Security Token Offering (STO): analysing the process of issuing security tokens.
Legal Disclaimer: Please note, none of the information below should be relied upon as legal advice. Please contact Diacle to assist you in finding a suitable lawyer for your requirements.
Who should read this note
This note is intended for companies seeking to raise capital through the issuance of Security Tokens or for investors who intend to invest in Security Tokens.
This note intends to illustrate the whole process and time-frame of launching a Security Token Offering (STO). An STO represents a cheaper and more accessible way of raising funds for companies than a traditional Initial Public Offering (IPO). Applying the blockchain technology and smart contracts to capital markets would allow founders to tokenise any type of asset compliant with all regulatory requirements; hence, investors would also benefit from having newer financial products and easier compliance. After a brief introduction to the concept of an STO, this article also highlights the most valuable reasons for issuing security tokens.
1.Introduction to STOs: the concept.
Over the last three years, the boom of Initial Coin Offerings (ICOs) has represented a real innovation in crypto-finance. ICOs have created a new type of financing for raising funds through the emission of tokens in projects based on blockchain systems in exchange for fiat currency or other virtual-currencies and with the possibility of high profits for investors. In 2017, ICOs globally raised about $7 billion and more than $13 billion in 2018.
The term ICO mirrors the term IPO (Initial Public Offering) but there are distinct differences between them. During an IPO, shares (securities) of the company itself are sold to the market (stock exchange) with the aim of opening its capital to new shareholders and increasing it. In contrast, an ICO is based on blockchain technology and greatly reduces the investment threshold and issuing difficulty. An ICO can pursue two main objectives: it can be used both to create new virtual-currencies (VCs) or for “project financing”. On the other hand, IPOs are the most traditional and mature way of raising funds in finance. Compared with ICOs they are more regulated and difficult to launch, the financial cost can be huge and listing processes can be complicated.
However, because most ICOs resulted in scams (e.g. Pincoin, iFan, Plexcoin, Bitcard, etc.) and regulation is unclear (indeed, it also depends on the specific jurisdiction involved), responsibility for increasing awareness has also been put on ICOs by the regulators.
Due to these shortcomings, people have started to turn to Security Token Offerings (STO), the next significant crypto-trend. As with ICOs, STOs are based on blockchain technology. They provide balance between both fundraising schemes in terms of regulation, issuance difficulties, and convenience of trading of tokens. Indeed, considering a security as a fungible, negotiable financial instrument that holds some type of monetary value (e.g. an investment product that is backed by a real-world asset), and also as a “cryptographic code that represents the ownership of assets”, it is possible to assume that a security token represents an investment contract into an underlying investment asset issued on the blockchain that can be either be an equity, debt, utility or security (such as mutual funds and exchange-traded funds (ETFs)).
Apart from STO regulations which may vary depending on the specific jurisdiction taken in to account, it is possible to highlight specific steps in setting up an STO that can be followed internationally.
The paragraphs below represent a general guide for all those who want to launch an STO.
2. Reasons for launching an STO
The following points assert several valuable reasons for launching an STO:
a) Low fees: trading in digital assets can undoubtedly reduce fees. Smart contracts and blockchains can automatise transactions without the need to deal with mediators and have lower costs.
b) Low barrier to entry: a cryptographic token is designed to tokenise any asset. This makes tokenisation a flexible instrument capable of raising funds in private markets for a lower up-front cost. Moreover, assets worth more than USD $1,000,000 (e.g. real estate; artwork; etc.) can now be easily fractionated and accessed by a much wider range of investors.
c) Funders can obtain more for less: companies issuing security tokens can benefit from several advantages. The programmable nature of the token itself allows founders to decide which rights should be embedded into it. They can decide what would be the best profile for their token without the need to surrender voting rights or board seats. As a consequence, they can best focus on their business.
d) Better regulatory oversight: strong regulatory compliance and KYC/AML verification are key requirements for STOs to protect both investors and companies launching STOs.
e) Automated compliance: because the regulation applying to security tokens issuance may vary depending on investor type, asset type, jurisdiction involved, and several other factors, the programmable nature of security tokens allows compliance to be embedded within the token itself.
f) Accessibility to Institutional Capital: Due to the possibility of extending security regulations to security token offerings, security tokens can attract institutional capital into the blockchain domain.
