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Under Scrutiny: How to Pass Due Diligence as a Blockchain Project – Thought Leaders

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Under Scrutiny: How to Pass Due Diligence as a Blockchain Project - Thought Leaders

Every business is destined to undergo multiple assessments. Regulators granting licenses and permissions, potential partners, investment advisors and investors – each of them has a set of filters that a tech project should pass to be considered viable. The task gets more tricky for deep tech startups utilizing blockchain, AI and other cutting-edge technologies.

This article is structured as a list of questions for a startup to check its investment readiness and prepare for a due diligence process, grouped in three broad categories: 1) technical, 2) legal, and 3) business. Starting with generic ones, we are diving deeper into industry-specific questions with particular examples in the tech part to illustrate nuances and pitfalls a project might face, especially fueled by high competition in the space.

Technical considerations:

Is the proposed solution technically possible?

This might sound obvious – but many founders neglect this question while chasing the visionary technological dream, especially in deeptech areas like AI/ML, brain-computer interfaces, biotech, or blockchain. If your project exists only as a concept yet (especially if you’re not the tech guy and will do external hiring), make sure that it is possible to develop before you pitch.

If the solution is not technically possible at the moment, how much time and effort is needed for research and development (R&D)? Are these estimates aligned with time and funding limitations, if there are any? 

In some cases, a tech team is strong and the idea is very promising, but it might take full five or ten years to develop and be adopted – like quantum computing for solving enterprise-grade problems in the pharmaceutical industry.

You have to be honest – and realistic – about the timing and expenses. You will certainly get this question. Here you need to distinguish between research and common software development costs: the research stage is inventing algorithms to build something that previously hasn’t been possible due to technological limitations, with uncertain results and timelines. The software development stage is building a well-understood solution, which only requires a certain period of time.

Clearly enough, investments at the research stage are much less predictable. However, development can also take much longer than team plans originally, trying to impress investors and overestimating capacity. Make sure you don’t.

In the case of a software product, does the project really need proprietary software and not a white-label solution or SaaS?

Reinventing the wheel might be seductive. However, in some cases, spending resources for the development of a new in-house technical solution can be a waste of time. If you as a startup do not suggest a software innovation, it might be easier and cheaper to purchase a ready technical part and customize it to the particular business needs.

What are the external dependencies (e.g. libraries)? How is external software maintained?

No software is written totally by the company in-house team. Every project in the world uses multiple external databases and code libraries, often open-source, maintained by global communities of developers or by corporations. The resilience of the project depends on the timely update of external software for security and efficiency.

If you’re doing an AI project, what is the source of data? Is it sufficient? Is it available?

The viability of AI projects is extremely dependent on data quality. Algorithms may be inefficient when there is not enough data. Also, inherent biases in the data (e.g. racial) will impact the final algorithm. Furthermore, there may be a chicken-and-egg problem if the customers are a source of data and, at the same time, the main value is delivered using the AI/ML. If the data is not free, its cost should be considered vs potential value compared to using less advanced methods.

If you’re doing an AI project, how is the context-dependence addressed? 

Even if there is plenty of data available, it may be gathered in a specific context, often being non-applicable in another. For example, if the network was able to distinguish cats and dogs indoors, it may be unable to do so outdoors.

If you’re doing a blockchain project, why the database should be distributed, in other words, why do you need blockchain? 

Many problems that are claimed to be solved with the blockchain can be solved with a simpler cryptographically protected database with a robust permission management system that can also utilize public-key cryptography if needed.

In the case of the original concept of blockchain, the database is distributed among multiple participants with all of them being able to make an input. This is not always needed. For example, an enterprise may need a database to store and process its internal data, in which case it shouldn’t be distributed. Or it may be a database of a governmental body, to which everyone should have access but only the government should be able to validate input data.

If it makes sense for a database to be distributed, does blockchain have to be public?

Blockchains can be generally divided into public and private. Public (permissionless) blockchains are the ones in which anyone can host a node, thus having access to all data recorded and validate database updates. In private (permissioned) blockchains only certain participants can have access to data and validate input.

