Forward Guidance: Adam Sharp Explains Initial Coin Offerings and Altcoins

by Samuel Taube, Managing Editor, Investment U

Important Note: During this podcast, we discuss a hypothetical IPO for an imaginary cryptocurrency that we spontaneously named "Sharpcoin" (after this week's guest, Adam Sharp).

As it turns out, there actually is a small cryptocurrency called Sharpcoin. To be clear, this podcast is not recommending an investment in Sharpcoin.


Transcript:

Samuel Taube: Joining us again today is Adam Sharp, co-founder of Early Investing. Today we are talking about alternative cryptocurrencies, or "altcoins," and initial coin offerings. Adam, thanks for joining us again.

Adam Sharp: Thanks for having me, Sam.

ST: As our listeners probably know at this point, you've had tremendous success investing in, shall we say, "conventional" cryptocurrencies like bitcoin, Ethereum, Litecoin and so on. What has motivated you to start looking into smaller coins and ICOs?

AS: Well, I think it's just a natural attraction. The type of people who are drawn to bitcoin - they're obviously looking for something different, something that has a very high potential for returns.

After you get into bitcoin for a while, and you get comfortable with it, and you've made a bunch of transactions, and you probably made some money on it, you start to think about what's next, because there's all these other cryptocurrencies out there.

There's now thousands of different cryptocurrencies. A lot of that, by the way, is due to the fact that bitcoin is open-source, which means that anyone can take the code and use it as they wish.

So you can create your own version of bitcoin. Virtually anyone can, but the thing that gives bitcoin itself real value is the fact that it's so liquid, it has such a good community around it, it can be traded for cash all over the world and some of the best developers in the world are working on it.

There's certainly a network effect, a benefit that you get once you have a big network like that and it builds over time, but the really neat thing about it being open source is that it allows anyone to create their own cryptocurrency if they want to use the bitcoin technology.

So in 2013, when I started investing in bitcoin, I also - almost immediately, really - just started looking into alternative cryptocurrencies because there were a few around then.

There were probably only about 10 that were worth knowing. A few of those are still alive today. Among them are Litecoin, Ripple, Feathercoin - there are a couple other ones that are still around, but I owned all those at the time.

ST: Did Ethereum exist back then or was that a later development?

AS: No, I think Ethereum was developed in 2015.

ST: Oh, OK.

AS: They had their ICO, which is an initial coin offering - we'll get into that in a little bit - but nothing really happened with alternative cryptocurrencies for a long time.

We had a very quiet period in bitcoin and other cryptocurrencies from about 2014 to early 2016. It was relatively quiet. Not much happened.

Of course, bitcoin came first and then you see after-effects as people start to branch out. They make a little money in bitcoin, and they start to branch out into the alternatives.

For most of cryptocurrencies' history, bitcoin has been just dominant - 95% of the entire market. Today, it's only around 50% of the entire market.

ST: Oh, wow. I didn't realize that. You just mentioned initial coin offerings as being something that's gotten you interested lately. Can you take us through the process of a typical ICO?

AS: Sure. So an initial coin offering is a relatively new phenomenon. Only in about the past year has it really taken off. It's essentially just when a new cryptocurrency launches and offers the initial coins for sale.

It's a little bit like an IPO with a stock, but in most of these cases, anyone can participate. So there are no wealth restrictions. You don't have to be an accredited investor. Pretty much anyone can participate.

The research into it is a lot different than an IPO, though, because you're not looking at metrics like earnings or sales growth or anything like that.

ST: Those don't exist for a currency.

AS: Exactly. So what happens with an ICO - we'll go through what to look for in an ICO in a little bit - the process of an ICO is different in every case, but generally speaking, you have a team of engineers... They get together... They have an idea for a new cryptocurrency or a token...

If there's enough interest around it, and if they believe in it enough, they'll start working on it. If they're using the bitcoin code as their starting point, they'll make the changes that they believe will improve the coin and eventually gather interest.

A lot of times they have a presale beforehand. So this is mostly for insiders. This is their friends and family and interested investors who are following the project.

