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A comprehensive guide to STOs (Security Token Offerings)

 

Security token offering

 

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In this article, we'll dive deep into the latest Blockchain-based financial instrument that is Security Token Offerings. We'll also answer more common questions like what are Security Tokens?, Utility Token Vs Security Token: what's the difference?, What regulations should i keep in mind while launching an STO? We'll also explain what's the benefit of Security tokens and the misconceptions about them. We've also got a curated list of service providers that can help you launch an STO.

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. The ICO method of fundraising became so popular, that since 2017 as much as $25 billion has been raised.


Initial Coin Offering (ICO) Funds Raised

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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. Naturally, people got weary of ICO projects and thus started the rapid downfall of ICOs. Prompted by the unfortunate fate of many ICO investors, regulatory authorities like the U.S Securities and Exchanges Commission started cracking down on ICOs projects.

The Chairman of the SEC, Jay Clayton was quoted saying, A number of concerns have been raised regarding the cryptocurrency and ICO markets, including that, as they are currently operating, there is substantially less investor protection than in our traditional securities markets, with correspondingly greater opportunities for fraud and manipulation,”

Numerous ICO projects were slapped with "cease and desist" orders for failing to register their ICOs with the SEC or filing for an exemption. Now you might be wondering, "What does an ICO have to do with the SEC?". Here's where things get murky, the SEC considers a majority of Digital Tokens as digital securities, even though they are utility tokens.

Why does it matter what the SEC thinks of ICOs? To date, The USA is a hotbed for Blockchain and Crypto startups and makes a large portion of already existing startups. Prompted by the tough stance of regulators, many entrepreneurs from the US flocked to more "crypto friendly" jurisdictions like Singapore, Switzerland, Malta and the Cayman Islands. Since then projects often ban US citizens from participating in their ICO events to avoid any trouble.

Security Token Offerings (STO) explained: What are security tokens?

Security Tokens can be defined as a Blockchain-based digital representation of anything of value, and is subject to regulation under the securities law of that jurisdiction. Unlike Utility tokens, the important distinction with Security tokens is that they're backed by tangible assets instead of providing a utility.


What is a Security Token Offering?

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.

Security Token Offerings (STO) explained: What is the Howey test?

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.

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. And there are other ways to boost your financial success, for eg. using personal finance apps like Walnut, Bachat, Mint etc based on where you live.

 

Number of Security Token Offerings (STOs)

Security token offerings

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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%.

 

Security Token Offering (STO) ecosystem


Security Token Offerings

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