Public chains significantly reduce the control over the business as the state of the database is now controlled by multiple people scattered across multiple countries. This also means an increased regulatory uncertainty, especially in the case of heavily regulated industries or the ones that are of systemic importance. For these reasons, the case for public chains must be really strong. In many cases, a private blockchain is enough to satisfy business requirements. For example, transaction processing requires only financial institutions participating in the blockchain, sharing medical history data requires only hospitals participation.

If you’re doing a blockchain project, what are the incentives of participants to act for the benefit of the system? What are the ways to break these incentives and how are they addressed?

As blockchain, especially the public one, is maintained by common efforts, and the quality of data, the transaction costs depend on the participants, incentives should be designed in a due way to ensure that the system is sustainable.

An example of where it is problematic is the Tezos blockchain that utilizes the so-called Liquid Proof of Stake (LPoS) consensus algorithm. A consensus algorithm is a way in which validators agree on the new state of the ledger. In LPoS consensus participants can stake a certain amount of a blockchain native token to get a right to either validate transactions themselves or select another trusted person that would do that instead, who would validate a transaction and distribute the reward. Although such algorithms have multiple benefits, the common point of criticism is that incentives for participants to become validators are questionable as they can select someone else, and still receive a significant chunk of reward because of the competition among potential validators, while not spending time and computational resources on network maintenance and governance. This creates a risk of blockchain centralization and various types of attacks.

How is the cybersecurity ensured?

Cybersecurity is a primary feature of any IT infrastructure. Especially for a regulator, who’s main concern is protecting customers.

If you’re doing a hardware business, how is the quality of supplies ensured?

While software businesses are dependent on external libraries, hardware businesses depend on supplies providers for the quality of their solutions.

Legal сonsiderations

Assessing legal implications of a project, compliance costs and limitations arising from legal requirements.

Does the company need licenses to operate legitimately, and which ones? 

This point is especially important for heavily regulated industries, such as fintech. Almost any financial services require some kind of licensing, and some of them – such as MiFID II in Europe – can take up to two years or more to acquire.

Also note that in most cases you need a separate license in every country where you intend to operate and provide services, although there may be various arrangements between competent authorities, especially between the EU Member States, that allow facilitated transfer of license.

How does the company handle KYC/AML issues?

All clients need to be identified, especially in the financial services industry, as well as the origin of their funds so that the business is not used as a means for money-laundering. However, making customers confirm their identity may not be a great and engaging UX, negatively impacting conversion rates. The proportionality principle should be applied – the higher the risk, the stricter measures.

Who holds the custody of the funds?

This question will be asked to any business that allows clients to deposit their funds, such as investment management. Holding clients’ money and assets also requires licensing, and the project should consider a partnership with an applicable license holder institution.

Who is liable for failures?

This happens to be one of the most neglected matters. Even if you will suffer eventual reputation damage, you can still protect itself from legal liability by building corresponding arrangements with service providers. For example, if client data is stored on third-party servers, they should be responsible for the data safekeeping. Note, though, that such arrangements will increase service costs. Sometimes providing a service for which a liability may be taken is a core business of a company. Although it is impossible to avoid liability completely in such case, it can still be reduced, for example, if employees are liable, and not a company, or if limits are imposed on the amount of liability.

Founders of blockchain projects, especially of decentralized ones, tend to consider that they hold no liability, as they don’t control the network. However, regulatory authorities may have another view as the legislation is built on the premise of a liable service provider who has the responsibility to ensure that the system operates in a due manner. Thus, the project team may become subject to claims in case of failures.

Taxes

Being poorly managed, taxes can significantly reduce company profits, especially in the case of unfavourable double taxation regime between countries the company operates in. Furthermore, taxation issues can make the company much less attractive as an investment opportunity. A proper optimization should be undertaken in order to mitigate these problems.

What is the intellectual property of the company? Is it protected? Does the company violate any IP?   

There are three main points to it.

Firstly, a company may at some point become a target for patent trolls, so it should get patents and copyrights for all its relevant assets.

