Frameworks for Funding and Token Distribution — Part 2: STO and SAFT

This is the second post in the series of blog articles on the capital generation and token distribution. The first article can be found here.

Security Token Offering (STO)

Recently, we have seen a huge rise in the number of STOs. In fact, if 2017 was the year of ICOs, then 2019 may be one of the STOs. Before holding an STO, though, you need to go through all the legal hoops needed to properly register your tokens as securities. As such, security tokens are fully regulated and operate completely within the legal framework of your jurisdiction. While this adds regulatory safety to both your company and your investors, complying with regulations naturally comes with several drawbacks.

The most prominent disadvantage of the STO is that it panders mainly to the financial elite.

Blockchain technology was always meant to be a financially liberating endeavour that redistributes power from the centralized elite to the general public.

The regulations you have to comply with for launching an STO often put severe limits on the ways you can offer your tokens (e.g. restricting you to accredited investors), which runs sideways respect the anarco-capitalist power of the cryptoeconomy.

Furthermore, the simple fact that you collect funds through an STO doesn’t imply that you are actually into the blockchain space. Rather than providing utility to their holders, security tokens are, well, securities that represent a tangible asset, such as bonds or equity shares. STOs can be seen as tokenized versions of traditional IPOs that merely utilize the disruptive power of blockchain technology, but don’t really add up to the process of decentralization.

Although it is cheaper and easier to launch an STO, compared to an IPO, the upfront costs can still easily reach a six-figure sum. Nevertheless, we can expect that these costs to go down in the near future, as consulting firms supporting with legal setup, PR, and marketing have already emerged and begun competing for customers. As a result, STO consulting packages are going to become cheaper and more comprehensive over the next years.

Moreover, regulators are becoming increasingly aware of the rise of the blockchain as an important piece of technological development. Hopefully, the more crypto-friendly countries will loosen up on their regulations, in order to allow this development to happen. Again, this will result in cheaper and easier procedures.

One final thing to keep in mind is that investors who buy security tokens, unlike utility tokens, do so in expectation of profits. Your company, therefore, needs to be a for-profit business and, if it is not already profitable, you must be able to return profits in the foreseeable future. Not only this influences the direction the company is going to take in its development, but it may somehow conflict with crypto-specific forms of association such as Decentralized Autonomous Organization (DAO) and the kind.

Companies that run STOs to fund themselves should not be regarded as decentralized blockchain businesses. However, Security Token Offerings are an option for SMEs that want to go public and are deterred by the large costs of a traditional IPO.

Simple Agreement for Future Tokens (SAFT)

In the US, a specialized framework has been developed, as a result of the SEC’s ruthless crackdown on ICOs. SAFTs are investment contracts (and therefore classified as securities), which grant the holder utility tokens, which are to be issued at a later date.

You can think of SAFTs as a replacement for token pre-sales, in which prefunctional tokens are sold through an ICO. Since these pre-sales will almost certainly fail the Howey test and are thus to be seen as securities, the SAFT instead tries to be compliant with US securities law, while keeping legal costs low. Again, this limits the options for issuing SAFTs, such as restricting your choice to accredited investors.

This approach, however, does not provide you with a lot of regulatory certainties. The problem remains that your tokens, at the moment you issue them, must be considered as utility tokens. One notable legal case is the class action lawsuit against Unikrn. Besides claiming that the tokens had no utility at the time of issuance, the plaintiff argues that Unikrn had already admitted to issuing securities by filing SAFTs. Ironically, the properties that increase the regulatory certainty are now being used against Unikrn.

I personally doubt that this troll-kind of reasoning would stand a chance in front of a court. Still, it is still an open question whether the SEC and their nebulous rules regarding securities will tolerate that a publicly offered token can, at some point, switch from a security to a utility token. Therefore, when issuing SAFTs, always remember that you are still operating in a legal grey area.

SAFTs can be seen as somewhat of a middle ground between utility token sales and STOs, possibly combining the best of both worlds. For US-based enterprises, this opens up the possibility to have a pre-sale to secure the initial funding of a crypto-network, while a utility token sale can still be held at a later date. For non-US projects, a SAFT means that there is a legally compliant way to gain US investors. In both cases, it is questionable, however, whether this regulatory uncertainty makes the approach worthwhile.

Tobias W. Kaiser is a Research Associate at a-Qube. He is specialized in Tokenomics, decentralized business models, and Game Theory.