Who Should Consider Capitalization by Way Of A Digital Security?

PrefLogic
PrefLogic
Nov 5 · 6 min read

The benefits that will attract issuers to digital securitization (“tokenization”) will vary with the interests of the issuer, whether it looks on tokenization from the perspective of market cap, industry sector, ownership structure or maturity of the business. The three primary forces that will drive digitization of securities are:

1. Capital formation: Project funding, Seed capital, Growth capital

2. Liquidity: VC funded companies, Mature private companies, Illiquid assets (real estate, art, other), Estate management

3. Efficiencies: Current public companies

Capital Formation:

The number of start-ups has severely declined in the last 10 to 15 years. The IPO hurdle is now $1B, meaning that an IPO rarely occurs at less than this threshold. There are very few VCs and Private Equity bankers doing smaller deals in the $1M to $10M range. The small and middle market of the growth economy is underserved and underbanked, yet it is well-established that this is where the greatest number of jobs are created. David Weild, IV, former Vice-Chair of NASDAQ and “Father” of the JOBS Act (Jumpstart Our Business Startups Act), has stated:

“if you look at the US Census Bureau data, the number of startups in this country has dropped off a cliff in the last ten years, and we think that’s related to the broader access to capital.”¹

Perhaps the best way to visualize this is to think of a chart or infographic showing the size of the deals on an X-axis (Left: small, Right, large). Imagine the billion-dollar mark to the far right where public offerings sit. Virtually all capital formation to the left of this $1B mark occurs in the broader private market. Even though this comprises the majority of the graph, there is a major ongoing disconnect between projects or companies that need capital and ones that can successfully raise that capital on reasonable terms.

This is where the Digital Security and the combined power of the JOBS Act, blockchain / smart contracts and the distribution power and network effects of the internet will have a disruptive influence on capital formation. The smallest of deals may be for project funding such as a real estate fix-and-flip investment. In this case, the person or company raising capital uses Digital Security issuance and cap table management to track investors, pay dividends and coordinate an exit, all without the need for exchange trading. Similarly, an early stage start-up may offer a digital security to raise seed capital or growth capital without the intent of immediate exchange trading. This same company could raise additional growth capital later, and at a time when maturity of the business and other metrics would support a successful Initial Exchange Offering (IEO).

Liquidity:

As you move further across the X-axis, the size of the deals increases, and typically in parallel with maturity of the company. This can include start-ups, VC funded companies and mature private companies. For all three examples, the two main options for liquidity have historically been merger and acquisition (M & A) or going public (IPO). With Digital Securities, the powerful concept of enabling trading by “tokenizing” a certain percentage of existing shares is emerging. Outstanding shares currently locked up can be offered to outside investors by way of Exchange Trading, bringing a brand-new type of value to both the buyer and the seller. While share count and governance do not require change, this liquidity can be very beneficial to founders, employees, early investors and VC investors. Many VC investments are locked up as long as ten years. Prior to VC funding, many founders empty their bank account to keep their company creation alive. This can be a long ten-year wait for founders and loyal employees. The advent of tokenization provides a mechanism whereby a path to liquidity of venture funding is through a digital asset strategy.

Think also of private companies where partial liquidity is possible and benefiting the same classes of owners. Ponder for a moment the power of this in estate management and transitioning family owned businesses to the next generation of owners. Lack of acceptable options to provide liquidity to those who want or require it has brought many successful family or private businesses to their demise. Look also at the many private companies successful and large enough to trade publicly but choosing not to do so. The top ten largest private companies range in revenue from $27B to $115B. A partial sell of equity would be a BIG DEAL, and who wouldn’t want to own a piece of Cargill, Albertsons or Ernst & Young?

Efficiencies:

The final category of companies to convert to digital securities are public companies and publicly traded instruments (equity, debt, real estate, bonds, etc.). Stephen McKeon has written about the 8 strengths of security tokens.² These include 24/7 markets, fractionalization, rapid settlement, cost reduction, automated compliance, improved liquidity, asset interoperability and expanded design space. This last item relates to the huge canvas for creativity provided by real time ability to communicate with and bring value to investors.

Blockchain-based digital securities are simply a better instrument to represent ownership than certificated securities. Currently they represent far less than 1 percent of the total. Jay Biancamano, Head of Digital Assets at State Street, the world’s second largest custodian bank, recently stated:

“We’re seeing assets start to become digitized…Trickle, trickle, trickle and then we believe there will be a flood.”³

So, what does the future look like? Sit back and imagine for a moment; what if internet traffic could be visualized by looking to the sky, or downward from space? We would see a dense blanket of activity with constant and vibrant motion. Now change the filter to look up and see the flow of digital securities traversing the globe. Sparse and patchy, right? It will not be long before this view changes radically and we will see an ultra-dense blanket of asset flow that never sleeps and reaches the most remote and underdeveloped places on earth. There will come a time that all securities are tokenized and therefore participate in this highly efficient and massive global flow of value. But don’t take my word for it, Robert Greifeld, former Chairman & CEO of NASDAQ, has been quoted as saying:

“100% of the stocks and bonds trading on Wall Street today could be tokenized, and in five years, 100% of the stocks and bonds on Wall Street will be tokenized.”⁴

I can’t predict how long it will take, but there will be an eventual “flippening” or a point where there are more publicly traded companies represented by a digital security than by a certificated issue. As this $500 trillion transformation takes place, it answers the question mentioned before:

Is there a future when all securities are required to be tokenized?

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¹ Security Token Industry Launch Event, October 5, 2018, NYC. David Wield: “The Wall Street Perspective: Cooperation vs. Coopetition vs. Competition”

² “The Security Token Thesis” Medium.com by Stephen McKeon, May 25, 2018

³ “Digital Assets Will ‘Trickle, Trickle, Trickle — Then Flood’ State Street Exec Says” Fortune.com by Robert Hackett, October 2, 2019

⁴ The North American Bitcoin Conference, January 18, 2018, Miami. Patrick Byrne: “A Blockchain Tech Stack for Civilization”

By: R. Jeffrey Cole, MD

Advisor to PrefLogic

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DISCLOSURE REGARDING ENDORSER. Dr. R. Jeffrey Cole, the author of this blog, owns a promissory note that is convertible into a significant number of shares of PrefLogic common stock at a fixed conversion price. In addition, PrefLogic has issued to Dr. Cole shares of PrefLogic common stock to compensate him for providing management and marketing advice to PrefLogic.

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