With so many ICO’s getting launched every day, it is difficult to differentiate a good ICO from a bad ICO. What is even more astonishing is that not even 20% of the ICO’s are able to reach soft cap (minimum amount to be raised). ICO, STO, crowd funding – all these terms are so mingled up that it is difficult to clearly understand what they stand for. We would help you understand each of these terms and their relevance. So, let’s start from the very beginning and understand the relevance of a Security Token Offering in a crowd funding/crypto ecosystem.
ICO (Initial Coin Offering) is a popular way of crowd funding for crypto projects. Through this process, a company which is any of the below:
- has an established non-block chain project
- or has a ground-breaking concept for Block chain application
- offers institutional investors and general public digital tokens or digital coins. These digital tokens/coins are a promise to future access to a company’s product or service. That’s why they are often called Utility tokens.
Now let’s compare an ICO with an IPO. IPO is the traditional way by which companies go public, offering shares to the financial institutions and the general public. A share entitles the holder ownership in the company, rights to vote and participate in the stakeholder meetings. It is a promise of getting dividends in the future or getting profit due to the rise in the prices of the shares. That’s why a token/coin offered during an ICO is different than shares offered during an IPO.
However, all ICO projects don’t offer utility tokens. Such tokens are like an investment contract, wherein the main reason for the investors to buy the tokens is the expectations of future profits in the form of dividends, revenue share or price appreciation. In July 2017, the SEC (Securities and Exchange Commission) published a report, according to which some tokens can be classified as securities and are subject to regulations as applicable on other securities.
Tokens offered in many of the ICOs don’t have any utility in the actual business ecosystem. They have features similar to ‘shares’ in an IPO. These are called Security Tokens. A Security Token is backed by something tangible like the assets, profits, or revenue of the company. Participating in a STO (Security Token Offering) is similar to participating in an ICO. The only difference is the fact that the tokens offered in a STO are the Security Tokens and not the Utility Tokens.
Also, one of the main benefits of issuing Security Tokens is the fact that they abide by regulatory frameworks, which makes them cheaper and more efficient than offering Utility Tokens. A business that issues tokens that follow all regulatory compliances is less likely to experience interruptions from SEC.
What is a Security Token Offering (STO)?
Among the acronym soup of digital currency phrases, one term is being heard more often: security token offering (STO). The STO is emerging as a powerful and valuable alternative to private equity and venture capital financing for companies globally. It is such a powerful alternative that Polymath estimates will grow to a $10 trillion opportunity over the next two years.
For companies seeking to raise capital, an STO is worth a closer look for a few good reasons I’ll share shortly. If your specific goal is to raise a large amount of capital and your company matches three or more of the profile points below, keep reading.
It is worth considering an STO if your firm is:
- Generating in excess of $10 million in annual revenue
- A high growth company
- Operating a global business
- Preferring to issue a transferable asset
- Interested in a funding method that connects with your customer base
- Desiring greater liquidity for stakeholders
- Before diving into why STOs are becoming more compelling for investors and companies raising capital alike, let’s step back to recap what security tokens are and how they function.
In simple terms, a security is a financial instrument representing a real asset. Stocks, bonds and managed real estate trusts are examples of securities. Historically, when a security is purchased, the transaction is signed on paper. A security token performs the same function, except it confirms ownership through blockchain transactions. Security tokens can offer many financial rights to investors including equity, dividends, revenue shares, profit shares, voting rights and other financial instruments.
What Makes an STO So Compelling for Business Owners?
1. Access to Global Capital
Historically, accessing foreign investors has largely been the domain for established companies who could afford the associated costs and risks. However, security token offerings are not limited by geographic borders.
This means companies, large and small, can present themselves to more investors over the internet. We saw the impact of this phenomenon in the recent ICO boom. Many service providers have since emerged to help companies market their offerings in foreign markets and different languages.
This flexibility gives start-ups and growth businesses entry to deeper funding pools and broader brand awareness. The global nature of tokens also means a wider marketplace of buyers and sellers can interact post-STO, which can translate into greater market liquidity.
2. New ways to market your offering
Traditionally, fundraising in a global environment included an almost limitless price tag and mind-bending complexity. Some challenges have included facing localized securities laws and the need for language translations.
The advent of the ICO brought about services and tools to support global token offerings. Advertising to the corners of the earth in multiple languages has become easier, and new techniques such as bounty programs enable companies to offer rewards to people globally in exchange for performing certain tasks, such as being active about a brand on social media.
Translating content into foreign languages and posting to communities on Telegram, WeChat, and KakaoTalk is also becoming a successful marketing strategy for raising capital. Experienced agencies with specific skills to support global token offerings are emerging, and investor onboarding programs such as the services offered by groups like Lexico can enable an easy conversion funnel.
3. Better terms
STOs offer enhanced terms when compared to raising capital from VCs. Firstly, companies do not have to give up control of their company or a board seat. This puts management teams in a stronger position to make business decisions, and it reduces the risk of being removed from their own company.
Next, for equity STOs, companies can sell common stock instead of preferred stock. This effectively lets management and other common stockholders retain a higher percentage ownership in their company, especially in downside scenarios.
While dividend rights will be granted to common stock security token holders, STOs can be accomplished without offering voting rights to these investors. Again, this is another advantage that gives management teams more control over their company. Finally, STOs generally raise at higher valuations.
4. Low Cost of Entry
A security token offering can be used to tokenize many assets, commodities and financial instruments. That means smaller companies have the opportunity to raise large amounts of capital from a global investor pool quickly without necessarily having to absorb large costs, particularly in legal fees.
