The art of the public offering
Let’s start where it all began — the first initial public offering launched in the Netherlands.
Between 1594 and 1602, several Dutch companies where establishing trading routes with the Asian regions. However, the rivalry was fierce in the face of the Spanish, English and Portuguese fleets. Voyages in this time were highly competitive and risky. Many of the ships got robbed by rivals, pirates, and endured many other misfortunes. For their voyages to be successful, the companies had to count on bigger numbers.
Therefore, the Dutch government forced the 12 divided Dutch companies to incorporate together, and created the Dutch East India Company (VOC) in 1602. The newly-formed company had to circumvent the competition problem which was blocking the trade with the Spice Islands. They needed to raise capital to arm their ships and increase its fleet.
Hence, the VOC started offering bonds and shares of the company to the public. That is how the first modern public offering and first listed company on a stock exchange was formed. People could go in an open barn (the so-called Bourse) located at the center of Amsterdam and buy a paper certificate giving the buyer an ownership and potential profits from VOC. It was a direct acquisition of a share from the company, hence no intermediary fees where paid.
Moreover, a secondary market for the shares of the company was formed. Thanks to a clause imprinted on the first page of the subscription book, shareholders had the right to transfer their shares to a third party. Shareholders could use their paper certificates as a means of payment. For example, it was an easy process to acquire a horse or a house by using your certificates. Merchants went to the bourse, wrote down the name of the new shareholder with certain formalities and the share was transferred. It was a simple process, which allows secondary trading and acquisition of shares without any additional costs. Not only the share is freely transferable peer-to-peer, but also the share’s liquidity was tremendously high. This strategy proved to be extremely successful and made the VOC one of the leading and wealthiest companies for several decades.
Let’s talk about the modern way of launching an Initial Public Offering.
With time, the process of launching an IPO became harder and inaccessible to medium to larger companies. It involves a lot of set-back work, lawyers, exchanges, brokers, middleman, regulators, in order to accept their asset and list them on an exchange with a limited number of participants.
As a start, to put a firm on the public market, you must go through underwriters. It makes up the largest cost of the IPO process. Only the underwriters costs on average between 4% and 7% of the gross IPO proceeds. Thereafter, the legals, the accounting firm, rating agency, financial institutions and many other intermediaries roll in. In total it would cost quite a fortune if the company does actually realize the IPO.
Naturally, the price depends on the size of the company and the industry in which it operates. The larger offerings incur more costs. However, the spending does not end after going public. For the maintenance of a publicly-listed company, price ranges from 1 mil to 1.9 mil USD in annual fees just for being there.
The secondary market of trading shares like in the VOC times, is long gone. When people want to trade or sell their shares, they must go through intermediaries, hence fees will follow. There are several steps until you can actually open an account and acquire a share as well as sell it. Moreover, the shares cannot be traded P2P or bought directly from the company. This is all in expense to the liquidity of the shares and the customers cost.
Regardless of this downfall for the general public and the many costs incurred, many firms continue doing public offerings. The need for additional capital and expansion across the world is in the mind of every decision-maker in medium and large size businesses. However, as stated earlier the enormous costs incurred make many of the IPOs either impossible or meaningless.
Take for example this: A kid has a bag of chips which he wants to sell to his peers in exchange for money. He will need to give it to the teacher in order to evaluate his bag. In addition, he will give 5% of his bag to a person who is going to sell it on his behalf. Moreover, the kid selling on his behalf will give the best parts to his friend and exclude the information to the rest of the class. Later, it would cost him several % for managing the bag after it has been sold out. And the shortcomings do not stop here. If classmates who want to trade with each they will have to go through an intermediary. This will make acquiring a chips more expensive. Hence, the whole procedure is flawed with middlemen and people who want a piece of what rightfully belongs to the kids.
Anyway, going back to the real world — what is the problem with that? Companies benefit from going public, as it brings fresh money into their system. Therefore, new business opportunities open up, more connections are made and the expansion of the company as a whole will be inevitable. However, companies incur a lot of expenses during and after the IPO process and simultaneously the secondary market offers limited liquidity to the shareholders.
How did this change after the crypto boom?
In today’s modern world, just two-three years ago something which resembles the IPO process started. The ICO boom picked its pace as it offered lower entering barriers to small and medium sized companies. The underlying idea is that people invest in something which is still picking its pace. The so-called Initial Coin Offering was trying to make IPO less expensive, more modern with the help of DLT(distributed ledger tech) and with countless benefits for secondary market users. There are no bankers, lawyers or regulators involved in the processes. Merely putting your idea on a white paper with blockchain development you could ride on the hype and raise your money.
Let me use the chips example again. In this scenario an ICO is more of a promise of a product rather than an already established one. The kid will start advertising in the classroom that he is planning on buying a bag of chips. The more people gathered and supported the idea the greater the value over time the bag has. In this way, you really do exclude all those people which evaluate your chips, and advertise, and sell on your behalf. Also, the intermediaries for exchanging the chips between classmates are excluded, hence making the system flawless without added costs.
