From the traditional private equity or debt to less conventional crowdfunding. The most recent tokenisation method is the next step in the evolution of the capital markets.
Often ICO token issuers made public promises regarding future increase of value of their token. Such claims are deemed to be promoting securities, according to regulators. There were additionally cases where ICOs blatantly disregarded their roadmap commitments. Around the same time as some bad ICO apples were falling, and regulatory scrutiny was increasing, STO or security token offering ideas became vocal, as the natural continuation of the ICO industry.
Indeed, STOs make more legal sense, but much less retail buzz. The times of raising hundreds of millions for a white paper idea are deﬁnitely gone. But it is the contention of the author of the present article – that does not mean all ICOs are dead. There still can be cases of utility represented by a smart contract token.
However, if there is no utility or service on offer, then it is likely a future proﬁt distribution, or outright corporate rights exercise. In other words – a security.
A security is a legally deﬁned ﬁnancial asset that can be traded or exchanged. A legal deﬁnition however varies by jurisdiction. The main categories are equity or debt, or derivatives thereof. Securities are offered by an issuer. The primary offering of a security today can be done either through crowdfunding, private placement, or full- ﬂedged public prospectus offering. Depending on the amount and jurisdiction, either option would constitute an issuance of a security.
A tokenised security offers a combination of advantages of both the ICO practice as well as the existing securities laws. On the one hand, an STO complies with the law to the letter. And on the other hand, an STO offers a similar promise of an immediate (or delayed in case of legally required lockup periods) liquidity.
There are no “securities token exchanges” to date (April 2019). But there are quite a few initiatives looking to obtain regulatory authorisation to run a securities exchange for the modiﬁed securities asset class – security tokens. Potential way of exchanging security tokens would be OTC desks provided by ownership transfer agents such as Fintelum. See more below.
The main difference that sets security tokens apart from non-token securities is the actual blockchain aspect. Now in stead, or rather in addition to regulatory requirements, such as registration of certiﬁcates, shares, bonds and debentures – a smart contract is issued representing the registered rights and obligations of the issued security, whereas bearer securities could be most effectively tokenised.
Investors or participants of an STO are typically cryptocurrency users, but not necessarily. STO practice will continue the path carved by the ICO industry in setting the use cases for cryptocurrency at large. The STO offer is not so democratic than ICO used to be. Security token offering is much less frictionless than it used to be with utility tokens.
Today, the potential buyer of an STO will need to overcome burdensome KYC/AML proﬁling process to be compliant with the sales of a security. And often try providing the impossible – the accredited, sophisticated or professional investor status. And depending on the jurisdiction and the project offering, the pain levels may vary. This is why, an STO issuer should have an attractive proposition on the table to be able to attract investors.
Security token or tokenised securities?
As a note of importance, not to confuse the two concepts, well posted out by Noelle Acheson in her piece 1https://www.coindesk.com/security-tokens-vs-tokenized-securities-its-more-than-semantics. Security tokens are the subject of our present article. Whereas tokenised securities are a token representation of an already existing security. For example, an Apple stock may be tokenised and traded on a separate exchange than the original stock is traded (eg.: APPL ticker, traded on the New York Stock Exchange). Although it is questionable, but there seem to be attempts at listing tokens that allegedly represent an Apple stock 2https://www.ﬁntelum.com/blog/digital-securities-tokens-based-on-share-of-10-nasdaq-listed-companies/.
This is part 4 of a 5 part series.
Security Tokens or STO – When any Asset Becomes a Digital & Immutable Proof of Ownership – Thought Leaders
The regulatory scrutiny has morphed into a permanent reality in the crypto space. This much had become clear in early 2018. Regulators from all corners of the globe are looking to ﬁt the crypto phenomenon into some regulatory rules or framework. The main question however is to discern what crypto assets are? And whether crypto assets are securities? If they are, then the relevant law must be applied.