Secondly, in order to make an MVP startups may violate someone’s intellectual property in some cases, for example, use protected images, design, UX, etc. It is unlikely to be problematic at the initial stage but may be when the company grows bigger. Especially if the IP violated belongs to direct competitors.

Thirdly, IP is an asset that increases valuation, that may be used for tax optimization.

Data Protection

In recent years GDPR became an increasingly pressing issue. Basic privacy setup goes far beyond cookies disclaimers and should include proper storage of personal data, hijacking of which may result in significant lawsuits, proper data management, such as not giving to third parties without consent, the possibility of erasure, etc.

The blockchain may often store sensitive personal and financial data, which are strictly protected on the regulatory level. They can sometimes be contradictory to the nature of the technology, such as the right to be forgotten or the obligation to store data on the server of the country where the person resides. It is advisable to consider not storing personal data on the public blockchains at all, which enables more control over them.

Business considerations

What problem does the project solve?

Emerging technologies are sometimes called “a solution looking for a problem” – not unjustly. Behind the engaging narrative and brilliant technological thought, it can be easy to lose the most important question: who is your target audience, and why it will use the proposed solution?

Check if the stated problem does exist, confirmed by the potential clients. Customer surveys and test can help a project make sure that you are moving in the right direction. If a project operates in a vacuum with no direct contact with its target audience – it is a red flag for investors, as it risks meeting no demand once it goes live.

Sometimes a problem is not pressing enough for it to require a separate solution.

How is the problem currently solved? How is the proposed solution better?

In order to be adopted, a project has to offer a very clear benefit to its customers – saving someone’s time or money, fulfilling a particular need or simply providing positive emotions.

If the benefit is marginal, clients are unlikely to pay more or bother switching to a new service at all – so make sure a project has to lead a competitive analysis and found its clearly defined niche in the market.

We once had a discussion with a project building a network of supercomputers in different countries that would solve the AI problems with built-in algorithms so that customers would only input data and choose algorithms. The problem was that in cloud computing they were competing with Amazon and Microsoft, and in AI software – with IBM. No chance they would win.

What are the core assumptions on which the business model is based? How are they validated or are going to be validated?

How actually the company is going to make money? What metrics in such cases determine the profits? Are the revenue predictions realistic?

For example, if transaction fees are the main source of revenue, certain transaction volumes are expected and should be justified by market analysis.

What is the place of a company in the industry value chain? Who are other participants the company is working with? How supply chain sustainability is managed?

No company delivers its value to end customers independently, it is always working together with multiple other actors. It is critical to identify the exact added value the company provides. All other companies in the value chain are external dependencies that may pose risk and should be managed, for example, by diversification.

How does the unit economics of the company work? Can it be profitable at all?

That is, does a single customer bring more money than it costs, including processing and acquisition costs.

In the case of broken unit economics, is the increased revenue per customer possible, or they will not pay more? Is it possible to cut costs in the future with significant investments, for example, software that reduces operational expenses, or marketing that raises the credibility, reducing acquisition cost?

In other words, investors will look at the factors that will make the investment justified.

What is the growth strategy? How is the growth engine validated? Does it suit the business model?

To make the investment feasible, a project should have a certain growth potential that matches the risk. For an operational profitable business growth expectation is lower compared to a startup. The company with the potential of viral growth prospects differ significantly from the B2B company that should employ sales department.

Who are the direct competitors? What is the competitive advantage, if any? If there are none, what are the possible options to gain some and the expected investments? If there are some, how are they sustained?

A business does not necessarily need a competitive advantage at every point of time if the demand on the market is significantly higher than supply. However, this is not a sustainable situation, and the competition will increase. Thus, if there is no competitive advantage, you should focus on getting one. If you do have one – make sure you’re able to sustain it and adapt to the ever-changing market conditions.

Did the company use debt funding? What is the debt to earnings ratio?

Indebtedness of the company creates additional risks for anyone engaging in business with it, resulting in less favourable collaboration or a lack thereof.

Who are the major company shareholders? How will they impact company direction? Do they support profitability or growth? Do they participate in operational management?

