What is Due Diligence?
Due Diligence refers to any investigation or audit conducted to confirm or refute certain facts or data related to a specific project, issue, or problem under consideration. It represents a manifestation of reasonable and well-founded caution, which involves identifying and examining risks and implementing corrective measures before making a final decision.
In general, due diligence is a versatile practice that can be applied in commercial, financial, tax, and legal contexts. Its scope of application is even broader, and with the growing global demand and popularity in recent years, conducting Due Diligence to assess crypto projects has become a crucial tool for ensuring security and reliability for investors and project stakeholders.
In the context of cryptocurrency, Due Diligence involves the review of legal documents, corporate structures, licenses, token-related terms, and contracts, as well as the analysis of compliance with KYC/AML requirements. Financial aspects also receive significant attention, such as verifying the origin and intended use of funds, evaluating the feasibility of business models, and analyzing the allocation and utilization of investments.
Given that a significant portion of functions in crypto projects are executed via smart contracts, technical audits are equally critical. These audits include examining the code for vulnerabilities, ensuring the system is secure against hacking attempts, and verifying that the contractual terms embedded in the smart contracts align correctly with the applicable legal framework.
Why Is It Important for Companies?
The necessity and significance of Due Diligence became evident during the collapse of the crypto market in 2017. At the time, the rapid rise of new projects and startups in the industry brought an alternative to traditional venture capital funding: Initial Coin Offerings (ICOs). ICOs are a form of crowdfunding where interested individuals are offered coins or tokens with the promise that, in the future, these tokens will provide certain ownership rights to the project or user privileges. In exchange, investments were required in legal tender or more stable and well-known cryptocurrencies like Bitcoin or Ethereum.
Ultimately, the promising future of ICOs failed to meet the expectations of millions who had invested in such projects, and the massive financial bubble eventually burst. The reasons for this varied: some startups proposed objectively unviable and non-functional products, which investors failed to notice due to either a lack of access to comprehensive information about the details and specifications of the proposals or the euphoria triggered by the success of Bitcoin and Ethereum.
Alongside the declining reputation of crypto assets and related operations, a broader understanding emerged of the critical importance of conducting Due Diligence—particularly for those planning to make significant investments in a project or for developers who wish to assure stakeholders of their transparency and integrity. This process, with its comprehensive approach, can identify hidden red flags that may be cleverly concealed behind innovative ideas, appealing websites, and piles of documentation.
It is important to note that this procedure goes far beyond merely reviewing the white paper, though such analysis is certainly a key component. Due Diligence encompasses the examination of all aspects of a project, including its team, technology, tokenomics, market potential, and competitiveness. It also involves assessing affiliated entities such as parent, subsidiary, or partner companies and ensuring compliance with existing regulatory norms.
In reality, Due Diligence for a crypto project is a multi-stage process that covers diverse areas and fields of research.
As conclusion
The Due Diligence procedure in the crypto industry is a standard of responsible behavior and a powerful tool for ensuring transparency and reliability. As demonstrated by the experience of the ICO collapse, only a comprehensive approach to project verification — from legal framework analysis to smart contract audits — can guarantee investor security and the overall stability of the sector.
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The content of this article is intended to provide a general guide to the subject matter, not to be considered as a legal consultation.