In the US, Securities and Exchange Commission (SEC) had announced that all crypto assets are investment contracts or – securities. This later corrected that all, except for Bitcoin and Ethereum (in its present stage) are to be deemed securities. 3https://coincenter.org/ ﬁles/2019-03/clayton-token-response.pdf
The reality is the American legal system largely still relies on the 86 year old Securities Act, with exceptions made available with enacting the JOBS Act in 2012. And within this amendment, there is a place for security tokens to be issued as well. Small issuances of up to USD 1m can be effected as crowdfunding projects. Larger deals can be done as private placements or public offerings limited to accredited (professional or high net worth) investors. Either way, the registration of the issuing security is mandatory. It is likely that the Securities Act may see a major revamp to exclude most cryptocurrencies from the scope of federal securities law. 4https://cryptovest.com/news/bipartisan-bill-proposes-to-exclude-crypto-from-us-securities-law/ In the meantime, the most recent discussion identiﬁes guidelines on how to assess if the publicly offered or sold digital asset is an investment contract and therefore a security. 5https://www.sec.gov/ﬁles/dlt-framework.pdf
In Europe, on the other hand, the European Securities and Markets Authority (ESMA) has called to extend Europe’s revised Markets in Financial Instruments Directive (MIFID II) to include cryptocurrency products such as initial coin offerings with securities features among transferable securities or other types of ﬁnancial instruments. 6https://www.esma.europa.eu/press-news/esma-news/crypto-assets-need-common-eu-wide-approach-ensure-investor-protection European Prospectus Regulations will apply in full from 21 July 2019 and replace the current directive. Under the Regulation each EU member state will be able to set its own limit between 1 and 8 million EUR when the mandatory prospectus requirement applies.
On the brink of Brexit, the UK’s Financial Conduct Authority (FCA) published an extensive consultation paper on the classiﬁcation and regulation of crypto assets. 7https://www.fca.org.uk/publication/consultation/cp19-03.pdf The paper seeks to provide regulatory clarity for ﬁrms and consumers, when certain activities around “cryptoassets” or tokens themselves fall within the FCA’s regulatory perimeter. The FCA reminds that the breach of authorisation regime is a criminal offence and carries a maximum penalty of 2 years imprisonment or an unlimited ﬁne, or both. Following the consultation period, FCA intends to publish the ﬁnal Policy Statement in relation to cryptoassets by summer 2019.
Other pioneering jurisdictions, such as Switzerland, Malta, Estonia, Lithuania, Liechtenstein have reviewed the types of crypto assets and proposed a classiﬁcation thereof.
All the above mentioned jurisdictions offer more-or-less similar classiﬁcation of tokens. Largely separating tree or four types. It is a matter of not so distant future, when every national regulatory body will be compelled to put out their opinion or guidelines on the subject.
Tokenisation – digital and immutable proof of ownership
The rise and fall of the ICO exuberance has resulted in setting a ﬁrm precedent in demand for tokenisation. It has also set an example for how the future of securities will likely look. There will always be a law governing securities issuance. But there also will be a decentralised reﬂection of the issued securities on the blockchain. With transparent protocol implementation, everyone should be able to access smart contract speciﬁcations and assess overall market interest.
The IEO or initial exchange offering appeared to remedy some of the most lacking aspects of a typical ICO, such as reliability, custodianship, vetting, transaction speed, cost, and sales channels. But it is yet to be seen, if it turns out to be the most appropriate utility token issuance method. After all, tokenisation is adding to a healthy competition amongst issuers and issuance platforms.
A legacy exchange listing cannot be applied to tokenised securities. Legacy exchanges lack understanding of the underlying technology and regulatory clearance. This is why there are many new technologically advanced initiatives, looking to set up a regulated space for security token listing and secondary market.
For a small-capital company a KYC/AML compliant STO campaign can be considered as an alternative way to access funding. Tokenising businesses by offering equity tokens, revenue sharing or raising capital with debt tokens may become an inevitable part of a company funding life cycle. A security token offering may be equaled to initial or subsequent equity or debt offering in the form of a digital token.
When asset becomes a digital and immutable proof of ownership to a global community, that is when we have created a democratic access for everyone to participate in the growth of the global economy. Today, not all countries have harmonised securities laws. But we are well on the way to lowering barriers of entry for both investors and issuers.
About the author
Liza Aizupiete, the Managing Director of Fintelum, which serves the crypto industry by carrying out a technically sound and KYC/AML compliant token sale process, crypto funds co-custody, transfer agency, secondary token OTC desk and corporate actions.
Previously Liza was a founder and the Managing Director of a cyptocurrency exchange Globitex, as well as the General Director of Lithuanian e-money institution NexPay UAB. A Latvian native, Liza graduated from the University of Geneva, Switzerland, majoring in Philosophy. Liza is experienced in the ﬁnancial industry, including trading, fund and portfolio management. Since 2012, she has become passionate about Bitcoin and later crypto industry at large, as a proponent of a decentralised and sound monetary system.
Fintelum is a comprehensive ICO/STO token launch platform for businesses looking to tokenise their assets in the form of utility, equity, debt and other asset or revenue sharing token. Fintelum suite of services comprises a regulated KYC investor onboarding, and continuous compliancy with the EU AML laws. The token sale process can be followed through a tailor made dashboard. The backofﬁce system allows data access and management as well as on-demand reporting. In addition, to help mitigate token sale process risks, Fintelum acts as a crypto currency co-custodian. The system incorporates an integrated multi signature cold/hot wallets. To serve the security token industry, Fintelum acts as a transfer agent, ensuring security token ownership amongst whitelisted investors. Fintelum is also able to provide secondary token OTC exchange desk functions, with ongoing corporate action services, such as voting, dividends and announcements.
