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A comprehensive guide to STOs (Security Token Offerings)
 

 

Security token offering

 

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Startups in the blockchain space are completely reimagining how they can raise funds to get their projects off the ground, with the rise of Security Token Offerings or STOs.


STOs came to the limelight as a ramification of the increased regulatory scrutiny on Initial Coin Offerings. Therefore to understand the importance of security token offerings, it’s quintessential to understand what happened to ICOs.

 

The rise and fall of Initial Coin Offerings


In the past two years, Initial Coin Offerings or ICOs were the go-to method of raising capital due to the relative ease of launching an ICO and strong investor outreach.

But what is an Initial Coin Offering? In essence, ICOs enabled virtually anyone with an internet connection to invest in various projects and in-return receive utility tokens. ICOs were so popular that projects managed to raise a staggering $14 billion during the year 2018, during which the number of ICOs increased by as much as 125% (source).

But all this changed when investors, both retail and professional, were duped by fraudulent actors in the space who took advantage of the incredible excitement around ICOs. It was estimated that investors lost almost $100 million in ICO exit scams. Prompted by these events, regulatory authorities like the U.S Securities and Exchanges Commission started cracking down on ICOs and slapped many of them with ‘cease and desist’ orders.

With greater pressure from regulatory authorities, ICO projects had to ensure greater compliance or take the risk of cease & desist orders from the SEC. As the odds were stacked up against ICOs, most startups found it more feasible to not conduct an Initial Coin Offering which can be clearly observed in the number of ICOs projects, dropping by as much as 60% this in Q1 2019 (QoQ), according to InWara's report


It is important to note that the reason ICO projects were ordained to cease operations is because, according to the SEC, most ICOs are actually security offerings (they fail the Howey test) and hence fall under the SEC’s jurisdiction of enforcing federal securities laws.

 

What is a Security Token Offering?


In the wake of the downfall of ICOs arises the need for a regulatory compliant token, hence the security token. A security token is a cryptographic token that represents tradable financial assets like stocks or bonds. A security token is in essence, a security and hence is fungible! Meaning they are easily exchangeable with each other.


Now in a security token offering, as the name suggests, a company offers investors security tokens in return for capital investment in their company, which is used to fuel the company's growth.

A security token grants investors legal rights, as they are subject to traditional securities laws, such as revenue distribution or voting. Which is in stark contrast to an ICO.  


In an Initial Coin Offering, a company offers investors utility tokens in return for capital investment. Token holders can use these utility tokens to get access to the company's product/ service.


Most ICOs are considered as security offerings especially by regulators like the SEC. This is since most of them satisfy the Howey test and hence represents an investment contract.


The foundations for Howey test were built several decades ago in a monumental case of the SEC vs Howey which was handled by the Supreme Court.

In the case, two Florida based professionals offered land contracts for tracts of land with citrus groves. These professionals offered buyers the option of leasing any purchased land back to the professionals who would then tend to the citrus plants. Since most buyers of the contracts lacked agricultural expertise they happily leased the land back to the professionals. But this was deemed illegal by the U.S Securities and Exchanges Commission and the professionals were sued for not filing a securities registration statement with the SEC. This case laid the foundation for determining whether a certain transaction is an investment contract or not.

An economic transaction will be considered as an investment contract if it satisfies the following criteria-


  • If the transaction is an investment of money.
  • If the investment of money is in a common enterprise.
  • If there is an expectation of earning profits from the work of the third party.


These conditions were later altered to include broad changes in what terms like ‘money’ and ‘common enterprise’ could be interpreted as. On top of this, another important consideration is how the profits that come from the investment are used. Is it under the investor's control?


Security Token Offerings are booming!

security token offerings

Source


Worldwide, the number of security token offerings observed an incredible surge of over 130% during Q1 of 2019. This was expected because of the increased pressure from regulators to ensure compliance with securities norms, which made it incredibly difficult to launch a public token offering. On top of this, there has been a proliferation of companies that provide security token offering services, enabling more companies to launch STOs. Looking for security token offering services? Check out this article to know the leading players to help launch an STO.


STO versus other fundraising mechanisms

A comparison between Security Token Offering and other fundraising mechanisms could give a better insight into  the benefits and drawbacks of an STO. Let’s compare an STO with the new-age Initial Coin Offering and the traditional VC funding.


Security token offering features-


  • Security Token Offerings are compliant with jurisdictional regulatory norms which means that the regulatory risk involved is relatively lower when compared to the ICO method. However, an STO still involves crypto tokens and, with the inherent volatility in the space, and therefore carries a higher risk to the investor when compared to traditional VC fundraising.

