How Companies Raise Capital Through Tokenization

A company can raise capital internally using retained profits. Alternatively, when companies need major funding, they may seek capital from external sources (e.g., banks, additional investors). For public companies, the decision may depend on factors such as capital structure, market conditions or price of its own stock but eventually the Board of Directors will decide whether to raise capital by issuing new shares (i.e., increasing equity) or issuing bonds (i.e., increasing debt). It is not as common, but you may come across certain projects where capital is raised through pre-sales. In the past decade, crowdfunding became popular among startups where capital is raised in exchange for a promise of shares, a promise to repay debt or a promise for a reward (e.g., access to products or services).

Digital assets are a new class of asset that has earned its seat at the table with the other major asset classes — gold, real estate, stocks, and bonds. Digital assets, through digital tokenization, have inspired a new method for companies to raise capital. Tokenization is not a new concept but being able to issue tokens on the blockchain is a game changer.

There is resemblance, to some degree, between tokenization in the digital asset world and the securitization process in finance. In traditional financial markets, the issuer of securities can pool various financial assets into one group such as mortgage-backed securities. Then the issuer sells fractional ownership shares of this pool of mortgages to investors. The main benefit of securitization is to create liquidity in markets.

Similarly, in the digital world an issuer can issue tokens that represent a stake of ownership in any type of property either on or off chain through a process called Initial Coin Offering (ICO). Decentralized Finance (DeFi), which uses technology to offer new or existing financial services on the blockchain, also benefits from tokenization by connecting multiple applications together enabling developers to repackage assets and subdivide them as needed¹. The major advantage over traditional finance is that due to common standards and protocols that are used on the blockchain (e.g., on Ethereum, ERC-20 is used for fungible tokens and ERC-721 for non-fungible tokens) the newly minted token can be easily traded for many other tokens and native cryptocurrencies which creates market liquidity at greater magnitude. And potentially, it creates opportunities to enter more complex smart contracts, such as derivatives by using your token as a collateral².

What are tokens?

Even though the word token is sometimes used as a generic term for all digital assets on blockchains, there is a consensus by market participants to distinguish between blockchain-native assets such as Bitcoin (BTC) and Ether (ETH) who live on their respective platforms and might be referred to as cryptocurrencies and other digital assets, referred to as tokens, that are issued as part of a smart contract on a blockchain³ such as Binance Smart Chain.

On a side note, the nomenclature cryptoasset is more appropriate than cryptocurrency given BTC’s and ETH’s state of high volatility since they were launched. In addition to the three basic functions, namely, store of value, unit of account and medium of exchange, economists look at other properties such as stability of the currency. First, Bitcoin and Ether are not widely accepted as medium of exchange and lately they have not been inspiring stability into consumers and investors.

When we hear the word token, it may remind us of a token at a festival or a poker chip at a casino. They all serve the same function which is essentially a claim to an asset or a service in the future. There are three main classes of digital tokens: security, utility, and non-fungible tokens.

Security (or equity) tokens represent ownership in an underlying asset or a pool of assets which gives the holder access to future cash flows. Utility tokens are fungible⁴ tokens required to use some functionality of a smart contract system or that has an intrinsic value defined by its respective smart contract system⁵. Filecoin, a utility token, provides digital storage and data retrieval method⁶. Non-fungible tokens are unique and represent art, music, sport videos and other collectibles. Their value is mostly derived from their uniqueness which translates into scarcity. They also benefit from blockchain’s strong ownership authentication process that utilizes the private and public key combination as a digital signature. In 2021, Mike Winklemann, the digital artist known as Beeple, sold his collage of images from his “Everydays” series for $69.4 million⁷.

How can companies raise funds by issuing tokens?

In a traditional equity ownership, the shareholder is fully vested in the company’s net assets. When issuing tokens, a company has the flexibility to specify the purpose of the offering. It can be to fund a particular product or service which is typically described in the project’s whitepaper. After announcing and marketing for the ICO, the company starts receiving funds in the form of digital assets because the offering will take place on one of the blockchains that can host a smart contract (Ethereum is the most popular). In exchange for the funds, the company issues a token. It could be an equity token but not necessarily. If the company prefers not to dilute the current equity composition, it may choose to issue utility tokens that enable the investor to redeem them for future products and services⁸. In May 2021, Exodus, a non-custodial cryptocurrency wallet, raised $75 million⁹ of equity tokens by filing Regulation A Tier 2 exemption with the Securities Exchange Commission (SEC).

Are issued tokens considered financial securities?

To protect investors, the Securities Act of 1933 and the Securities Exchange Act of 1934 require certain disclosures and reports to be filed by the security issuer. As a result, a token issuer should consider whether the U.S. federal securities laws apply to the transaction.

