2017 may be revolutionary in the financial world because of having established a new way for companies to easily raise funds. With blockchain technologies on the rise, hundreds of startups have rushed to conduct their fundraising by an Initial Coin Offering (ICO) — selling their tokens to investors. There is good reason behind this craze, as tokenizing securities provides a range of benefits for parties on both sides of the deal.
We want to demystify the fundraising process for you by helping you understand the various token types and how they are best used. For the purpose of this post, we will focus on the security token.
What’s an ICO and how does it work?
Compared to previous methods of fundraising, ICOs make raising funds much easier for both the company and the investor.
The company starts by issuing a limited number of tokens. As a matter of economics, limiting the quantity of tokens helps ensure the token’s value in the future. Investors who are interested in participating in an ICO complete a form on the project’s website to pass the KYC (know your customer) process and send the required documents to verify their identity. Once permission is granted, the investor can purchase the tokens by sending their funds to the project’s crypto wallet address. Once the funds reach the recipient, the project sends the investor the equivalent number of tokens by means of a smart contract.
Tokens fall into two big groups: utility and security, and are distinguished based on functionality.
What are utility tokens?
Utility tokens can be used by participants of a given project within the project’s network. They can be used to purchase products from participants or from the project itself, or to cast votes. Utility tokens can be likened to coupons because an exchange occurs when redeemed.
A good example of a utility token is ARDAT — the token created by the Arda Smart Training Community. Arda rewards its users with ARDAT tokens for reaching personalized milestones and sharing data within the community. Users in turn use their ARDAT to redeem offers from advertisers on the platform, essentially cashing in their tokens in exchange for a product.
Steemit is a platform that uses utility tokens to cast votes. On this platform, users post their own articles and promote other authors’ content by voting with the local currency called Steem Power. The higher the user’s account reputation, the more valuable the votes given to other participants. The votes that someone’s articles receive can be later converted to USD through an exchange platform. This is a perfect money-making tool for good writers.
What are security tokens?
First, let’s give a definition of a security in the traditional financial market. A security is a tradeable asset that is backed by the company’s property and gives its holder a chance to get a revenue share according to the invested amount.
Consequently, a security token is a digitized form of a traditional security. In the context of ICOs, a security token is characterized by the following:
- Investment of money. Investors contribute funds to the project to help develop the product in question. It’s considered a good practice for blockchain-oriented projects to make regular reports on the funds’ expenditures to give more transparency to all the interested parties.
- An expectation of profits. Investors expect that as the project develops and conquers new markets, its profits will rise and so will the revenue share. Unlike utility tokens, security tokens cannot be used for purchasing goods and services within the platform and their price depends on market demand and the project’s capitalization.
- Certain ownership rights of a company. The more tokens you possess the bigger your share, and the bigger your influence on the project’s network. As blockchain projects are all about decentralization, they usually try to distribute their tokens fairly among the investors by setting an upper limit for the amount of tokens that can be purchased.
tZero, an Overstock.com subsidiary, is a company that has created a security token. tZero is developing blockchain-supported solutions to improve capital markets and fix the inefficiencies of Wall Street. Their product to digitally locate receipts by storing the information on a blockchain makes checking inventory and audits easier reducing settlement time and costs. Their security token is aptly called tZERO and pays token holders 10% of adjusted gross revenue on a quarterly basis.
The Howey Test: Is this a security token?
The Howey Test helps individuals determine whether a token is a security or not.
In 1946, long before the internet, the Supreme Court heard a case regarding a land sale contract in Florida and whether a leaseback constituted an investment contract based on the Securities Act. During this case, a landmark test was developed which aimed to determine if the leaseback agreement qualified as an investment contract. This test was named after the defendants Howey Co. and Howey-in-the-Hills Service. In this case it was ruled that Howey’s leaseback agreement was an investment contract, hence a form of security, and they had broken the law by not filing a securities registration agreement.
According to the Howey Test, a transaction is an investment contract if:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
Simply put, when applying this test to cryptocurrency tokens, two questions should be answered:
- Does the token offer a possibility to contribute to startup capital or have a share in its profits?
- Is the profit generated by the efforts of a third party?
If the answer is positive to both of these questions, then and only then a token can be regarded as a security.
If a token is deemed to be a security it must register with the SEC and follow the SEC’s regulations.
Exchanges for trading security tokens
There are various trading platforms where security tokens can be safely exchanged.
- Polymath: A regulation-compliant platform that facilitates security token ICOs and trading.
- tZero: Enhanced security and user-friendly interface.
- Gibraltar Blockchain Exchange (GBX): An EU-regulated stock exchange that has implemented blockchain technologies to facilitate trading.
- OpenFinance Network: The first US-based regulated security token trading platform with a pre-defined framework for token listing.
- Bancor: Platform that allows exchanging your tokens at algorithmically calculated rates.
- AirSwap: A good alternative to traditional crypto exchanges as it allows transactions on a global scale and connects users across different markets.
