This is the second of a two piece article series regarding Security Token Offerings (“STO”). The first explains why STOs are becoming increasingly popular. The second explains how to properly perform an STO.
The world of initial coin offerings have raised over $22Bn in just 2 years. After 2 years, the SEC has finally put forth a framework for determining whether or not a token sold in an ICO is under their regulatory purview. Anticipating this long-time coming guidance, the industry has already began to move towards compliant security token offerings. With a current rising cryptocurrency market reminiscent of 2016, the year before the meteoric rise of Bitcoin and ICOs, it’s important to start preparing for the next big fundraising opportunity.
This will be a guide that addresses how to prepare for a security token offering, issues you need to consider, and an overall primer on getting started with your token offering journey.
From my own work advising companies on running security token offerings, there are three major considerations regarding STOs: Regulation, Technology Infrastructure, and Secondary Markets
Regulation governs how to conduct your offering, who you can raise money from, and restrictions on your new tradable asset once it is out in the wild. Technology infrastructure ensures secure storage and transaction execution, determines ecosystem interoperability, and enables capabilities for the token being generated. Finally, secondary markets are the platforms required for your investors to be able to trade tokens, arguably the most important relationship to keep your investors happy.
When it comes to raising money through a security token offering, the goal is to raise money from a broad set of investors without the registration burden of an initial public offering.
However, just because tokens attract new kinds of investors does not mean you can create an offering with complete disregard towards regulation. Depending on who you raise money from, how much you plan to raise, and how you plan to do it, there are varying degrees of regulation.
With the help of Gordon Einstein, a US securities lawyer, chief legal officer of Distributed Labs, and advisor to over 20 Blockchain companies, I’ve compiled the most popular exemptions when conducting a compliant security token offering. Note that you should consult a lawyer for more precise legal information, and should consider the follow as general guidance.
For those who don’t know, a US accredited investor is anyone with over $1MM net worth or a salary above $200,000 a year for the past two years.
There are many choices out there, and it might be hard to decide which path to pursue. When considering which route to choose, Einstein has the following to say,
It’s important to ask yourself why you are doing the STO. Are you doing this to raise money or are you doing this to get tokens in the hands of customers? If it is just to raise money, then you are doing under Reg D or Reg A. If you want tokens in the hands of customers so they use it, you have two options: Reg A+ or a public IPO of your tokens. Once you make the fundamental decision, it highly informs everything else you are going to do.
Remember that Utility tokens are not securities, but rather transferrable software licenses. Another strategy to get utility tokens into the hands of people is to conduct a separate ICO of utility tokens once the platform is built and then maybe get the investors of your security tokens to convert into utility tokens once the ICO is complete. No need to become a reporting company when you held a security offering for a utility token.
It is possible to have a combination of various exemptions. For instance, tZero, the most well-funded and compliant US-based digital asset and digital securities exchange and subsidiary of public company, Overstock.com, raised money through both a Reg D 506c and Reg S offering.
When considering your technology stack, the first consideration is which blockchain will your token live on. Once this is figured out, the next decision is how will the token be designed in order to be both secure and interoperable with the market. I spoke with Saum Noursalehi, CEO of TZero, to learn more,
Most of the industry has rallied around ERC-20 tokens. This standard is a smart contract technology designed for security tokens, based on the Ethereum blockchain. Several standards built on top of the ERC-20 protocol exist, including our open source t0ken protocol.
For those that don’t know, a smart contract is an immutable and technologically-enforced contract that lives on the blockchain. It cannot be changed or altered except as originally coded and deployed in the open source.
In the world of utility-based tokens, most issuers have chosen to standardize on the ERC-20 standard. This standard simply creates a new ledger with it’s own native token or unit of account on top of the ethereum blockchain. ERC-20 has been chosen due to the simplicity of design and the ease of interoperability.
