March 12th, 2021
When a new cryptocurrency or token is created, the founders have full say in how the newly created coins or tokens are allocated. Typically, this information is published as part of the whitepaper and on the project’s site.
Before buying into a particular token, investors have the opportunity to inspect this allocation. If the proportions of tokens or coins allocated for a particular purpose seem off, they have the choice not to invest.
However, it is common for the founder or founding team behind a new cryptocurrency to hold a significant percentage of the newly created coins. This can be intended to fund development and acts as a reward and motivation for creating a successful company.
This concept isn’t unique to the crypto world. Founders of companies commonly hold a major share of their company’s stock, which is why many tech founders are also the richest people in the world.
One of the biggest criticisms of cryptocurrency is that it is very difficult to assign a “fair” value to a token. While this is true of any company or currency, virtual currencies are especially prone to this. This is why predictions of Bitcoin’s “true value” vary wildly and why cryptocurrency can be so volatile.
When it comes to Initial Coin Offerings (ICOs) and Initial Token Offerings (ITOs), the value of a new digital asset is largely based upon what customers are willing to pay. By pumping up enthusiasm and promising an array of new and valuable features – contingent on available funding – founders can drive up the perceived value of their asset and of their shares in it.
For a legitimate project, high valuations are a huge asset because they provide founders with the liquidity that they need to execute on their plans and they may open up new options as well.
These sky-high valuations become a problem when founders have no intention of delivering on their promises.
As any trader will say: buy high and sell low. In an exit scam, a founder takes this to heart and liquidates their shares in the token or coin that they created and then disappears.
By selling at the peak of the excitement for a digital asset, a founder can get a good price for their tokens. However, the laws of supply and demand mean that the sudden glut of tokens on the market – in addition to the fact that the founder won’t be following through with their promises – causes the price to crash. As a result, the founder makes a mint at the token’s investors’ expense.
A number of exit scams have occurred, but it is not always easy to differentiate a true exit scam from a suspicious exit. For example, Chef Nomi was decried for an exit scam with SushiSwap after he sold off many of his tokens. He later returned the money that he made to the project, but it is difficult to tell whether this was an actual exit scam or just a “mistake”.
Exit scams are often planned by their founders from the beginning. The plan is to create a token, pump up excitement and its value, and then sell off at the peak.
These types of tokens have certain warning signs that investors should look out for:
Crowdfunding through ICOs and ITOs is what makes many blockchain projects possible. However, exit scams are a serious risk for the consumer. Before investing in a project, do your research and check for red flags or signs that a project is legit.
If you’re a serious investor, you can schedule a third-party audit with a company like Halborn. Get in touch today at email@example.com to find out about our crypto auditing services.