  • A security token offering will have very low dilution. Dilution is a term that signifies the decrease in ownership of existing stakeholders in a company as a ramification of raising capital. For example, when a company raises funds from VC firm, new shares are issues to represent the firms ownership stake in the company.  This is relatively low in STOs since company founders have more freedom to decide what percentage of stake they want to give up on.

  • As STOs are subject to federal securities laws, standard AML/KYC norms are a necessary. This wasn’t the case for ICOs. Notably, retail investors played a huge role in the success of ICOs.

  • Traditional Venture Capital firms don't just offer capital to startups, they also offer their professional connections, which can be leveraged to help grow the business faster. Security token offerings don’t provide the strategic or operational impact given that the investors may or may not be experts in blockchain, let alone security tokens.

Security Token Regulations/ compliance and costs of security tokens


Let’s consider the important regulations that companies planning on launching a security token offerings have to follow, in some of the major blockchain-crypto markets.

STO regulations: USA


USA was the market leader in terms of number in the blockchain-crypto space with a majority of ICO projects originating from the country. But later on, as regulatory compliance became a priority, these numbers quickly dwindled to become just a shadow of what they used to be. As a result of this, US-based startups are heavily leaning towards regulatory compliant security tokens and security token offerings. Security Token Offerings in the USA would have to follow the following regulations.


Regulation D

This regulation is advantageous because it allows companies to raise funds through the sale of securities without the need for registering these securities with the SEC, if certain regulatory conditions are met. But the company must file form a file form D disclosure document with the SEC.

Furthermore, regulation D has two variants 506B and 506 C. Let’s look at the similarities and differences. Both variants have no upper limit on the amount of funds they can raise and no waiting period. General solicitation is allowed in 506C while it is not in 506B. 506B allows a maximum of 35 non-accredited investors to take part in the offering while 506C does not.

So who qualifies as an accredited investor?

An accredited investor is a person who is allowed to deal in securities that may or may not be registered with financial institutions and may include natural high net worth individuals, banks etc. A person is considered as an accredited investor if they have a net worth exceeding $1 million or if you have earned an individual income of more than $2,00,000 per year for the past two years or for a couple this becomes $3,00,000 a year.

 

Regulation A+


This regulation enables founders of a project to offer an ‘SEC approved’ security to non-accredited investors up to a maximum amount of $50 million. Regulation A+ is often the most capital and time intensive of all the regulations. Companies are required to register with the SEC before launching their security offering.


Regulation A+ has two variants namely, tier I and tier II. Tier I forms permits companies to raise funds less than $20 million while tier II permits funds between $20-$50 million. Both variants permit general solicitation of security offering and also have a waiting period of around 60 days. Unaccredited investors are permitted to take part in the security offering as long as the investment is less than 10% of their entire net worth.


Regulation CF


Regulation CF or regulation crowdfunding enables companies to offer and trade securities through crowdfunding.

It requires all economic transactions to be made through a trusted financial intermediary online and allows companies to raise a maximum amount of $1 million over a period of 12 months. It also limits the amount individual investors can invest across a 12 month period. This form has no stipulated waiting time and permits general solicitation. Companies can exempt themselves from registering with the SEC.


Regulation S

This regulation comes into effect during the offshore sales of securities of US issuers. Regulation S provides an exclusion from the section 5 registration requirements of the Securities Act of 1933. If you're a US based company launching an STO then chances are that you'll fall into category 3 of this regulation. Under category three the lock-up period for the securities being sold is can be a year ( for US issuer or foreign private issuer that does not file periodic reports with the SEC) or 6 months ( for a US issuer that does file periodic reports with SEC).

 

STO regulations: Europe Union


Inside the European Union, startups are required to create a prospectus. This document should clearly describe the security being offered to investors and also must ensure compliance with local regulatory norms.


  • Mirroring the regulation D in the USA, in Europe, security offerings can request qualiied investors to take part in the offering.
  • Security offerings are allowed to freely trade their securities to a maximum of 150 people.
  • Security offerings are allowed to take place without creating a prospectus, if the value of these securities is under 5 million euros.
  • If each investor in a security offering buys at least 1,00,000 euros worth of securities then the organizers are allowed to freely trade them.
  • Dubbed as the nominal value exemption, security offerings are allowed to sell securities freely if and only if the value of that security is worth 1,00,000 euros.

In Europe Union Art. 4(1)(44) of the directive on markets in financial instruments requires security law registration. The main difference between USA regulations is that non-transferable tokens will not be considered as a security. This is since according to the directive in financial instruments a token is considered as a security if it is transferable, negotiable and standardized.



STO regulations: Singapore


Singapore is among the most blockchain-crypto friendly countries in the world, on top of being one of the best places to do business in.  The MAS or the Monetary Authority of Singapore is the country’s central bank and financial authority. The MAS has released a set of guidelines for security offering especially.  

