Starting a Cryptocurrency Fund: Valuation Considerations
It is critical for fund managers and accounting professionals to have up-to-date valuations on investments when accepting capital contributions from new and existing investors. While valuation metrics for the broad majority of securities and futures products are well-developed, cryptocurrencies and other blockchain technologies present novel issues for Bitcoin and cryptocurrency fund managers when it comes to valuation. In this post, we will discuss valuation considerations for three activities: cryptocurrency trading, initial coin offerings (ICOs), and mining.
Valuation for large, well-known cryptocurrencies is relatively straightforward. Coinbase, Kraken and Poloniex are examples of U.S.-based exchanges that provide up-to-date prices on established cryptocurrencies. These exchanges can create reliable valuation metrics for the larger, more highly-traded cryptocurrencies such as Bitcoin, Etherum, and Litecoin. The aforementioned cryptocurrencies have 24-volume rates in excess of $100 million.
While not as reliable for the establishment of prices as the larger exchanges, the website https://coinmarketcap.com/currencies/ has up-to-date cryptocurrency prices and volume for almost every cryptocurrency available. Fund managers and accounting professionals should proceed cautiously, however, when it comes to the reliability of valuation of cryptocurrencies that have weak volume and/or are traded on smaller, foreign exchanges. At this time, we believe it is best to solely trade cryptocurrencies that are (i) available on established, U.S. exchanges and (ii) meet the fund or accounting professional’s internal volume requirements for reliable valuation.
Investing in ICOs presents new challenges. As we addressed in our previous post, it is likely that most tokens distributed in ICOs would be considered securities, subject to regulation by the Securities and Exchange Commission. We believe it is best practice for fund managers who intend to invest in ICOs to preemptively follow the applicable registration requirements imposed by the Investment Advisers Act of 1940 or applicable state securities regulator. In addition to regulatory considerations, the individual tokens distributed in an ICO can present challenging valuation issues. We believe the best practice, at this time, is to side pocket ICO investments.
At the moment, the majority of companies conducting ICOs are doing so with an accompanying white paper that explains the details behind the token issuance. These white papers rarely, if ever, include audited financial statements and/or any obligation to continuously update financials in a manner that would allow a fund manager or accounting professional the ability to establish a reliable valuation for the investment. In addition, many of the ICOs (that are almost certainly securities) promise distributions of a percentage of profits of an unascertainable value as well as promises to buy back existing tokens in the future.
https://coinmarketcap.com/assets/views/all/ provides a compilation of previously ICO’d tokens, but very few tokens trade on reputable U.S. exchanges and/or have sufficient volume to establish reliable valuation. Similar to a traditional hedge fund investing in shares of a non-exchange-traded, emerging company, we believe it is the best practice to side pocket ICO’d tokens until the tokens are (i) listed on a reputable U.S. exchange with sufficient volume or (ii) bought back by the issuing company.
Mining is an integral part of many blockchain networks. Mining is the process of solving complex mathematical equations to add and verify transactions on a particular blockchain network in exchange for a reward of that particular blockchain network. Individuals and entities mine cryptocurrencies by running programs on their computers that utilize the available computing hardware to solve these mathematical processes. While it sounds simple enough, mining is not a cheap endeavor. Each miner competes with the other miners of the blockchain network to solve the mathematical equations in the fastest time possible. Therefore, more processing power means a higher likelihood of compensation. More processing power, however, also means exponentially higher associated expenses.
Mining expenses can be divided into two categories: upfront and operational costs. The upfront costs involve the purchasing of multiple, high-powered graphical processing units (GPUs), a sufficient heat dissipation system, industrial electricity wiring, and a facility to store the equipment. The upfront costs of establishing a network that is of a sufficient scale to generate meaningful profits can be substantial—a small-scale commercial operation could potentially get started with around $250,000 in upfront expenses, while larger operations can easily top $1 million in upfront expenses.
Once the upfront costs of a mining operation are realized, the operation must factor in operational costs. This primarily consists of electricity costs associated with powering the hardware and cooling and ventilating the facility. These costs can be substantial and can cut into the profitability of cryptocurrency mining. One mid-range facility operated by The MegaBigPower Company estimated it spent approximately $1 million in electricity costs and upkeep expenses for a 20,000 square foot facility in 2014. For comparison, one of the world’s largest bitcoin mines, located outside of Beijing, spends $39,000 on electricity expenses each day ($14.2 million a year) to operate its 25,000 machines 24 hours a day. For comparison, there are multiple mining centers with square footage in excess of 100,000 sq. ft.
As a result, establishing a forward-looking valuation for an investment in a mining operation can be particularly challenging. For larger, more well-known cryptocurrencies, one can calculate estimated profits from mining activities based on the computing power and electricity costs associated with a mining operation. These estimates are of dubious value, however, and generally only available for the more established cryptocurrencies.
We believe there are three ways to handle valuation of mining operations:
First, the fairest and simplest method of valuing mining operations is to side pocket upfront and operational mining expenses, due to the difficulty, if not impossibility, of predicting the amount of profit the fund will generate per dollar spent on upfront mining expenses. Holding the upfront expenses (such as purchasing the building and hardware) at cost in the general fund could potentially provide a substantial windfall to subsequent investors in the fund by allowing the subsequent investors to receive profits from mining activities despite not actually contributing to the substantial upfront costs associated with getting a mining operation off the ground.
Another option is to side pocket the upfront expenses and share the maintenance costs among all interest holders in the fund. The upfront infrastructure purchases could be held at cost, while the valuation of mining activities in the general fund would increase or decrease based on revenue from mining operations minus expenses. If a fund proceeded in this manner, the fund could divide profits from mining activities between side pocket investors and the general fund until the side pocket investors hit a certain ROI. This could reduce the windfall that subsequent investors would receive despite not contributing to the upfront expenses associate with establishing a mining operation.
The last method of valuation is for the fund to finance upfront costs into the general fund. This would dilute the ROI for investors who financed the significant upfront capital solely because the fund lacks the ability to establish a prospective valuation on mining. The best practice in this case would be to value the upfront expenses at cost or, in the more expensive alternative, retain a firm to provide a reasonable valuation metric (i.e. potential profit/dollar spent on infrastructure) in which the fund can rely on in establishing its AUM.
While cryptocurrencies and blockchain technologies have increased exponentially in popularity and utility, reliable methods of valuation still have a long way to go. We will continue to provide you with updates concerning new and existing methods of valuation of cryptocurrencies and blockchain assets. Please feel free to reach out to us if you have any questions regarding valuation of cryptocurrencies and blockchain assets, or if you are thinking of starting a cryptocurrency fund.