Crypto for Advisors: Making Sense of Crypto

Another big week in the US came with the launch of exchange-traded funds for Ethereum, making the second-largest cryptocurrency by market cap available to investors in a traditional offering.

Have you ever wondered how to evaluate crypto projects and what criteria you should consider? In today’s issue, Matthew Burgoyne, a partner at the law firm Osler Hoskin & Harcourt LLP, offers a guide for investment advisors to evaluate crypto projects.

Function X President David Ben Kay answers questions advisors may consider when evaluating investments on Ask the Experts.

–SM

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How to Evaluate Crypto Projects: A Guide for Investment Advisors

As the momentum of the crypto and blockchain sector continues to grow, securities advisors are undoubtedly facing more questions from clients about specific crypto assets and their underlying projects. Evaluating these projects requires a thorough understanding of several important factors to ensure informed investment decisions. The following sections highlight areas that advisors should consider when evaluating the nature and legitimacy of any crypto project and corresponding crypto asset:

Due diligence of the project founder

Research the background of project founders, including their professional background, previous projects, and industry reputation. Look for verifiable expertise and be wary of potential scams. Red flags include newly created social media profiles and anonymous teams.

Review and critically analyze the token economy

Tokenomics refers to the economic model of the token and includes its supply, distribution, and usage within the project. The key aspects to analyze are:

Supply and distribution: Understand the total supply of tokens and how they are distributed among stakeholders. Pay attention to allocations for founders, team members, advisors, and investors. A well-balanced distribution minimizes the risk of market manipulation.

Benefit: Consider the practical use of the token within the project. Tokens should have a clear purpose, such as facilitating transactions, accessing services, or encouraging participation. Projects with unclear or unnecessary token usage should be approached with caution.

Inflation and deflation mechanisms: Assess whether the project has mechanisms to control token supply, such as token burns (reducing supply). Understanding these mechanisms helps assess long-term value stability.

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Evaluation of the business plan

A realistic and solid business plan is essential to the viability of any token project. In the crypto industry, a business plan is typically presented in a whitepaper, a basic document that outlines the project’s vision, the nature and use of blockchain technology, and its implementation strategy. Key elements to review include:

Token necessity: Determine why a token is necessary for the project. The token should solve a specific problem or increase the functionality of the project, not just serve as a fundraising tool.

Market need and competition: Analyze market demand for the project’s solution and identify competitors. As in the world of traditional finance (“TradFi”), a unique value proposition and a well-defined market niche are indicators of potential success.

Revenue model: It is essential to understand how the project plans to generate revenue. Look for sustainable and scalable revenue streams that can be realistically achieved within given market conditions.

Risk factors

Identifying potential risks is crucial when evaluating token projects. Common risk factors include:

Technical risks: Assess the potential for technical failures or vulnerabilities; multiple blockchain and software code audits conducted by reputable third parties are positive signs and reduce the likelihood of hacking incidents that could lead to significant losses for consumers.

Liquidity risks: Liquidity for certain tokens can be heavily concentrated across a few crypto asset trading platforms or liquidity pools. When a significant portion of tokens are held in just a few of these venues, trading them efficiently can become challenging, especially during periods of high trading volume

Risk from competitors: Many tokens face significant competition from other blockchain platforms that offer similar or advanced functionality. When analyzing a crypto project, consider whether there are high gas/transaction fees or network congestion associated with the blockchain. There may be competing projects and tokens that offer lower transaction costs and faster transaction times, which could push software developers and users away from the project under review.

Regulatory matters

Consider whether the issuance of the token triggers regulatory requirements such as anti-money laundering (AML) laws or securities laws; many new projects will trigger one or both jurisdictions, while some older, well-established projects that are sufficiently decentralized will not. It is important to verify whether project founders have sought legal counsel and whether sales are restricted in major markets such as the US and UK. Such restrictions may indicate an attempt to circumvent securities regulators in those countries and may suggest that the token sale may involve the sale of securities or derivatives.

Solution

Evaluating token projects requires a comprehensive approach, considering the credibility of the founders, the economic model of the token, the quality and viability of the business plan, potential risks, and regulatory compliance. By thoroughly analyzing these factors, investment advisors can provide their clients with informed guidance and help them navigate the complex and evolving landscape of crypto assets.

– Matthew Burgoyne, Partner, Osler Hoskin & Harcourt LLP

Ask an Expert

Q: What are the key elements when looking at crypto projects from a legal perspective?

A: From a legal perspective, the three main areas I look at when evaluating a crypto project are: compliance, governance, and security. Are there dedicated, skilled individuals on the team who look after these areas? While it is natural and expected for the team to have technical and marketing expertise, I also want to see individuals with strong legal and financial experience to ensure that the company is set up in compliance with local laws and can operate as intended, and that they are aware of international laws and norms that may impact the execution of the proposed business plan. I prefer to see these individuals in key leadership and decision-making positions, but if the company is very early-stage, the company’s advisors should at least include lawyers and accountants or individuals with strong legal and financial management backgrounds. If the company is planning to issue or has already issued a token, I would also expect to see a legal opinion from the relevant jurisdictions to ensure compliance with local laws and regulations.

Q: How can advisors help their clients make investment decisions based on this information?

A: Legal compliance and governance are factors that go into any investor’s assessment of the risks involved in a proposed project. They are certainly not the only factors, they are simply part of the calculation when deciding whether to invest. There are still many legal issues, especially in the crypto industry, that fall into grey areas and therefore carry potentially higher risk. Whether the potential rewards from a project outweigh the potential risks will depend on the investor’s risk tolerance and judgment.

Q: What is an example of a good legal project?

A: Projects that are past the startup stage and have a history of good compliance and governance practices will be easier subjects to do due diligence on. The licenses, registrations, and necessary files will already be in place, as will the guidelines for internal practices and operations, usually in written form. This is in contrast to early-stage startups. In these cases, there will be more emphasis on individual team members and their previous experience and track record on other projects, as well as a white paper that outlines the regulatory framework the project will operate within and how governance issues will be addressed internally.

These comments are pretty general and can be applied to any project, but they are especially important in the crypto space, where much is still fluid from a legal perspective. Lawyers are tasked with gathering as much objective information as possible to provide the potential investor with an assessment that allows for a well-informed decision.

– David Ben Kay, President, Function X

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