Getting Your Startup Digital Asset Company Investor-Ready

Traditional investors are hungry for exposure to the fast-growing digital asset industry. At the same time, industry startups such as software companies, mining companies, financial services companies, token issuers, NFT markets/promoters, and more are generally small companies that are woefully unprepared for exposure to private equity, venture capital, SPACs, and investment funds. The following items are critical for a cryptocurrency startup to consider before a capital raise.

Timing, Size, and Method of Capital Raise – A company that is growing their revenue quickly year over year will fetch a much higher valuation than one that is still just an idea or is in its infancy. The size, timing, and method of capital raises is critical. Raising too much capital too early means selling off portions of the company at a lower valuation, whereas raising too little capital too late will slow growth and development as the company struggles to hire staff and pay its bills. Companies should also consider the cost/benefit of raising capital through debt financing, convertible notes, SAFE/SAFTs, private equity/venture capital, or an IPO.

Realistic Budget/Projections – While historical financial statements are important to investors, they will also be looking with an eye towards the future. A startup client once handed me financial projections anticipating 98% profit margins in year three and beyond. While Blockchain and digital asset companies have the ability to use automation to become very profitable, the laws of economics still apply.

Blockchain and digital asset companies will not be able to maintain immense profit margins indefinitely, as other Blockchain-based competitors will eventually emerge. It is important to create realistic projections so they are not overly optimistic and considered unreasonable by sophisticated investors. While a startup isn’t expected to have large teams of personnel dedicated to financial planning and analysis, investors will want to see realistic budgets and projections. A one- or two-person accounting department may not be able to prepare projections in addition to their other duties.

Profit Margins – Profit margins are not critical for early-stage capital raises, but for more established startups, profit margins can be everything. Higher risk means a lower company valuation. A startup company that is a profitable business today is a much safer investment than a company that has yet to prove its profit potential.

Mining companies can be profitable immediately since their income is based on capital investment and electricity costs, rather than introducing a product to customers. Service-based companies and companies planning on issuing tokens will have a longer road to profitability. It is important for a startup to trim unnecessary costs and isolate one-time costs to provide more accurate future profit margin estimates to potential investors.

Uncollectible Assets - Financial statements containing inaccurate information are not a good look for a startup attempting to court investors. If a company has receivables from a customer that are uncollectible, incorrect account balances for fixed assets/mining equipment, or loans to an owner/officer that are not going to be paid back, investors will see poorly prepared financial statements as a reflection on management capabilities.

Prior Year Tax Liabilities – As mentioned previously, higher risk investments receive with lower valuations. Unknown potential tax liabilities for errors or omissions on prior tax returns will be very concerning to investors. If prior year tax returns contain issues, those returns should either be amended or the issue should be disclosed to potential investors upfront, so the investor does not uncover the error themselves and wonder what other undisclosed risks/liabilities may exist.

Internal Controls / Policies & Procedures – It is important for digital asset startups to be aware of any regulations that may impact their company. For example, financial services companies need to consider Bank Secrecy Act regulations. Digital asset exchanges operating in New York State will need a BitLicense. Companies performing ICOs will likely need to address the requirements of the Securities & Exchange Commission. Foreign entities can have very complex tax situations and legal structures which require assistance from international tax experts. All digital asset entities will need to address the legal requirements for their business in the jurisdiction(s) in which they operate. It is important for every digital asset startup to talk to a qualified lawyer with knowledge of crypto assets and the regulations around them.

Additionally, financial services companies, custodians, and exchanges will generally need to have policies and procedures in place for cybersecurity, anti-money laundering, transaction monitoring, and more. Bittrex’s BitLicense application was rejected in 2019 for failing to create and follow appropriate compliance policies. Consultants with experience in these areas can assist startup crypto entities write, review, and implement these policies.

Financial Statement Audits – Companies at the IPO stage (and often younger companies as well) will require financial statement audits. This means that the company’s financial statements will need to be prepared in accordance with Generally Accepted Accounting Principles (GAAP). GAAP adds a significant level of complexity due to accrual basis accounting requirements, footnote disclosures, and the accounting treatment of crypto assets on the company’s income statement and balance sheet. This is a heavy lift for a young company, so the start-up will need to hire an experienced CFO and staff, or the accounting functions will need to be outsourced.  

Presentation & Economics – The 2017 ICO boom is over. Crypto projects now need well thought out business plans, marketing strategies, and an economic model that is understandable to the ultimate customers and investors. Companies creating their own tokens (both ICOs and NFTs) often fail to establish a clear business model, and clearly outline the rights and obligations of the company, the token holders, and the investors. The relationships between these parties will have both legal and tax implications to the company, so management will need to work with lawyers and accountants before issuing whitepapers or other marketing materials.

While all investors expect a great business model or idea, sophisticated investors need a lot more. They will require audited financial statements, budgets, cash-flow projections, and sufficient liquidity to grow in both the short and long-term. At the same time, sophisticated investors are always hunting for potential land mines that could introduce risks to their portfolio that they do not want. Digital asset companies need to look ahead to future capital raises and prepare well before going to the market for funding. If you have questions about cryptocurrency, contact Mark DiMichael at mdimichael@citrincooperman.com.