3. The preliminary stage of an STO (around 6 months)
The preliminary stage involves the following key factors:
a) There must be an idea behind the STO that is interesting enough to attract investors;
b) The token structure must be in compliance with regulatory requirements. Tokens sold during an STO have to qualify as security tokens. This depends on the specific regulation considered:
In the EU, the criteria adopted to determine whether a token may typify a security are:
Transferability - according to Art. 2(a) of the Prospectus Regulation, the issued financial instrument has to be likely to be transferable from an individual to another (it practically means “passing the ownership”).
Standardization - Art. 4(1)(18) MiFID refers to securities as “classes of securities” with specific attributes.
Negotiability - according to Art. 2(1)(a) of the Prospectus Directive tokens represent securities when they are “negotiable on capital markets”.
Comparability with a specific list of investment contracts (e.g. shares or bonds) - Art. 4(1)(18) MiFID states that the three criteria above have to be connected with the features of a list of non-exhaustive examples of products that represent securities and that can be split into three classes: a) “shares” and comparable products; b) “bonds and other forms of securitised debts”; c) “any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies…or other indices or measures.”
For all STOs, companies are obliged to draw up a Prospectus and to comply with the local (national) security law requirements, unless at least one of the following exemption regulations applies:
Qualified investor’s exemption (Private offerings) - Private Placements are:
Offers limited to qualified investors;
Any offers to less than 150 non-qualified investors in each Member State.
The nominal value exemption - equity and non-equity securities with a denomination per unit of at least EUR 100,000 offered to the public are exempted from the obligation of writing a prospectus.
The amount exemption - securities offered to the public between a total consideration of EUR 5,000,000 and EUR 100,000, can be obliged to write a prospectus by national laws or issuer discretionary decision.
The large investments example - companies can sell their securities freely if each investor purchases at least EUR 100,000 worth of securities issued.
In the US, the Security Act 1933 and the Securities and Exchange Act 1934 provide the legal framework for the regulation of the sale of securities within the U.S. context.
Whether a token is considered a security depends on whether it can be identified as an investment contract.
In particular, the Howey test represents a tool to establish if a product falls into the definition of an investment contract (thus, security). Indeed, four requirements have to be fulfilled:
investment of money into
a common enterprise with
the reasonable expectation of profits derived
from the entrepreneurial or managerial efforts of others.
This test is essentially based on a flexible principle and applies to all contractual structures based on the use of “money of others on the promise of profits”.
In the US, before launching an STO, the security issuer must be registered with the Security and Exchange Commission (SEC), unless, according to the JOBS (Jumpstart Our Business Startups) Act, it qualifies with one of the following exemptions:
Regulation D (private offerings) - Issuers have to comply with the following three rules: Rule 506 (b), Rule 506 (c), and Rule 504.
Under Rule 506(b), a company:
Can raise an unlimited amount of money;
May sell its securities to an unlimited number of “accredited investors” and up to 35 other purchasers;
Cannot use general solicitation or advertising to market the securities;
Must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws;
Must be available to answer questions by prospective purchasers.
Under Rule 506(c), a company:
Can broadly solicit and generally advertise the offering only to accredited investors;
Takes reasonable steps to verify that the investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.
Rule 504 of Regulation D provides an exemption from the registration requirements of the federal securities laws for some companies when they offer and sell up to USD5,000,000 of their securities in any 12-month period. Investors in such offerings should be informed that they may not be able to sell the securities for at least a year unless the issuer registers the resale transaction with the Commission.
The following companies are not eligible to use the Rule 504 exemption:
Companies that already are Exchange Act reporting companies;
Companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies;
Companies that are disqualified under Rule 504’s “bad actor” disqualification provisions.
Rule 506(b) and Rule 506(c) have no limit for the fundraising but allow only accredited Investors in the U.S to invest. Rule 504 does not have restrictions on investor status. Rule 503, issuers are limited to USD 5,000,000 of capital raised and are required to register the security with state regulators. Reg D also allows for General Solicitation, which allows the companies to advertise their fundraising and projects.
Regulation A+ (limited public offerings) - It seems appropriate for businesses looking to raise under USD 50,000,000 and looking to solicit non-accredited investors. Given the restriction to provide two years of financial statements, we could assume that Reg A+ would be a better match for established startups. In contrast to Reg D, securities issued under Reg A+ do not have restrictions on resale, which should result in more liquid markets.
As the Securities Act states there are two offering tiers:
Tier 1, for offerings of up to $20 million in a 12-month period; and
Tier 2, for offerings of up to $50 million in a 12-month period.
For offerings of up to $20 million, companies can elect to proceed under the requirements for either Tier 1 or Tier 2.
Regulation S (foreign offerings) - Companies can have their security token offerings take place outside the US but cannot involve US investors.