Imagine, for a moment, raising capital from a global investor pool using traditional means. You’d be required to engage a new lawyer in every country where an investor wanted to buy into your offering. Security tokens remove that requirement because compliance is integrated into the token itself.
In the US, frameworks such as Reg D and Reg A+ are used by companies seeking to raise capital, and compliance with their requirements can be guaranteed without the use of lawyers.
5. Uses Beyond a Traditional Security
By incorporating utility token-like features into security tokens, additional value can be created. For example, if “Hotel Crypto” released a security token, customers of the hotel who purchased tokens could be entitled to a 10% discount on their room rate or free access to VIP areas.
With tokenized offerings, companies have the opportunity to use their imagination to offer new benefits to their customers. In another example, companies could offer benefits with financial value to customers who hold their tokens for more than three years, for example, discounted meals, spa treatments, in-room entertainment or reduced room rates.
Essentially, companies offering security tokens have an option to reward customers for buying and holding their securities over time. These rewards go beyond an appreciation of the value of the underlying security.
So What’s the Catch?
While there are many benefits of STO’s, its true this style of raising capital is not suitable for everyone. To begin, this is a nascent market. With the first STO’s being completed less than two years ago, we do not yet have extensive precedent (legal or otherwise) to reference.
Second, without the benefit of time, insights around how STO’s will perform over the long term are still being formed.
Third, regulators could weigh in at any time and influence the market with compliance rulings. As it stands, the closer scrutiny given to security tokens can make compliance more burdensome.
Fourth, there is still uncertainty around when a token should be treated as a security, although the SEC is attempting to address this.
Finally, running an STO demands that businesses create and manage tokens. Security tokens are not immune to the threats of hackers. Having access to the right cyber security skills and technology is critical for success.
Want to Know if an STO is Right for You?
There’s no doubt the STO funding avenue offers a persuasive alternative to private equity and venture capital funding. While there are many advantages to an STO, it is important that this strategy makes sense for your business.
I have found that many executives looking into STO financing originally say something like: “Hey, companies are raising crazy amounts of money this way – it must be easy.” The truth is that outsiders only see the tip of the iceberg, and there is much that happens behind the scenes which many don’t understand. Knowing what happens behind the scenes and the partners to bring into an offering are critical insights that an advisor can provide to make the difference in an STO’s success.
Security Token Offering Basic Elements
What Makes a Token Sale Subject to SEC Securities Laws?
Here are a few basic elements to keep in mind when determining whether the token is a security:
The first and most important question to address is what makes a token a security. In the Unites States, the main focus is on the purpose of the investment. The centennial case that addressed this issue is Securities and Exchange Commission v. Howey Co., 328 U.S. 293 (1946). The test addresses four issues:
- whether the investment is of money or assets;
- whether the investment of money or assets is in a common enterprise;
- whether there is an expectation of profits from the investment; and
- whether any profit arises from the efforts of a promoter or third party. Instances where the answer is yes to the above four questions, then the token sale is likely subject to the U.S. securities laws.
Is The Token a Payment Instrument?
The definition of “security” is wide-ranging. Under Section 2(a)(36) of the 1940 Act, a security means, unless reported otherwise, “any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest . . .“ The full definition can be found online. The 1933 and 1934’s act’s definition of a security is essentially identical. Essentially, an e-money or payment service can be considered a security.
Does an Exemption Apply?
Even if the token falls under the definition of a security, there may be an exemption that applies. The exemption allows investors to issue the token, without being called a security and as a result, it wouldn’t be necessary to have a prospectus. The best way to determine whether one’s token is a security or if an exemption applies is to speak to a securities professional.
Is it a Private Placement for Qualified Institutional Investors?
Another way to bypass securities laws is designation of the token as a private placement for qualified investors. The assumption here is that institutional investors are not prone to the same risks as everyday investors due to their knowledge concerning investments and securities. As a result, the sale is not subject to the same rules. For this exemption to apply, there must be a certain number of high net-worth individuals.
Again, although it is possible to determine whether a token is a security on one’s own, the secured transactions is a highly technical field that is best left to a professional. Therefore, if possible, reach out to someone who has experience dealing with these types of matters so that one can ensure that they are in compliance or whether an exemption applies.
The Transition from Utility to Security Tokens
Let’s start with the reasons why. Why are security tokens so important?
The reasons are primarily legal, but not just regulatory. While it’s true that regulatory authorities increasingly view utility tokens as securities despite the protests of issuers, there is another good reason for security tokens: Investor rights.
So far, the majority of crypto projects have gone bust. When this happens, where does investor money go? If the token is truly just a utility like a carnival token or playing card then the purchaser has no recourse at all. The company can issue tokens, take the money, close down and never lift another finger to improve the ecosystem regardless of the amount of money raised. A buyer of a true utility token is not an investor, but a collector. Your token is no different than buying bubble gum, and the closure of the manufacturer along with all the money you paid should have no meaning.
If the current landscape of “utilities” with no recourse for buyers’ sounds like a recipe for fraud and failed investments, you’d be right. However, if the tokens were to represent something more like stock or equity, then the purchasers have legal rights their investment and the issuers have legal obligations to do well by their investors.
If a company closes, it has to liquidate its assets. Anyone who has studied finance knows the sequence: on liquidation, debt secured by assets is paid first. Then bondholders, mezzanine debt, and owners of common stock, if there’s anything left. A token, unless it represents equity or another specific type of security, entitles you to nothing on liquidation.
If you are ready to invest in cryptocurrency for the long-haul we recommend storing them in a cold storage self-directed individual retirement account (SDIRA). Read more about our Best Cryptocurrency IRA Options here.
Do you have any questions on Security Token Offerings? Ask below!