Nick: T, regular readers know you’re a globetrotter.
Earlier this week, you traveled to Lisbon, Portugal, to attend the annual Web Summit. Forbes calls it “the best technology conference on the planet.” Can you tell us what goes on there?
Teeka: Web Summit is a mix of large, Fortune 500 companies and small startups. It’s an exciting place to get a preview of cutting-edge technology before it hits the market.
A lot of crypto start-ups go there to pitch their projects and ideas. They hope the big players will fund them.
There was also a big list of speakers who presented at the conference, including UN Secretary General António Guterres and former British Prime Minister Tony Blair.
I didn’t speak, but I got a VIP pass that gave me access to the speakers’ room and talk to them. I got to hear from famous hedge fund manager Ray Dalio, who presented on Wednesday.
I also got to meet with one of the head writers for TechCrunch. It’s a great website for breaking news and trends in the tech space.
Nick: Sounds like you were very busy over there. Do you have any takeaways from your meetings?
Teeka: I do. And there’s a scary one. I’m really upset by a new development in the crypto space.
I’m finding out that some projects did a terrible job of managing the money they raised during their initial coin offerings [ICOs]. These ICOs are similar to initial public offerings [IPOs] held by private companies.
Here’s what happened…
Some of these projects didn’t convert enough of their cryptos into paper money. Instead of focusing on their projects, they became cryptocurrency speculators. And with the recent bear market in crypto, they lost a huge percentage of their capital.
Now, they’re scrambling for money. And what they could do is potentially damaging to token holders. While it’s technically legal, it sure feels like fraud to me.
Let me just say this before I continue… It’s not just the new cryptocurrency space that’s seeing fraud. You can find fraud in the stock market as well.
Enron was a huge, $100 billion scam in the late 1990s. And you still see scams today. The gold mining sector is full of them. You’re beginning to see more scams in the marijuana space, too.
Investors lose millions—even billions—of dollars to these scams. That’s why you must be careful and research every investment you make.
Nick: That’s great advice, T. In the Daily, we always remind readers to do their homework before investing in any idea.
So what are these projects doing that has you worried?
Teeka: Some companies hurting for money are now selling “security tokens” to raise additional capital.
These tokens are being marketed as similar to traditional securities. The implied promise is they can pay dividends or interest… or share profits from their projects.
To raise money, management takes the equity portions out of their businesses and sells them separately. It’s like when companies issue new stock to raise capital.
This is going to create huge problems and catch many crypto investors off guard.
Here’s why…
Over the past couple of years, ICOs generally issued “utility tokens.” Utility tokens are used as part of the businesses. But they have no equity stakes in them.
However, the market has assigned something called “network value” to utility tokens.
Network value is what the market thinks the network of users on the platform is worth. I call this a form of “synthetic” equity.
It’s not equity in the traditional sense, such as an ownership stake… But it’s treated as such by the market.
Many tokens were—and still are—valued as if investors are getting a piece of the network. I call this the “synthetic equity perception.”
Here’s the problem as I see it…
If you take a project that has a utility token and then add a security token—thereby explicitly splitting ownership and utility—you’re fracturing the synthetic equity perception.
Nick: What happens when this perception fractures?
Teeka: These investors will realize their utility tokens are nearly worthless.
Utility tokens with no access to network value are like tokens from Chuck E. Cheese’s.
The tokens have utility inside the restaurant—you can use them to play games at the arcade. But they’re worthless outside of Chuck E. Cheese’s… and they give you no share in the ultimate “network” value of the business.
It’s the same with utility tokens that have been explicitly separated from their equity—in this case, their network value. If a token has no network value attached to it, that greatly diminishes its value.
Nick: That sounds sketchy… Will projects that split their tokens do anything to assist their current utility token holders?
Teeka: The honest ones will give all utility token holders a chance to participate in the new security tokens. But not all companies are honest…
I had a meeting this week with someone from a company that wasn’t so honest. He wanted to talk about how he could sell the plan to issue security tokens to big accredited investors, while sticking the small investors with what would become near-worthless utility tokens. He referred to his smaller investors as the “unwashed masses”—those were his exact words.
The guy flat-out wanted to dupe the public. And he didn’t have any shame about doing so. To be honest, I wanted to get up and punch him in the face… and I’m not a violent person.
Thankfully, this isn’t a company I’ve recommended. But I feel bad for all the people who did invest in that project. They could lose all their money.
Nick: Should investors choose security tokens over utility tokens?
Teeka: Security tokens will have a place in the world, but it’s a bit too early. Let me be clear… my opinion is in the minority. Many people I’ve spoken to are saying, “Security tokens are amazing.”
I think they could be, but not yet.
Eventually, there will be a place for security tokens… But that’s probably three to five years away.
Right now, security tokens have no liquidity. There are no exchanges to trade them on. You need to find a broker or dealer to act as an intermediary.
And there are no custodians for them. You need a special wallet to store each security token. It’s a huge pain to own them.
On the other hand, utility tokens are easy to store, self-custody, and trade. They have global liquidity, and regulators are finally wrapping their heads around how to regulate them.
Nick: So what should readers do to avoid this potential pitfall?
Teeka: Look, crypto investing is tough. It takes a lot of work. And this will be no exception.
If you’ve invested in alt coins on your own, you need to understand it’s usage that will ultimately drive a token’s value. That’s why I focus on uncovering tokens where the use case, management team, and token economics all line up.
Even then, there’s no guarantee we’ll get it right every time. That’s why we rely on small, uniform position-sizing to protect us from the volatility and unknowns of crypto investing.
The key takeaway is to be very suspicious of utility token projects that want to create two classes of tokens [security tokens and utility tokens] all of a sudden. A credible outfit will offer ALL token holders the ability to convert their utility tokens to security tokens.
We had this happen recently with Iconomi [ICN], one of the projects in Palm Beach Confidential.
There was nothing suspicious about it because they opened up the transfer to everyone. Iconomi changed its legal structure to a joint-stock company. So it will tokenize its shares and issue security tokens, giving everyone an opportunity to convert their tokens to its new equity token. [You can read the latest update on ICN here.]
It is not splitting into two classes of tokens.
It bears repeating: Projects that try to convert over into having both a security token and a utility token will destroy the value of their utility token.
Nick: Thanks for the warning, T. I’m sure our readers will appreciate it.
Teeka: You’re welcome.