In the presale, there's typically a healthy discount because you're buying before we even know if the ICO is going to be a success. You're taking a lot of extra risk by participating in the presale, so you usually get a substantial discount to the ICO price.

Then, if everything goes well with the ICO, everybody then invests in the ICO. Once these coins are out and they start trading on a cryptocurrency exchange - if it goes well - then the ICO holders will make a lot of money and the presale owners will make even more money.

ST: Do the engineers typically partner with one exchange to do an ICO? Or can it be done on their own? How does that generally work?

AS: Great question. I should have gotten into that, but it's a little complex. ICOs do not happen on exchanges. They mostly happen on the cryptocurrency's own website.

ST: Ah, OK.

AS: They actually use a platform using another cryptocurrency called Ethereum most of the time - not all the time.

ST: Oh, interesting.

AS: But a lot of the time, they build the coin to be compatible with the Ethereum network. There's a protocol, essentially, where you can make a cryptocurrency so that it's compatible with the Ethereum network, and the Ethereum blockchain records all the transactions. It just makes it a lot easier for your coin to get listed on exchanges and things like that.

Most of the time when you're participating in an ICO and you're buying these new coins, you're buying them with either Ethereum or bitcoin.

Most people try to take both. Some people only take Ethereum. A few people only take bitcoin, but since a lot of it actually happens on the Ethereum network, a lot of the ICOs are conducted and priced in, essentially, Ethereum.

They'll say, "You'll get 100 of our new coins," just for example, "for each one Ethereum that you give us." I should explain a little bit more about why people use the Ethereum platform for ICOs.

So Ethereum is a cryptocurrency, but it's also much more than that. With Ethereum, you can build what are called "smart contracts" on the block chain. A smart contract simply allows you to put a series of conditions in place. Actually, it'll just be easiest if we get into an example, like an ICO.

So a smart contract is what powers an ICO. If you were to participate in the ICO for an imaginary coin - we'll just call it "Sharpcoin"... You have some Ethereum in your wallet on your computer. (It has to be a special kind of wallet.) You can't send it from an exchange for an ICO, just as a side note.

So you're ready to participate. You go to "Sharpcoin.net." Again, this is just an imaginary example.

ST: There might actually be a coin called Sharpcoin... I don't know.

AS: So you would go there. When the ICO opens, they're going to provide an address where you can send Ethereum to get your Sharpcoins. This is going to be a smart contract address.

So when you send your Ethereum to this address, it is going to note that in the blockchain. And eventually it's going to send you - in return for your Ethereum - the Sharpcoins automatically from that address. That's why it's called a smart contract.

There's logic built into it that says, "OK, Adam. Just sent me one Ethereum. We're offering 100 Sharp coins per Ethereum, so we're going to go ahead and send him back 100 Sharpcoins."

Now, it usually takes a couple days. It doesn't happen instantly, but this is just an example of how an ICO happens and how it actually uses smart contracts - which are a pretty interesting blockchain technology - as part of the process.

ST: I guess that replaces the underwriters and other human elements in an IPO.

AS: Exactly. There technically are still middlemen. You still need lawyers and everything like that, but it's a much less intensive process than an IPO.

To be honest, we don't know where the regulation is going to go with this. We know that there's going to be some sort of regulation coming eventually, but hopefully it'll be reasonable. That's all we can really do.

The way I look at it is, the cat's out of the bag at this point. It's going to be very hard for regulators to put it back in the bag.

ST: This is true.

We were talking earlier, before we started rolling, about the term "altcoin" - how sometimes that has a bit of a negative connotation, referring to sketchy currencies and whatnot. My next question is this: When it comes to evaluating ICOs and smaller, younger coins, how do you tell the good from the bad?

AS: Great question. A lot of it has to do with trying to figure out the motivations of the people involved. What exactly are they after? Do they seem like they're actually really motivated by whatever the goal of their project is? Or does it seem like they're out to just collect a hefty payday? Because those people are out there.