- SharesPost: Launched in 2009 as a platform for trading on light private equity secondaries. The project also gives its users a possibility to trade security tokens.
Advantages of security tokens
As we’ve already stated above, in comparison with the traditional securities market, tokenizing the assets of a company gives a number of advantages both to the token issuers and to the investors.
You are limited to trading stocks on a traditional US market exchange between 9:30 a.m. and 4 p.m. EST weekdays. There is no evening or weekend trading option.
However, during these breaks anything can happen. You may not discover something bad has occurred until the following day when you get a report and see the price of your securities has dropped by 50%. Similar scenarios could happen in companies beyond the US, as well.
Transferring securities to the blockchain gives companies the possibility to sell and investors to purchase the tokens continuously throughout the entire week. This leads to higher transparency and increased liquidity as you can monitor the news and events of the selected project online and exchange tokens accordingly.
Issuing your own securities in the traditional financial market costs a fortune. Costs arise from needing to hire investment bankers, lawyers, and experienced advisors from the outside to properly launch it, not to mention huge piles of paperwork that will need to be completed.
The procedure is not only costly, but also time consuming. If you are new to this business get ready to spend at least a year preparing for an IPO. This is quite a long period of time and anything can happen within this timeframe. Costs could increase and laws could change.
Transferring your securities to the blockchain can save tons of time and money. Yes, you will still want to use your lawyer’s advice and it would be wise to consult an experienced person, but from the technical point of view, it’s much easier and faster to issue security tokens than traditional securities.
Quicken deals by removing the middleman
With the help of smart contracts, the whole deal can be completed on the blockchain. Thus, when the programmed conditions are met, the contract is applied automatically, removing the need to wait for the third party’s verification.
No geographical boundaries
In addition to fast deals, blockchain-based security tokens give the possibility to raise funds internationally. There may be some local restrictions in selected regions where cryptocurrencies are forbidden, but still, the geographical coverage will be much wider than on the traditional asset market. Thus, you can get a much more exposure to foreign investors.
In the traditional private assets market, it may be a very costly process to change ownership, especially if you exit the position before the fund is liquidated.
If you trade a security token on a cryptocurrency exchange the only overhead you will have to pay is the maker-taker fee, a small commission to upload and to withdraw your tokens to the platform. Small transaction fees and instant transactions are one of the greatest advantages that cryptocurrencies give their users in comparison with all other traditional financial institutions.
Additional value to existing securities
With blockchain technologies, your securities can provide additional value to your investors. For example, if a person owns security tokens of a clothing store, he or she could receive an additional discount connected to a special card and confirmed on the blockchain.
Disadvantages of security tokens
There are, without a doubt, advantages that security tokens have over traditional securities. However, every coin has two sides, and so does blockchain. Consider the following limitations before making a final decision.
Although smart contracts are a very powerful tool that help automate business processes, they still do not cover all the functions of middlemen. For example, it is still not possible to automate the deal underwriting or to prepare marketing materials via a smart contract.
Smart contracts are created with the help of very complex programming languages such as Solidity, which inevitably can have bugs in the code. Bugs can lead to money loss which you will be unable to undo due to the nature of blockchain whereby transactions are irreversible.
Cryptocurrencies are new and are still a gray area in most countries . Regulations are slowly coming together, but are also changing rapidly. In the US the Securities Exchange Commission (SEC) serves to protect people from fraudulent activity such as misrepresentation and deceit. If a token passes the Howey Test and is deemed to be a security the company issuing the token must be compliant with SEC regulation.
Compliance begins with registering the investment contract and involves corporate reporting, proxy solicitation, meeting anti-money laundering (AML) and know your customer (KYC) requirements, and more.
There are huge benefits to issuing security tokens, but not all companies have the resources to address the legal requirements. Meeting the SEC’s requirements is costly and time consuming and will require good lawyers and accountants to be done well. The upside for an investor is that knowing that a company is in compliance with SEC regulation will make them feel much more comfortable, as they are protected.
While this article is not representative of legal advice, it takes a trained securities professional to ascertain whether or not a token is a security or a utility. We recommend that a trained lawyer reviews your token structure and token economics to determine the best path forward for your particular project.
Security tokens are undoubtedly a revolutionary way to drive economics. With the advantages that they have in comparison to traditional equity markets, they have all the chances to get a substantial share in the real-world economy.
However, with security tokens projects have a convenient tool to raise funds and simply run away and none of their investors will have a legal right to get a refund. In a future post, we will review security tokens regulation and the methods that governments implement in order to restrict scam projects, so stay tuned.
If you are considering creating a security token and need to talk to someone knowledgeable in the subject, we have a few names up our sleeve. Reach out to us and we’d be happy to help.
*Disclosure: We are not lawyers. This is a representation of our understanding of security tokens and should only be used to kick-start your research. No final decisions should be made based on this article.