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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".

STO Launch Strategies

The Nu+ Company – Sustainability with Chocolate and Trees

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chocolate

Not every STO needs to revolve around a billion dollar tokenization.  One of the draws towards the digital securities sector is the ability to open capital generation opportunities for companies of all sizes.  A young start-up has recognized the potential benefits they stand to experience by turning to this new way of raising capital.

The Nu+ Company, a German company with a focus on healthy and sustainable food practices, have announced their intent to raise funds through tokenization platform, NeuFund.  The company specializes in their line of chocolate bars, which tout unique characteristics.

While full details of their anticipated raise have not yet been divulged, the company has made their pitch deck available for interested parties to peruse.

As this capital generation event is being structured as a security token offering within Liechtenstein, strict compliance measures will most likely be put in place.  This means access to accredited investors only, along with typical AML & KYC practices – although, as stated, structuring of the event has yet to be confirmed.

Blockchain

A large part of the appeal behind a company such as The Nu+ Company, is the ideology which drives them.  This fact is not uncommon in many companies which have sought out the benefits of blockchain.  As the technology has the ability to afford ease of access to capital – while driving new levels of efficiency in many company operations – tokenization through Neufund is right up The Nu+ Company’s alley.

Another example of a company utilizing blockchain, in a means of attaining their goals for bettering our impact on the earth, is Almond.  This London based start-up has developed an intuitive app, designed to incentivize sustainable purchasing habits.  Much like The Nu+ Company, Almond will plant trees to offset carbon footprints, based on user activity.  Make sure to check out the following articles to learn more about how Almond intends on affecting change.

Almond – Be the Change the Earth Needs

Interview Series – Oliver Bolton, CEO of Almond Impact

Health Conscious Chocolate

The Nu+ Company has developed various chocolate bars, to date.  These products were designed with  the health of both, the environment and the human body, in mind.  They are vegan, nutrient rich, and touted to contain 65% less sugar than a traditional a chocolate bar.

Currently, The Nu+ Company has a product line with three flagship products.

  • nucao
  • nucao white
  • nupro
  • Small on the surface, big change underneath

To date, these products have totaled over 1.5million sold, resulting in over €2 million in revenue last year.

Complete Package

The Nu+ Company is more than just their product.  While their chocolate has been engineered with health and sustainability in mind, the team did not stop there.  What is the point of developing such a product, only to package the chocolate in a traditional fashion?, ie. plastic.

This led the team to recently establishing a deal with a company called Futamura.  In doing so, The Nu+ Company will make use of a Futamura product called ‘NatureFlex’.  This is a new form of packaging, which has the potential to replace plastic.  The following are a few key traits of what NatureFlex has to offer.

  • Heat-sealable
  • Renewable
  • Compostable

Planting trees

The aforementioned ideology, which drives The Nu+ Company, is not simply for show.  The team behind the project fully intend to act on their idea of sustainability.  This is most evident in their promise to do their part in re-establishing forestry within the island nation of Madagascar.

The promise, on behalf of The Nu+ Company, is that for every bar sold, the company will fund the planting of one tree.  More specifically, they will plant mangrove trees – known for their ability to consume high levels of CO2.

Madagascar is like no other place on Earth, and has captivated humans for decades, due to the unique wildlife found within its forests.  Unfortunately, it is believed that roughly 97% of dry forests in the country have been decimated – primarily due to human activity.  For those that subscribe to Netflix, an original production was produced under the title ‘Our Planet’.  There is an illuminating episode found in this series, discussing the scope of this issue, which continues to plague Madagascar.

The Team 

While the team at The Nu+ Company numbers over 40, including advisors, it is the vision of a trio of cofounders which got the company off the ground.

Each of these individuals boast degrees in Industrial Engineering – a profession typically based on maximizing the efficiency of systems and products.  This is something that should serve the team well, as this start-up looks to really get off the ground.

Looking At You

The Nu+ Company is in the fortunate position of following up another recently successful campaign, hosted through Neufund.  GreyP is a Croatian tech company, set on transforming the mobility sector, with an influx of ‘smart features’.  They also held their STO in Liechtenstein, much like the upcoming STO discussed here today.  Their process and experiences should act as a rough blueprint, moving forward, for The Nu+ Company, as they look to replicate the success of GreyP.

GreyP Scores with NeuFund STO – Black One Entertainment on Deck

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STO Launch Strategies

Swiss Regulators Approve First Tokenized Incorporation – Overfuture

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Overfuture Tokenizes Incorperation

This week marks another important first for the EU security token sector after the Swiss IT solutions and industrial systems provider, Overfuture received final approval from regulators to list its articles of incorporation on a public blockchain. The news marks the first time a company received approval to carry out such a task in Switzerland. As such, the approval marks an important milestone for the entire Swiss blockchain community.

News first broke of the approval via a press release from the STO advisory firm Andriotto Financial Services. In the release, the firm explained in detail some of the attributes of the plan. The report stated that Overfuture will tokenize their Initial Public Offering (IPO) in order to offer investors access to tokenized class A shares.