Shareholders are a source of information about the business that will be looked upon. In the financial industry or when offering securities to the public, major shareholders and directors should pass fitness and properness checks. The company should be cautious and make its due diligence when accepting investments not only regarding the legal background of the investor but also the broader impact it will have on the company’s strategy.

Conclusions

If a project is looking into engaging serious partners, attracting significant funding round or raising public and media awareness, it will definitely become a subject to thorough scrutiny that will target not only superficial financial parameters and the quality of the idea, but also the non-sexy things, such as taxes, intellectual property, cybersecurity, and supply chain resilience. Answering those questions in advance makes you not only well-prepared for the due diligence, but also more able to succeed in the fierce competition on the market, and should be undertaken as early as possible.

Due diligence requires asking hard questions. But it is critical to ensure that we devote our time and money to what will have a real impact on the world.

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Gene has experience of 20 years of business and financial markets. He is the CEO of STObox, an award-winning platform for securities issuance, offering, administration and transaction settlement. He is also an author of the book "How to Attract Investments with STO: A Practical Guide".

Security Tokens

New Shore Invest Starts a New Ship Finance Platform

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New Shore Invest to Tokenize Ship Ownership

A new ship finance platform by the name of New Shore Invest seeks to integrate blockchain technology into the sector. The firm will utilize the tech to create and issue equity-based limited partnership shares. The new strategy opens up the international shipping market to investors globally. Additionally, the move showcases the disruptive qualities that blockchain technology provides.

New Shore Invest’s fractional ownership will launch in Germany in Q1 2020. The firm intends to allow all retail investors to participate in the program which is loosely based on the outdated German KG model. The German KG financing model was popular in the early 2000s. Unfortunately, the system became obsolete following the 2008 financial crisis in which financing firms tightened their requirements significantly.

Discussing the revival strategy, Hanno Tamminga, founder of New Shore Invest, spoke on the importance of digitalizing the market. He explained how tokenization is important to ship owners because it provides them with access to fresh equity that was previously unavailable.

He wasn’t the only founder to praise the maneuver. Hannes Hollaender, co-founder and partner of New Shore took a second to discuss the firm’s plans moving forward. He explained that in order to excite investors, his company needed to find a strategy that was both “green and innovative.” He also described how the new system will fill the current gap of equity for shipowners.

KG shares

For its part, New Shore facilitates and structures limited partnership shares of single ship companies. These security tokens utilize advanced smart contracts. In this manner, all its rights and obligations according to the articles of association are directly integrated within the token’s protocol.

New Shore Invest via Homepage

New Shore Invest via Homepage

Importantly, these tokens are to be ERC-1400 compliant. Basically, they will live on the Ethereum blockchain. The decision to utilize the ERC standard was a smart one on the part of New Shore Invest. For one, Ethereum’s ERC standards are by far the most popular tokenization option in the market. As such, they offer a variety of interoperability not found within other token types.

New Shore Invest STO

New Shore Invest’s strategy will break each tokenized ship company down and offer the shares to investors via STOs. This strategy is far more efficient than the original German KG model. Also. it provides a cost-efficient, secure, and faster alternative to the current business practices in the sector. For example, investors can purchase online and it only takes minutes to complete a transaction. Best of all, there are no fees for investors who participate.

New Shore Investors

According to company documents, all investors receive dividends based on the number of tokens they hold. Additionally, investors receive a profit share of any vessels sold. Finally, investors gain a handful of new liquidity as the new shares are able to be traded and transferred in a secondary market.

NorthCape Capital

The Oslo-based venture capital firm, NorthCape Capital was the main financier for the project. The company is no stranger to the sector. To date, NorthCape arranged and structured $ 18 billion of lease financing. Importantly, this financing was spread across both the maritime and aviation sectors

Time to Check Out the New Shore

Given the experience and large network, the New Shore platform incorporates, its no surprise to see this team succeed. The concept of tokenizing ship ownership puts a new age twist on one of the oldest financial services available. You can expect to see this firm expand its strategy into other areas of transport as the company begins to reap the benefits of its unique business model.

