This was another big week in the U.S., with the launch of exchange-traded funds for Ethereum, making the second-largest cryptocurrency by market cap available to investors through a traditional offering.

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

In Ask an Expert, David Ben Kay, president at Function X, answers questions advisors can consider when evaluating investments.

–S.M.

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How to Evaluate Crypto Projects: A Guide for Investment Advisors

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

Project founder due diligence

Investigate the backgrounds of project founders, including their professional history, previous projects and industry reputation. Look for verifiable expertise and be alert for potential fraud. Red flags include newly created social media profiles and anonymous teams.

Reviewing and critically analyzing tokenomics

Tokenomics refers to the economic model of the token, including its supply, distribution, and utility within the project. Key aspects to analyze include:

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

• Utility: Evaluate the practical use of the token within the project. Tokens should have a clear purpose, such as facilitating transactions, accessing services, or incentivizing participation. Projects with vague 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 in evaluating long-term value stability.

Evaluating the business plan

A realistic and sound business plan is essential for the viability of any token project. In the crypto industry, a business plan is commonly presented within a white paper, which is a foundational document that outlines the project’s vision, the nature and use of blockchain technology and implementation strategy. Key elements to review include:

• Necessity of the token: Determine why a token is essential for the project. The token should solve a specific problem or enhance the functionality of the project, not just serve as a fundraising tool.

• Market need and competition: Analyze the market demand for the project’s solution and identify its competitors. As is the case in the traditional finance (“TradFi”) world, 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 are realistically achievable within the given market conditions.

Risk factors

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

• Technical risks: Assess the likelihood of technical failures or vulnerabilities; multiple blockchain and software code audits conducted by reputable third parties are positive signs and lessens the likelihood of hacking incidents, which can lead to significant loss for consumers.

• Liquidity risks: The liquidity for certain tokens can be heavily concentrated on a few crypto asset trading platforms or liquidity pools. When a significant portion of tokens is held within only a few of these venues, buying or selling them efficiently may 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 enhanced functionalities. 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 which offer lower transaction costs and faster processing times, which could attract software developers and users away from the project under review.

Regulatory considerations

Evaluate whether the issuance of the token triggers regulatory requirements, such as anti-money laundering (AML) laws or securities laws; many new projects trigger one or both areas of law, while some older, well-established projects that are sufficiently decentralized do not trigger these laws. It is essential to verify whether the project founders have obtained legal advice and if sales are restricted in major markets like the U.S. and the UK. Such restrictions could indicate an attempt to circumvent securities regulators in those countries, suggesting that the token sale may involve the sale of securities or derivatives.

Conclusion

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 informed guidance to their clients, helping 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 into crypto projects from a legal perspective?

A: From a legal perspective, three key areas that I look at in assessing a crypto project are: compliance, governance and security. Does the team include dedicated, competent individuals looking after these areas? While it is natural and expected that the team has technical and marketing expertise, I would also want to see individuals with strong legal and financial experience to ensure that the company has been established in compliance with local laws to be able to operate as it intends and that it has an awareness about international laws and norms that could impact execution of their proposed business plan. I would prefer to see these individuals in key leadership and decision-making positions, although if the company is in a very early stage, then at least advisors to the company should include lawyers and accountants or those with a strong legal and financial management background. If the company is intending to or has issued a token, I would also expect to see a legal opinion from 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 included in any investor’s assessment of the risks involved in a proposed project. They are not the only factors by any means, just part of the calculus in assessing whether or not to invest. Particularly in the crypto industry there are still many legal issues which fall into gray areas – and therefore potentially of higher risk. It will depend on the investor’s risk tolerance and judgment as to whether the potential returns on a project outweigh the potential risks.

Q: What is a good example of a project from a legal perspective?

A: Projects that are beyond the startup stage and have a record of good compliance and governance practices are going to be easier subjects for due diligence. Licenses, registrations and required filings will already be in place, as well as guidelines for internal practices and operations that are generally in written form. This is in contrast to early-stage startups. In those cases, more emphasis will be given to the individual team members and their previous experience and track records in other projects as well as the white paper that contemplates the regulatory framework that the project will operate in as well as how governance issues will be handled internally.

While these comments are quite generic and can apply to any project, they are of particular importance in the crypto field where, from a legal perspective, many things are still in a state of flux. Lawyers are tasked with gathering as much objective information as possible to present the prospective investor with an assessment that enables a well informed decision.

- David Ben Kay, President, Function X

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