In the report, Andriotto Financial Services called the accomplishment a “huge revolution for the financial industry.” Importantly, the report explains why allowing firms to launch an IPO and coordinate secondary market transactions without the use of banks is a game-changer. For example, a traditional IPO requires the use of multiple financial intermediaries. These firms can include broker-dealers, central depositary systems, notaries, and investment managers, just to name a few.

Removing these third-parties from the equation brings about some serious benefits. For one, it lowers the overall cost of conducting business. Additionally, it reduces the friction encountered by both firms and investors looking to participate in public crowdfunding strategies.

Overfuture Strategic Partnerships

In order to make the Overfuture IPO a reality, the firm made a number of strategic partnerships. For its part, the Swiss-based European Digital Assets Exchange, EURO DAXX programmed the smart contracts that ensure each share remains compliant throughout its lifecycle. Smart contracts remove the need for multiple third-parties because the regulatory compliance mechanisms become part of the token’s core protocol.

Overture IPO Info via Prospectus

Overture IPO Info via Prospectus

Andriotto Financial Services provided the necessary financial advice surrounding the entire project. Andriotto is well-known in the space as a financial service advisory. The decision to utilize the firm definitely expedited the project. Additionally, Andriotto Financial Services ensured full compliance with Swiss regulations.

Two Audit Firms – Overfuture

As a regulatory compliant tokenized IPO, Overfuture decided on the use of dual auditing firms. The firm hired Swiss-based auditors, PKF Certifica SA, as well as, Studio Mariotti & Capelleti. The latter is an Italian auditing firm that has been in operation since 2011.

IPO Details

According to Overfuture’s investor prospectus, the firm intends to offer a total of 8,399,000 common equity shares. Importantly, these tokenized shares will live on the Ethereum blockchain. Ethereum-based tokenization protocols are by far the most popular standards in use today in the sector. Notably, each share will cost €1.25 ($1.38). Notably, the IPO is only available to Non-US residents.

Overfuture Looks Bright

Overfuture is an IT solutions and industrial systems provider. The firm provides advanced systems to large enterprises globally. As such, the company remains on the cutting edge of information tech and innovative technologies. Given the company’s network, timing, and technical know-how, you can expect to see the Overfuture IPO go off without a hitch.

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Security Tokens

MEDsis Partner WTIA to Launch Kfinancial

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MEDsis Partners with WTIA to Launch Kfinancial

The next-generation blockchain financial platform, MEDsis International announced a strategic partnership with Korean-based WTIA this week. The partnership is part of a broader strategy focused on the launch of the highly-anticipated Kfinancial platform. Importantly, the launch is set to coincide with the company’s upcoming STO.

The partnership and expansion strategy carried out by MEDsis isn’t a complete surprise. The firm announced plans for such a deal way back in December 2018. In the announcement, the company expressed a desire to develop a custom blockchain. In the end, the company decided it was more cost-effective and an overall better approach to partner with the WTIA Korean blockchain to accomplish its tasks.

MEDsis Expansion

Interestingly, the partnership strategy continues to take shape. Company officials stated that contracts, financials, strategies, pilot program results, funding, and strategic partnerships will continue to see expansion as the program develops. According to company officials, all of this information will become publicly available through the upcoming KFinancial White Paper.

MEDsis via Homepage

MEDsis via Homepage

Discussing the new strategy, Joshua Dax Cabrera, CEO of MEDsis spoke on the years of planning the firm has put into the expansion. The new partnership will provide unprecedented reach for the MEDsis platform moving forward. Cabrera explained that the new approach brings MEDsis’ global payment opportunities to the masses. Additionally, he touched on how the maneuver strengthens the firm’s current partnerships as well.

MEDsis – KFinancial White Paper

The release of the new joint White Paper associated with the STO will shed some light on the project moving forward. For its part, KFinancial will become the stand-alone payments and fintech division of the new joint venture company KFIN WTIA PTE. The new firm will operate out of Singapore. Importantly, Singapore is one of the most blockchain-friendly countries in the world currently.

Billions in Revenue

The merger will bring investors and token holders the direct rights to more than $3 billion in projected revenue. Uniquely, the STO will assign revenue and not equity toward the STO. In this way, investors receive direct access to revenues without previously anticipated equity dilution.

Discussing the merger, WTIA Chairman Keun Kim, explained the motivation behind the decision to partner with WTIA. Kim described the immense benefits obtained through the merger. He explained that the new platform brings the partnership to the world. Additionally, this new level of market confidence will help to further security token adoption globally. He ended his interview discussing the importance of job creation in the markets the firm intends to expand into first. These markets include “Argentina, Brazil, and beyond.”

A Company on the Move

The MEDsis payments ecosystem gained strong positioning in its perspective markets with this latest maneuver. The decision by company executives to focus on the underserved Latin American markets could prove to be pivotal in the space. For now, MEDsis prepares to see their products and services go global as the firm’s STO is set for a May 1, 2020 launch date.

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