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Security Tokens

Harrison Clark Rickerby Adds Nicola McNeely As Head of Tech

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Nicola McNeely Head of Tech for Harrison Clark Rickerby

This month, the Cheltenham-based law firm, Harrison Clark Rickerby made a significant pivot towards the blockchain sector with the acquisition of Nicola McNeely. McNeely will serve as the firm’s Head of Technology moving forward. The decision showcases a growing demand for STO service providers in the space.

 

Harrison Clark Rickerby – Blockchain Aspirations

McNeely will lend her years of experience, network, and expertise to help Harrison Clark Rickerby expand into the security token sector. Her tasks will include advising the firm on the legal and regulatory aspects of implementing blockchain technology in a crowdfunding capacity. Specifically, McNeely will formulate the business structures associated with raising capital through Security Token Offerings (STOs).

 

As part of her position, she will need to work closely with a variety of different clients. These clients will range from start-ups, all the way to market disrupters and large corporations looking into the integration of blockchain technology.

 

Nicola McNeely via Twitter - Harrison Clark Rickerby
Nicola McNeely via Twitter – Harrison Clark Rickerby

 

Discussing the monumental maneuver, Robert Capper, Head of Sectors described the overall feeling of the firm. He explained that the team very much looks forward to working with her with the overall goal to support the development of her vision and plan. He ended his statement by touching on the years of knowledge and experience McNeely possesses and how he hopes that this experience will translate into renewed energy and commitment by his team.

 

A Leader in the Field

Ms. McNeely proved that she is an industry leader through years of experience in the market. Previously, she held an executive position at The Royal Mint. Here, her tasks included working with new business and intellectual property developers. Additionally, she handled the IT outsourcing agreements, master services agreements, and the integration of blockchain solutions.

 

Speaking on her new position, McNeely touched on the importance of innovative technology within our lives. She explained that working with technologies that are ahead of the curve is one of the keys to be successful in the space. As such, she stated that she looks forward to her role as the main support for clients who want to use technology to develop their business.

 

McNeely Responsibilities

According to company documents, McNeely will lead a team of twelve experts to develop Harrison Clark Rickerby’s STO strategy. This team will be located across the company’s eight offices. The fact that McNeely loves working with entrepreneurial and innovative people should prove to be an important trait. In turn, she can provide the right help to enable them to grow.

 

Harrison Clark Rickerby Is a leading Cheltenham-based law firm. The company employs a staff of just over 500 people. Currently, the firm has offices in Worcester, Hereford, Cheltenham, Birmingham, the Wye Valley, the Thames Valley, Central London, and Cambridge.

 

Harrison Clark Rickerby – An STO Future

The decision by Harrison Clark Rickerby to bring McNeely onto the team appears to be the right move. She has the network and experience to help propel this law firm into the spotlight. You can expect to see the effects of her strategy unfold this year as her guidance takes hold. For now, blockchain investors just got a powerful legal alley.

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Regulation

The Best Countries to Launch Your Security Token

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Best Country to launch security token

Security token offerings (STOs) are now commonplace in the cryptomarket. This unique fundraising strategy gives companies the ability to easily monitor, distribute, and regulate their campaign utilizing blockchain technology. STOs combine the best features of ICOs with the stringent regulations found in particular markets.

Aside from the benefits achieved by companies that use an STO strategy, there are also many reasons why an investor would seek out this type of investment. For one, STOs are far more transparent than an ICO. Companies involved in STOs must reveal sensitive company information including their address, upper management, and financials.

This information further protects investors from the ramped scamming that occurs in the ICO markets. One report published by the Statis Group showed that as much as 80-percent of the ICOs conducted in 2017 turned out to be scams. It’s exactly this fraudulent activity that led to the development of security tokens.

Now that security tokens are more popular, many countries want to host STO related businesses. In order to entice these businesses onto their shores, government officials are ready to make some serious concessions. Below are the best countries to launch your security token.