Designing your token with interoperability in mind is very important. Picking the wrong standard means that there may not be many options for your investors to securely store their tokens and secondary markets may not have the capability to host your token. The network designed for ERC-20 tokens is so wide that most cryptocurrency wallets or exchanges can very easily integrate tokens built on this standard.
When it comes to security-based tokens, as laid out in the previous section, there is an additional layer of regulatory compliance required around who is able to buy, trade and interact with the tokens. As a result, companies and organizations have created new standards that take the ERC-20 model and include additional complexities, such as address whitelistings and locking, to allow the tokens to comply with security regulation.
These new standards are consider ERC-20 backwards compatible, which means any cryptocurrency wallet or exchange that can host ERC-20 tokens already some or all of the infrastructure needed to easily add a token of the new standard. There are four different token standards you should be aware of.
The original security token standard developed by Polymath. The token allows for a set of rules to be defined within the smart contract on who can interact with the token and how. Polymath offers a set of pre-coded regulatory modules that can be implemented when using this standard.
Very similar to ST-20, except that this standard involves three smart contracts (A, B & C) to allow for upgradability. Smart contract A is a simple ERC-20 token which references smart contract B for the rules of who can interact with tokens and how they can interact. Smart contract B then references smart contract C for the most up to date rules of who can interact with the tokens and how they can interact. The rules for smart contract C can then be altered without needing to change the state of the ledger in smart contract A or having any downtime for the token. This occurs by deploying a new smart contract C and having smart contract B reference the new contract. This standard is developed by Harbor.
Designed for more complex types of securities, incorporating differences between shares from the same issuer. The design is such that there is a single master token with various “tranches,” which are essentially sub-ledgers, each representing a percentage of the master token. This allows an issuer to offer different classes of securities for the same underlying asset, such as restricted vs. non restricted stock or preferred vs. common shares. This standard was developed in cooperation by some of the developers behind both the ST-20 and the ERC-20 standards. The token can also be backwards compatible with the ERC-777 standard, a standard designed for non-fungible tokens.
This standard is designed to allow for interoperability of various token standards, such as ST-20 and R-Token, with cryptocurrency exchanges and wallets. This standard was designed by the team behind Tokensoft and Polymath.
A major reason attributed to the success of fundraising through token offerings is the liquidity provided through the reduced trading friction enabled through the blockchain. This means that investors are able to invest in blockchain-backed tokens with a much lower risk profile compared to a traditional, illiquid asset (given the same value backing the asset). This makes secondary markets, a platform where investors of a security token offering can sell their tokens on an open market, an extremely valuable part of the ecosystem. To have a successful token offering, you must have a way for your investors to trade.
However, unlike exchanges hosting traditional cryptocurrency or utility-based tokens, exchanges hosting security tokens must abide by additional regulatory scrutiny to allow trading. The result is that many exchanges around the world refuse to offer security tokens.
Many exchanges across the globe are exploring security token trading pairs such as Coinbase, Binance, the Canadian Securities Exchange, tht SIX Swiss Exchange, and the Malta Stock Exchange. But even so, with all those involved, there are very few live security token exchanges.
When considering security token exchanges, there are currently two paths, centralized and decentralized. Centralized exchanges have the benefits of being user friendly, being regulated, and building access to traditional capital. However, there are currently only two US compliant security token exchanges, tZero and OpenFinance, and they currently do not have the same trading activity as traditional stock exchanges or cryptocurrency exchanges.
For decentralized exchanges, such as Bancor, there are many more choices. The barrier to list a token is much smaller and they have been online for a greater period of time. But, unfortunately, users must manage their own private keys and there is a greater reliance on smart contracts. The reliance on smart contracts means that investors should do their research on the security of the code, since a bug in the code could lead to millions of dollars being lost or stolen.
If you are looking for an alternative way to raise money for your company, but there isn’t a use case for offering a utility-based token in your setup, you now have all the tools you need to raise a technologically-compliant security token offering. Want to learn more about raising money through an ICO? Check out my other articles or learn more at https://www.inwage.com.