Regulation CF (CrowdFunding) - When raising funds with Reg CF, startups can raise up to USD 1,070,000. This is meant to quickly fund small projects to boost innovation. We would argue that a lot of projects can be started with as little as USD 1,000,000 if done right. The downside is the 12-month lock on secondary markets.
c) It is important to define and clarify the strategy to increase the value of the token by defining:
d) Evaluating whether the STO would be the right way for raising funds for the specific business involved. Essentially, it is based on a careful assessment of several factors:
Foreseeable annual turnover. It depends on the business, the country of issuance, the regulation applied (or chosen), and the type of security token issued;
The expectancy of the rapid growth of the business;
The need for a high level of liquidity;
Carrying on international business;
The need to increase the number of potential security-holders by extending the offer of securities to an individual close to average consumers;
The need to embed a utility tool (with a smart-contract) in the token itself.
e) Scanning tokenising platforms available on the market for the creation and issuance of the security token, such as Polymath, Harbor, Securitize, Tokeny, etc.
f) Drafting a whitepaper.
This is the most important document for marketing the STO. It contains all of the information related to the product issued. The whitepaper must be precise and straight to the point because it informs the investors about the token features and the business itself.
A description of the product issued:
Typical features (how it can be used)
General details, by determining what tokens are backed by, including any type of security that is applicable;
A description of the issuer:
A general overview of the industry in which the issuer operates;
Legal disclaimers and all legal notices.
Building up a team of experts that implements the idea.
Website creation. It is really important because it introduces, advertises and sells (or links to other websites that sell) the product.
4. Pre-STO (1 month)
This phase focuses on the choice of the right strategy, the creation of security tokens and their introduction to the market:
Choice of the Tokenisation Platform to create Security Tokens.
It is time to decide which Platform is going to issue the security token (e.g. Polymath, Harbor, Securitize, Tokeny, etc.).
Usually, these platforms allow the issuance of security tokens by providing tools that facilitate compliance with securities laws and Know-Your-Customer (KYC) and Anti-Money-Laundering (AML) regulations.
Choice of the token Exchange Platform (e.g. tZero; BankToTheFuture; Bancor; DX.Exchange; Templum; GSX; Smart Valor; Blocktrade; etc.).
5. Setting up an STO (1-2 months)
In this stage, the company has to focus on the security token creation. Nowadays, the market offers several solutions, such as Polymath, Harbor, Securitize, Tokeny, etc. The company has to choose the most suitable platform for its purposes and then start to create the token. Any platform has its own process for issuing the token, but what is worth mentioning is that the majority of them already offer legal advice and KYC/AML compliance tools. Depending on the type of token and platform chosen, the process may take from 1 to 2 months.
6. Marketing an STO (3 months)
Once the preparation stage is completed, it is time to increase the hype surrounding the launch of the STO. The marketing campaign is vital for a successful STO. Information regarding token structure, whitepaper, company and team members has to be clear and adequately delivered to the right type of crypto investors.
An STO is easier to market if its benefits are compared to those of an ICO. This is because an STO is less likely to result in a scam due to being backed by real and tangible assets and the stringent regulatory requirements that increase the level of security for investors.
Because of the importance of marketing, companies launching an STO usually rely on marketing experts that can help to maximise the visibility of the offer. This stage may include optimisation of the website, search engine optimisation, roadshows, mail marketing and advertisements on social media.
However, depending on laws and regulations applying to the specific STO, companies launching the marketing campaign have to be careful because in some countries there are laws against promoting certain types of investments.
Once the STO is launched and money is collected, it is important to decide the destination of funds. The market changes rapidly, the token’s value may fluctuate, and the capital raised must not be wasted. For this reason, at this stage, companies should already have an idea about the use of the funds. The right investment may facilitate the trade of the issued securities and increase the value of the security token itself.
Moreover, it is very important to keep the hype high. It can be done with the right post-STO marketing strategy.
Looking at the history of token offerings, much road has been made in recent years. ICOs represented a useful tool to raise funds but were surrounded by regulatory uncertainty and most of them resulted in scams. The situation has changed with STOs. They represent the perfect synthesis between ICOs and IPOs. STOs are capable of satisfying the needs of companies issuing tokens because any type of asset is capable of being tokenised, and the securities regulations can be easily applied to security tokens. At this time, it seems inevitable that security tokens represent the next financial revolution. Similarly to how Bitcoin has transformed currency, STOs will tokenise financial assets such as equity, funds or debts. This means that any kind of ownership can be tokenised in a potential multi-trillion dollar addressable market.
References for this article can be found here