Malta

The island country of Malta is one of the premier locations to launch your security token. The country embraced blockchain technology from the start. The Maltese Prime Minister, Joseph Muscat, issued a public statement this year in which he acknowledged both the fears of regulators “and the fact” that this technology is quickly changing industries across the globe.

Malta via Master Explorer

Malta via Master Explorer

Maltese officials are serious about their desire to be the leading blockchain country in the world. In the same statement, the Prime Minister stressed the importance of heading the digitization of the economy. He went as far as to state – “we must be the one that others copy.”

Malta is home to some of the largest security token projects currently in the works. In September the Malta Stock Exchange (MSX) announced a partnership with Binance, the world largest exchange by volume. Binance seeks to create a new security token platform in the country in the coming months.

Lithuania

Lithuania made some significant headway last year towards their goal of becoming EU’s security token capital. The country introduced security token friendly regulations. The country’s Minister of Finance issued broad security token regulations that covered the taxation, accounting, issuance, and compliance.

Blockchain companies send their project to a supervisor of financial markets and their office well send back a reply regarding the status of your token. Basically, Lithuanian officials do their version of the Howie Test to your project and give you a solid answer prior to your firm moving forward on their project.

Since Lithuania is a member of the EU, they gained a huge advantage by legalizing and regulating STOs in their country. Government officials hope to entice all of the EU to host their STOs in the country.

Switzerland

Switzerland has a long history as a financial safe haven. The country features low taxes and a crypto friendly environment. Switzerland was one of the first countries to adopt cryptocurrency regulations.

Switzerland has had a pro-crypto stance since 2014 when regulators released a report detailing the significance of cryptocurrencies. Interestingly, the report acknowledged cryptocurrencies handle the same tasks as money but stopped sort of labeling it legal tender due to the lack of an issuing country.

STOs submit their project to the Swiss Financial Market Supervisory Authority (FINMA). This regulatory body reviews each STO to confirm what designation the project falls under. Token labels include payment, utility, asset, and hybrid tokens.

Israel

Israel is home to numerous blockchain-based startups. The country leads the world in research & development according to a recent Bloomberg report. The report placed Israel in the number two spot, only behind South Korea in terms of innovators. Israel welcomed blockchain companies by cutting crypto taxes in half in October of this year.

Tel Aviv, Isreal

According to a Cryptoslate report, Israel started 2018 with 88 blockchain startup in operation. In March 2018, Israel released an interim report which detailed the regulations for ICOs. The report was intended to strike a “balance between technological innovation and the protection of investors.”

The Israel Security Authority’s ex-head, Prof. Shmuel Hauser went as far as to recommend the country foster the creation of an international blockchain center on his retirement. This move ensures Israel remains a dominant force in the cryptomarket.

Canada

Canada continues to lead the North American crypto revolution. The Canadian Securities Exchange (CSE) announced in February plans to launch a new securities token platform. The platform is based on the Ethereum Blockchain.

Toronto, Canada is the birthplace of Ethereum and the city continues to be a strong hub for crypto activity. Additionally, the platform allows users to launch their own security token easily. This decision is consistent with Toronto’s desire to be an industry leader.

According to the press release, the new security token platform is designed to give companies an alternative to the ICO space.  Kabuni Technologies is the first security token scheduled for launch on the platform. The company also filed a prospectus with the British Columbia Securities Commission (BSCE).

Dubai

Dubai remains a powerful influence in the cryptomarket. The country was one of the first to issue a state-backed cryptocurrency back in October 2017. In February of this year, The Dubai Multi Commodities Centre (DMCC) began to facilitate a market in cryptocurrencies.

The DMCC is a member of the Global Blockchain Council. The project initially began as part of the Dubai Smart City initiative. Speaking on cryptocurrencies, the project’s director, Franco Bosoni, discussed how he could see a commodities-like future for these digital assets. Dubai is now in the middle of developing a robust framework for the security token commodity to operate within.

Security Tokens – A Smart Move

The countries exemplify the innovative spirit and their decision to position their markets in line with the digitization of the economy is sure to pay off. The security token market continues to expand and these countries are now seeing the benefits of their pro crypto stance. You should expect more countries months.

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