Before an Initial Coin Offering, issuers are expected to apply the framework of the Howey Test¹⁰ to determine if the token is an “investment contract” and therefore subject to SEC registration and filing requirements.

Some of the token issuers have been elusive in the way they market their tokens and document their whitepapers to claim that the token is not a security and avoid regulatory implications.

Former SEC Chairman, Jay Clayton, has expressed this in a December 2017 statement¹¹.

“Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.”

In April 2021, Commissioner Hester Peirce provided an updated version of her safe harbor proposal which “provide[s] network developers with a three-year grace period within which, under certain conditions, they can facilitate participation in and the development of a functional or decentralized network, exempted from the registration provisions of the federal securities laws¹².”

The number of cryptocurrencies is growing every year. According to CoinMarketCap, as of June 2022, there are a little less than 20,000¹³ cryptocurrencies.

We may not know how many of these coins are voluntarily compliant with statutory regulation, but we know that government oversight should keep up with this fast-growing industry. The release of President Biden’s Executive Order on Ensuring Responsible Development of Digital Assets is a good step towards that goal.

Accounting for tokens by entities that are not broker-dealers or investment companies

As of this writing, there is no specific authoritative guidance that addresses accounting for digital assets. In 2021, the Financial Accounting Standards Board (“FASB”) staff published an Invitation to Comment to request stakeholder feedback on its standard-setting agenda. Most of the respondents identified digital asset accounting as a priority topic. The AICPA & CIMA issued a guide, “Accounting for and auditing of digital assets” which is a nonauthoritative practice aid to provide guidance on how to account for and audit digital assets under U.S. generally accepted accounting principles (GAAP) and generally accepted auditing standards (GAAS). Additionally, accounting firms have been publishing their thoughts on this topic. For instance, PwC’s leadership staff shared their thoughts on possible treatments of digital assets during the February 2021 episode of accounting podcast¹⁴.

The rights, obligations and the economics of the transaction should drive the accounting of digital assets.

Digital assets, such as utility tokens, will most likely fall under the intangible asset with indefinite life model. The asset will be recorded at cost subject to annual or trigger-based impairment test. When impaired, write down the asset; however, write ups to fair value are not allowed. Security tokens, and potentially stablecoins, will most likely be classified as a financial asset or a derivative because they give the holder the right to a future cash flow. These tokens would be recorded at fair value.

Those two scenarios describe the asset side of the accounting entry. However, there is no clear guidance on how to treat the other side of the entry (i.e., equity or liability).

When crypto assets are received in exchange for goods or services then Topic 606 is applied if sold to a customer and Topic 610–20 if the counterparty is not a customer. In either case, the crypto asset received in exchange for the good or service is initially measured at its contract inception date fair value. Changes in the fair value of a crypto intangible asset after contract inception do not affect the amount of revenue (Topic 606) or gain (Subtopic 610–20) recognized for the sale of the good or service¹⁵.

The 20,000 cryptocurrencies we mentioned above boast a market capitalization of approximately $900 billion¹⁶. This figure was close to $2 trillion earlier in the year. Inflation and the war in Ukraine have triggered a contraction in the crypto market. Nevertheless, digital asset ecosystems and their use cases have shown great benefits and the markets will eventually resume their growth trend. This is a great time for regulators and standard-setters to provide clarity and guidance on reporting and disclosure requirements which will foster a positive environment for the growth of digital assets and protect investors at the same time.

[1] Harvey, Ramachandran, Santoro, DeFi and the Future of Finance (Wiley, 2021), 66.

[2] Ibid

[3] Antony Lewis, The Basics of Bitcoins and Blockchains (Mango, 2018), 301.

[4] Fungible means interchangeable, one of the properties of money. A consumer should be indifferent between 1 note of $10 bill or 10 notes of $1 bill.

[5] Harvey, Ramachandran, Santoro, DeFi and the Future of Finance, 162, 171.

[6] https://en.wikipedia.org/wiki/Filecoin

[7] https://en.wikipedia.org/wiki/Mike_Winkelmann

[8] Lewis, The Basics of Bitcoin and Blockchain, 355

[9] https://www.coindesk.com/business/2021/03/03/crypto-wallet-exodus-seeks-sec-permission-to-tokenize-shares-aims-for-75m-raise/

[10] The test was established by the Supreme Court because of the 1947 case Securities and Exchange Commission versus W. J. Howey Co.

[11] https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[12] https://www.sec.gov/news/public-statement/peirce-statement-token-safe-harbor-proposal-2.0

[13] https://coinmarketcap.com/

[14]https://viewpoint.pwc.com/dt/us/en/pwc/podcasts/podcasts_US/Cryptocurrency_Digital_asset_Whats_the_accounting.html

[15] KPMG, Accounting For Crypto Assets, March 2022

[16] https://coinmarketcap.com/