.
Business qualities of a token as a key to the highest demand
· Review of the token utilisation model
· Review of technical features
· Review of the potential growth of user community
At this stage we will need to understand how the token circulates within the system and how to assess the growth of user community. Simply put, you will need to evaluate the project subjectively, because everything written up in the project's White Paper is just the vision of the startup founders' and token issuers. You can only agree or disagree with it.
If the White Paper contains no significant errors, this is good and normal – people did their best, they did whatever they could to create solid grounds for being trusted. Now everything will depend on the trust of people downstream. The end results are also hugely important: If what the project promised starts to come to life, this will cause the rise in the token's worth. Things are not as exacting in this industry as they may be in venture capital or public offering fields.
Conclusion: main area of token review
The token's main parameters are its quality – what does it do and how, the assessment of supply shortage, and the risks.
· Quality: What does it do and how?
· Risks: legal, marketing, technological
At a later time we will look deeper at the legal, marketing and technology issues, will explore the examples of specific ICOs, and dive into the nuances with the help of the best experts on the market, including those working for our company, who will share how all this works from the inside.
Nick Evdokimov, co-founder and vision director, ICOBox
Image Credit: Zapp2Photo / Shutterstock