I'll give you an example. There was a large ICO that raised $230 million earlier this year called Tezos. This thing just had red flags all over it to me because the founders of this particular cryptocurrency were set to collect 8% of all of the proceeds of the ICO personally, in cash.

This just threw off major red flags to me. Why would they need 8% of this directly just to them?

ST: That's higher than a stock commission.

AS: Yeah. With a more reasonable ICO, they'll lay out the terms and they'll say, "We're setting aside this much for founders. We're setting aside this much for our early supporters," etc.

But they should have a vesting schedule. Their coins should vest over years so they don't just get them all in a big lump sum. If they're getting cash out of the deal immediately, it's completely strange.

ST: Because they could just disappear in that case.

AS: Again, I may have gotten some of the details wrong. Just to clarify, I think it was 8% in cash they were collecting, but I'm not positive on that. You want to look for details that are red flags.

You want to look for things like whether any of the people involved been associated with any fraud in the past. Just simple things like this. Just doing research on all the team members and all the advisors and evaluating the core mission.

What is it they're trying to do? Are they trying to replace some really inefficient process in finance? That could be promising. Are they doing some pie in the sky carbon credit thing that sounds a little dodgy? You just have to use your gut to figure out which ones of these are legit and which ones aren't.

A lot of it you can gauge by the people involved. How reputable are the people involved? What is their experience? Have they worked at startups in the blockchain space? Have they worked at some of the large exchanges? Do they have experience in crypto? Or are they all from the construction industry? It's a lot like investing in an early-stage tech startup.

So you just have to evaluate the people, look at the mission, figure out how big the market could be and then place your bets accordingly.

ST: I see. I know that you just launched a whole new research service based on this called Crypto Asset Strategies, and I was wondering, do you think you could give us one or two altcoins or upcoming ICOs that you're particularly excited about right now? I don't know if that's too big of an ask for you guys.

AS: Sure. No problem. There's actually an interesting ICO going on right now called Blockstack that I've been watching pretty closely. They're essentially trying to build - I guess I can best describe it as something like the Apple or Google Play stores - a new app store for internet applications and computer applications.

Everything on this platform will be transacted on Blockstack tokens. So that's just a big one.

What really got me interested in that one at first is just the venture capitalists involved. There are some very, very good investors involved. Some of the best venture capitalists and private equity investors in the world. So I'm definitely watching that one. It probably won't be on exchanges for a little while, but it's a project I'm keeping my eye on.

Ethereum is very interesting itself. That's the second-largest cryptocurrency. I think its market cap is around $30 billion, if I remember correctly. So it's still small compared with bitcoin's $130 billion market cap. And by the way, that's just the total value of all coins in circulation today.

Ethereum is a very interesting one because it's like a pick-and-shovel play on a cryptocurrency because a lot of new cryptocurrencies launch on the Ethereum network, and there are all sorts of decentralized applications being built on top of it.

So it's more like a platform than a cryptocurrency, but it generally takes people a little while to fully understand it because it's a totally new beast. It's not like anything we've seen before. It functions as a cryptocurrency, and you can invest in ICOs with it.

ST: It's also similar to a programming language, right?

AS: Yeah. They have their own programming language. You can essentially do almost anything with smart contracts in terms of financial transactions.

You could do insurance with it. You could use it to pay dividends out to shareholders, which is an extremely cumbersome process today. Because you're doing it on a blockchain, which is just a decentralized ledger, it's a record of transactions.

With Ethereum, the neat thing is you can use these smart contracts to trigger things like financial transfers, payments, dividends, all sorts of things. I think everybody should own a little bit of Ethereum... and bitcoin, of course.

Unfortunately, I have to reserve the rest of our altcoin picks for members, but we do provide a lot of free information in our e-letter, so you can check that out at earlyinvesting.com.

ST: If you want to learn more about Adam's altcoin and ICO picks, check out Crypto Asset Strategies.

Adam, thanks for joining us again.

AS: Thanks a lot, Sam. It's always fun.

Click here to see the first opportunities from Adam's new research service, Crypto Asset Strategies.