Learn more at https://www.ﬁntelum.com
This is part 5 of a 5 part series.
Security Tokens or STO vs Crowdfunding, ICOs & IEOs – Thought Leaders
Crowdfunding and ICO – a step in evolution of capital markets
ICO acronym abbreviates to “initial coin offering”. But the practice stems from small capital funding method known as the crowdfunding.
In 2009 a US company called Kickstarter launched and successfully continues today to promote and facilitate funding of creative ideas and products. The idea is to pre-sell some product that a creative team pledge to develop or mass produce and deliver to its backers. The practice had no clear legal foundation back when it started. It was only three years later, in 2012, the US law was amended to regulate the new practice of easier access to small capital ﬁnancing, by adopting Jumpstart Our Business Startups (JOBS) Act 8https://www.sec.gov/spotlight/jobs-act.shtml.
Similarly, ICO phenomenon sprung up from the burgeoning crypto community. The ﬁrst ICO is widely accepted to be the Mastercoin blockchain project in 2013. It set itself apart as the ﬁrst crypto crowdfunding case. The idea was to presell a blockchain coin/token as a service that the team pledged to develop in future. To purchase interest in the project, one was able to pay in bitcoin cryptocurrency. All of a sudden, a new practice was born.
A new use case for cryptocurrencies was forged and started to unfold rapidly. By 2017, not only many new cryptocurrencies emerged, but there were hundreds of ICO projects,
pre-selling their services, often, but not exclusively blockchain-based business applications. Indeed, raising funding in less restrictive way was the prime goal of the practice. Selling a token as interest in the project that had some utility or representation. Hence the new expression – utility token.
By deﬁnition, investing in a nebulous utility token (typically Ethereum EIP-20, also known as ERC-20 compliant) had very loose legal obligations, only those pledged by the issuing entity. The investment was not an equity purchase, nor it was a loan, rather – a voluntary contribution. The attraction was an almost immediate liquidity of the newly minted token. After the initial offering, a bubbling secondary market developed and offered easy entry and exit to all participants. Selling a token was selling a promise of a non-existent yet service, not dissimilar to the age of discoveries of long sea voyage ventures.
Similarly, the beginning of 17th century introduced the ﬁrst permanent joint stock form, where the investment into shares did not need to be returned, but could be traded on a stock exchange. 9https://en.wikipedia.org/wiki/East_India_Company
The crypto investment practice unfolded into a wave of ICO projects, culminating in 2017. Thus many startups and mostly white paper ideas got funded. Most were real projects. Some were bad apples. But the most attractive aspect of the ICO were the returns on investments. According to one source, the ROI yielded in excess of 10x, even if you had invested in both the winners and losers alike over the 2017 year. The whole industry was on a steep upwards pressure, with strong interest from the institutional sector. Such returns are unprecedented in the normal trading environment. Fortunes were made and lost.
The year 2017-2018 went down in history as the ICO hype unfolded. It culminated with several major events that occurred at the same time. One was Bitcoin blockchain forking and the subsequent nose dive of most cryptocurrency value. There were other notable events that coincided and contributed to the overall price fall.
From peak to trough the crypto asset market value was at times suddenly and later gradually reduced from over USD800B to little over USD100B. The so called crypto winter had set in. The bittersweet mass interest receded and an immediate ﬂight away from all things crypto ensued. See chart below. 10https://coinmarketcap.com/charts/
IEO – initial exchange offering
Similarly as with Slack and Spotify exchange listing, there are some ICOs that have listed directly on token exchanges. This way projects can leverage token trading venue client base to showcase their projects directly, without active promotion of the offering through other, often ineffective, marketing channels. This has prompted many token trading venues to start issuing utility token IEOs on behalf of token issuing start-ups.
For the contributors, exchange listing adds trustworthiness, security and vetting, knowing that a reputable exchange, such as Binance will have done certain due diligence before listing an unknown project. Indeed, for utility tokens IEO may prove to be a safe, if not cheap way to gain community trust. It is yet to be seen, however, if the initial listings continue to persist over a longer stretch of time, and what regulatory requirements may be imposed as to listing requirements. This also is a piece of history in the making.
This is part 3 of a 5 part series.