Similar to Europe, security offering organizers are required to draft a prospectus and submit it to the MAS before the launch of the security offering. The organizers are exempted from submitting a prospectus only if they satisfy the following conditions.


  • The MAS can regulate the issuance or offering if the security tokens under consideration fall under capital market products which are under the SFA (Securities and Futures Act). this will be determined by the MAS by analysing the characteristics and rights attached with the token.
  • A token can possess or represent a wide array of features or things like a share or debenture.
  • In a Collective Investment Scheme, the offering should not exceed $5 million a year and is also subject to the conditions of the MAS.
  • A private security offering can be offered to a maximum of 50 individuals in any given year.


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How to launch an STO


Launching an STO can be broken down into three main steps namely, pre-issuance phase, token issuance phase and security token management phase. Let’s briefly look into the characteristics of each step, for a more detailed step-by-step guide into launching an STO and the leading players to help launch an STO, check out InWara’s article.

Pre-issuance phase-

  • Setting up a structure for the STO that is in line with company views. As security tokens represent company stock the management has to decide whether token holders will have voting rights? Do they pay dividends? and so on.
  • Documentation is the second step and is essential to launch an STO. documentation may involve details such as the overview of the company, investment risks, price per token etc. In essence, every detail a potential token holder would want to know.
  • Marketing a security token offering is permitted under certain regulations like 506C and is a critical step to attract the right target audience.

Token issuance phase-

  • Making sure the security token offering is complaint with AML/KYC norms as often STOs are restricted to accredited investors.
  • Choosing the right security token issuance platform is critical since, security tokens are an entirely different beast than utility tokens, which means building it from the ground up requires a different technical approach. This can be a daunting process but can be made easier by choosing the right issuance platform. Some of the leading players include Polymath, Securitize among others.
  • Issuing the security tokens and raising capital from interested investors.

Token management-

  • Ensuring proper communication channels are set up with investors is a critical step. Often information that is communicated includes periodic financial reports etc.
  • Enabling trading of securities on secondary markets like exchanges.
  • Increased liquidity to traditionally low liquid assets.

 

Benefits security tokens could bring to the table


The most obvious benefit is enhanced regulatory compliance, which can help alleviate the risk of running into trouble with regulatory authorities. This can greatly reduce the regulatory risk involved. On top of that, a security token can be programmed to authenticate the buyer and seller which can restrict the tokens being purchased with parties whose identities have not been verified. Here are some of the other major benefits


  • Increased liquidity: Liquidity is defined as the quantitative discount the seller has to accept in order to liquidate their assets. Security tokens will allow for liquidity in traditionally illiquid areas like real estate or fine art.
  • As opposed to utility tokens that only grant investors right to the future product/ service of the project, Security tokens are backed by assets.
  • Security tokens could help institutional investors get into the blockchain-crypto space, as they’ve largely stayed away from the space due to lack of a clear regulatory framework.
  • Traditional financial transactions are often very expensive because of the large number of financial intermediaries present. Using security token hence could help reduce the costs of trading securities.
  • Increased global trade, currently it’s very difficult for invest in securities from across borders. But as mentioned earlier trading tokenized securities will be relatively easier and more convenient.

 

Common misconceptions about security tokens

 

Just because of the wide array of benefits that security tokens bring to the table many people often mix up some of the characteristics of security tokens. Confusing it with features it never has. So let’s look at some of the most common misconceptions-

 

  • Contrary to what many believe security tokens and tokenized securities are not the same. Both terms are often used interchangeably by many but this only stifles the prospects of each. We’ve talked about security tokens in depth so I’ll dive into what a tokenized security is.
  • Tokenized securities are traditional securities but in novel digitized form. Going by the very definition of tokenization, it is the process of transforming the rights associated with an asset into a digital token on the blockchain.
  • Traditionally real-world assets like stocks or bonds have been traded using documents which makes the entire process complex and cumbersome. Although commodity exchanges have helped to streamline the process to a certain degree by replacing physical paper with digital transactions and standardized agreements, the process is still quite complex and could be further improved.
  • This is where tokenized securities and blockchain steps in, with features such as non-fungibility that enables real-world assets to be traded in a secure and transparent way.
  • Another common misconception is that security tokens guarantee success just because they are compliant with regulatory norms and also because they are backed by real-world assets. This is simply not true.

 

Number of security token offerings

Security token offerings

Source


At least twelve projects that have launched security token offerings have failed. Which is akin to almost 3.6% of the total number of STOs. It would be more accurate to say that security token offerings have a significantly lower rate of failure when compared to other methods like Initial Coin Offerings which have an average failure rate of 14.35%.

 

STO ecosystem


Security Token Offerings

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