There is nothing which puts barriers on information and everyone gets the same treatment. The problem becomes that the kid may just promise to all participant he will buy the bag of chips, and at the end of the day just go home with all of the collected money. There is nothing stopping him from doing that.
The public started to undermine them because there was no person evaluating the product. That evaluation by the teacher or say it the regulator, just sticks as a necessity for the trustworthiness of the business. Without it, people investing in the product rely on the good will of the issuer.
The ICO’s boom lasted for less than two years. This method of raising money is slowly dying out, since the public has been stung by its downsides and have lost faith in it. Many companies with great ideas are starting their ICO’s just now. People are creating new project and produce brilliant ideas which will be a shame if they don’t get realized, but down to its nature ICO’s are not regulated and is purely promising something depending on many conditionals, without certainty for the end product.
ICO’s have had their piece of the market, however, they lack the rigidity of the IPO which regulatory oversight makes them safe(er) for investors to put their money in.
Where do private and public STO’s fit in?
Okay now let’s look at the new kid on the block — the public STO. How and why people think it is better than the IPO and ICO.
Starting from the basics. What is a public STO in the same example? The kid is offering his bag of chips, which is already in his possession. He advertises by himself, giving the same information to all classmates. His peers can buy it directly from him and they can exchange the chips with no intermediaries between each other, thus making everyone happy. This seems a lot like the ICO process, but what is on the debit side? In this scenario, the kid still needs to present his bag of chips to the teacher. Hence, the teacher gives the class a sign that this is a viable purchase and will punish the issuer for any mischief.
Let’s get back to the real world. What does this entail for an STO to become an offering in which everyone can participate?
As a start, a STO backs its offering with a real asset, equity, bond or derivative. Hence, this looks much more like the IPO I mentioned earlier. There is a real business or a product behind it. Since the tokens represents something similar to a traditional security, the regulators will also treat it the same. Once classified as a security, the token must abide the securities regulations. This brings a lot of regulatory challenges to the issuers. Since the middle person(financial institutions) has been removed in the issuance of the security, it will shifting a lot of the responsibilities to the seller.
However, in return for this hassle created for the issuer, the purchasers will have much more freedom. Purchasers get the benefits provided by the ICO: the transferability and mobility of their shares, with additional security and liquidity, no additional costs for intermediaries and exchanges and no friction in transaction, as well as that the information is equal to all. This gives access to the best parts of the offering. Institutional investors and the general public have the same standing in the primary market.
There also must be drawn a distinction between private and public STO’s. In the former, when stock/bonds are offered privately, the company again excludes the public. Subsequently, the secondary offering will have the problem that people are buying shares from an intermediary and not from the actual issuer, provided that there is public offering at the end.
Another barrier for private offerings is that in most jurisdiction trading of such shares is restricted to other institutional and professional investors. Even in some jurisdiction a necessity is to have holding period of the securities. This yet again will affect the price of the shares, its liquidity and influence from big players. In this scenario the larger investor can get the share at a preferential price, later selling the share at the rate they see fit. Hence, secondary market is again flawed by unfair market value of the share. Of course the private offering has its advantages, however they are strictly limited to the issuer, while the general public or say it the normal people get excluded.
Let’s get back to the public STO’s. They promote their securities to everyone on an equal footing. This bring to a certain extend the stability of their share since everyone will get the same information at the start. Hence delluting, and short selling will be unfavorable even to big companies which usually dictate prices. Yet again the regulatory burden introduced on public STO’s is great. Securities get treated differently across jurisdictions. And while one security may be admissible for trading in the EU, other countries such as the US do not grant it permission to be traded unless the necessary exemption are applied for. Hence, the public offering of security tokens is flawed by this restriction in market outreach.
In conclusion, I would argue that public STO’s do indeed mix up the best of both worlds. The rigidity of IPO regulations and evaluation, while also introducing the benefits which the DLT and ICO’s have paved the way to. There are still unresolved issues from a regulatory perspective on how to admit securities from one market to the other in a less burdensome way. However barriers of entry will stay for a quite some time until there is a common approach by bigger countries. Nevertheless, in my opinion this Frankenstein of traditional and modern world economies will stay for good as it provides the public with their opportunity to invest easily in companies which are already established.
Vasi — Legal Associate at Blueshare.io
Sources:
https://pure.uva.nl/ws/files/1427401/85966_05.pdf
https://www.pwc.ru/en/capital-markets/assets/roadmap-for-an-ipo-eng.pdf
https://www.pwc.com/us/en/deals/publications/assets/cost-of-an-ipo.pdf
https://assets.kpmg.com/content/dam/kpmg/pdf/2015/06/KPMG-A-Guide-to-Going-Public-Interactive.pdf