Security Tokens or STO – What are your Alternatives? – Thought Leaders
Private equity or venture capital funding
When you are just starting out, it is yourself or/and the proverbial triple FFF (friends, family and fools) and perhaps business angels that contributes to the birth of your startup business morphing from an idea in to a company. Then, you begin to look around for more seed or growth funding. Typically these are venture capital or risk capital funds that are eager to jump on the opportunity of the next uber-big venture. Their proﬁt expectations are usually in the range of 20-30% per annum. Whereas, if they hit it big with your great idea, they may even touch 2-20x return, depending how well you do on the exit. Attracting venture capital is generally applauded and celebrated as an achievement. There are some disadvantages however worth mentioning.
One such disadvantage is a possible oversized loss of equity. An equity investor may require anywhere from 10% to 90% of your company. Depending on the shareholder agreement, any milestones or strict targets, even the most benevolent investor may turn out to be a vulture preying on your company. It is important therefore to always weigh all pros and cons about letting in a new equity holder with special requirements. As the saying goes, investors invest in people, not projects. When deciding on an investment option, the same should be said about startups accepting funding: you should seek out long-term partnerships with people, not just the money, at any perilous cost. 11https://www.youtube.com/watch?v=sTzfkvjBtyM
The other disadvantage of attracting venture capital or private equity investor is the diminished management control. When a serious ﬁrm or individual bring in a substantial amount of funding to a startup, it typically comes with a requirement of management and expenditure control. It is understandable for someone who puts up large amount of money on a promise alone to want to actually see and control the way the money is spent. The easiest way to yield control and oversight is to require a seat at the management or supervisory boards of the company. Once a controlling seat is given, with it comes a diminished executive power for the top management. It becomes harder to push through major decisions, and expenditure amounts that exceed those stipulated in the shareholder agreement. Each major decision gets to be questioned and not always by the most quick minded likes of people. It may, of course, turn out to be a blessing than a curse. For startups that lack experience or clear vision. But it is usually a hindrance and not a boon.
To sum up, private equity or venture capital investor may very well be of beneﬁt to the young startup founders. But, the disadvantages of oversized loss of equity and a certain loss of management control may be the reasons for seeking other options.
Another way of ﬁnancing a business is taking a loan, or issuing a convertible loan against future equity. If you are an established company, for short-term purposes you may issue other forms of debt, such as mezzanine, or you may get long term ﬁnancing in the form of debenture.
A loan is given by a private, or an institutional investor, such as a bank. A loan however ideally is given against a collateral. A loan is basically a credit. However, credit is something you have to earn ﬁrst. Taking a loan therefore is usually reserved to companies that already have revenue streams, or have high potential for earnings. Taking a loan to spend on a startup is risky for the taker beyond high interest rates. The most real risk is borne by the founder on repayment. As a founder you may need to pledge your private property or ﬁnd a guarantor to act in your favour and on your behalf, to satisfy credit collateral requirements. Debt instruments like corporate bonds are regulated securities and also incur costs of issuance.
IPOs – are they relevant at all?
IPOs are also called the exit. This usually is the exit strategy for early equity investors and venture capitalists, as well as founders. But, the IPO route is open to largely mature companies with certain revenue streams and proven track record. A typical IPO-ready company would have to show uniqueness not only in differentiating business idea, or solid management, but also have a proven track record of proﬁtability, revenue growth and guarantee a substantial market capitalisation for a liquid market trading.
Preparing for an IPO is expensive. It traditionally involves heavy legal efforts on drafting the prospectus and ﬁnding the right underwriter investment bank to initially back the business. But this process is also no longer being upheld in its entirety. An exemplifying case is a recent going public of a company called Slack. The social network platform followed the lead by Spotify to get the company listed without actually going through the IPO process. 12https://www.businessinsider.com/slack-spotify-tech-ipo-direct-listings-venture-funding-softbank-visionfund-2019-1
The major downside of an IPO process amounts to expense and time the company needs assume to fulﬁl all the legal requirements prescribed by each jurisdiction. Both Spotify and Slack in the USA demonstrate that costs are being cut away where logically possible. If your company has gained a recognisability and social following by the virtue of its services, you may not even need to go down the expensive IPO route. It could cost the issuing company anywhere starting with USD 2m to USD 10m to prepare and pay all related fees for an IPO. 13https://www.pwc.com/us/en/deals/publications/assets/cost-of-an-ipo.pdf Although the law is clear on security issuance, with the advent of primary listing, IPO industry is seeing a certain revamping of the process.
The bottom line being: either of the alternatives discussed above are distracting, time- consuming, irrelevant or outright expensive.
This is part two of a five part series.
- Stellar Chosen by Wevest for Security Token Offering Platform April 21, 2019
- Vtoken Exchange Celebrates SEC Filing in Time Square April 20, 2019
- AlphaPoint and Elevated Returns to Develop Secondary Market April 19, 2019
- Due Diligence Process Delays tZERO Investment April 18, 2019
- Brian Collins, CEO at Horizon Globex – Interview Series April 18, 2019