Security Token Offerings (STOs) — All You Need to Know

Wondering how to best go about raising funds for your blockchain project? Here’s an overview of STOs and how they differ from ICOs.

It seems like everyone is talking about Security Token Offerings (STOs). From YouTubers, investors, and gurus to reputable news outlets, there is a massive amount of exposure regarding these offerings around the industry.

Whether you are a newcomer to the world of blockchain technology, and cryptocurrency or even a seasoned veteran, the numerous acronyms can be confusing. The fact that blockchain technology itself is in its infancy means that many more, new terms and different products will enter the market.

With this in mind, the GuerrillaBuzz team wrote this guide to help blockchain enthusiasts and investors like you understand the pros and cons of STOs.

What is an STO?

Securities

To understand what a security token offering (STO) is, first, we must look at what a security is.

In terms of finance, a security is a certification or some other financial instrument, that has an intrinsic monetary value. These securities can then either be traded by exchanges, who will broker the transaction or, they can be traded directly from peer-to-peer. These securities are then broken down into two subcategories, equity, and debt securities. This is in effect, owning part of a company, without actually taking it into your possession.

Companies use these methods so that they can raise capital from investors, to fund other parts of the business, such as expansion plans. In return for their investment, the financiers are typically able to make their money back and make a profit through means such as dividends, interest rates, or a share in the company profits.

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Security Tokens

Security tokens are, in essence, cryptographic tokens that can pay the owner dividends, entitle them to a share of profits, pay them interest, or, they can be used to reinvest into other security tokens.

There is a prerequisite to qualify a crypto token as a security token. As a requirement, the token must pass the Howey Test, which was set out in the case of SEC vs. Howey (1946) in the United States.

If the token aligns with the following rules, it will be considered a security token:

1. It involves an investment of money.
2. The investment is in a joint enterprise, where there is more than one investor.
3. There is an expectation of turning a profit from the works of either a third party or the promoter of the token.

Security tokens generally garner their market value from an outside asset that is tradable. Because these class as securities, regulations apply to them and a breach in rules will leave the offeror exposed to potential liability.

If marketed effectively, with a platform that can help advertise your business through an STO, it can be a potent tool in raising capital. It is also widely believed that STOs will eventually outgrow traditional ICOs since they offer more security for investors, due to the regulations in place.

Selling a security token is comparable to an ICO in the sense that coins are issued to the investors. However, while an ICO investor would seek to gain value through the unlocking of a platform, or the appreciation in value of the coin, an STO investor would seek to achieve cash flow in future, potential dividends or any right to vote that comes with the security.

Security tokens, as previously mentioned are backed by outside assets that give them an intrinsic monetary value as soon as they are issued. This is in contrast to the use of a regular utility token, where the actual value is based on speculation until a platform is developed and marketed for it.

The model of using a security token makes the process of raising capital for your project, look less like a Kickstarter page and more like a professional stock that is for sale.

You can also create dedicated black and whitelists with an STO that assists with anti-money laundering and know-your-customer regulatory requirements. Through operating in the manner, an STO can cut out a lot of the stigma that has currently been generated by the usual “Wild West” approach to crowdfunding. An example of some of these is a lack of corporate responsibility, the potential for fraud and having no way of getting anything back if the company fails.

These positives surrounding STOs seem likely to generate a massive increase, in the amount of capital invested in the blockchain industry.

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Tokens that Confer Rights and Rewards

Finally, there are numerous different types of token, that confer different rights and rewards to the purchaser. Let’s explore these for a moment.

• Rights: By acquiring a particular token, the holder will then be granted certain rights within the platform of that token. For example, by owning DAO Coins, you could have obtained voting rights within DAO. This would have allowed you to have a say in which projects receive funding and which do not.
• Value Exchange: Tokens, in effect, create value and monetary system within its own platform. These tokens allow buyers and sellers to trade with a real value within the confines of the platform. This can help to govern rewards when specific tasks have been completed. The ability to create and maintain value within the system is a key role of tokens.
• Fees: Tokens can act as a method of entry, to be allowed to use particular functionalities within the system itself.
• Function: A token doing this can allow an owner to enhance the experience of people who use that particular system. An example of this would be allowing a token holder to host advertisements within the system.
• Currency: Tokens can be used as a form of currency for exchanges both inside and outside of the platform, dependent on their value at the time.
• Earnings: A token with this characteristic would assist in the fair division of any profits or any other financial benefits that may apply to investors and token holders.

The more of these functions that a token fulfills, the higher the potential value of the token itself. Now that we know a lot about security tokens, we can explore why and when your business should consider an STO.

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When should you consider an STO?

There may be a point when you are considering marketing your company through an STO. You might be thinking about it right now. There are some key points to consider so that you can make sure you get good value for your STO.

You should only consider using an STO if you are looking to generate a lot of capital and your company aligns with the following descriptions.

1. Annual revenues exceeding $10 million. To run a successful funding round by using an STO, your business needs to generate the best valuation possible. The higher the turnover and profits of your business, the higher your company valuation will be. This will increase the amount of capital you can get for the percentages of your business.
2. A global business: To maximize the potential of your STO, you must be able to market to a worldwide audience, rather than being limited to being regional. This will help you to raise a lot more capital, a lot quicker.
3. Interested in a funding method that connects with your customer base. If you wish to issue an asset that is readily transferable, then it would be wise to consider using an STO, as these can be transferred relatively easily.
4. Experiencing high growth. This will help maximize the positive effects of carrying out an STO.
5. Having a tolerance for risk. The regulatory position surrounding STOs can change in different places, at any time. This could potentially place your source of investment at risk. Especially, if countries with more spending power tighten their regulations. This carries the risk of massive losses. The likelihood of this happening to seems to be slight. Nevertheless, you should proceed with caution.
6. Desiring greater liquidity in your stakeholders’ assets. As opposed to ICOs, which do not offer that much in this sense, STOs are an incredibly liquid investment.

If your company fits in with the majority of these descriptions, then your company would be likely to gain capital and support from your fundraising efforts.

However, if your company falls short of these points, it may be worth not jumping in at the deep end. A failed attempt at launching using an STO could have dire financial implications for your business. Especially, if the amount of capital raised is lower than the amount of money used to set up the offering.

If you are still set on using an STO, then it would be worth waiting until your business is at a point where it aligns with these descriptions more closely. It will also give you more time to plan your offering.

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What is the Difference Between an STO an ICO?

While STOs and Initial Coin Offerings (ICOs) are similar, in the sense that they are both used by companies to generate capital for their projects, in most other aspects, they are significantly different.

1. Perceived Safety: Security tokens are considered securities, whereas ICOs aren’t. Therefore people who invest using an STO are protected by securities legislation. This helps to prevent fraud or to provide the investor with a type of recourse if the company they have invested in goes bankrupt. Because of this, STOs are generally considered as a potentially safer purchase.
2. Backing: STOs, as securities, are backed by assets with monetary value. ICOs, on the other hand, do not have their value fixed by any tangible assets and therefore do not have an intrinsic monetary value.
3. Value Generation: ICOs generate their value through the technology of their platforms and the appreciation of their coins. STOs create their value through the operations and the climate of the business itself. For an STO to be valuable, your company would need to be run efficiently like a publicly traded company. An ICO would not devalue your coins as severely due in the event of adverse events hitting your company.
4. Legal Costs: STOs are securities and therefore bound by securities regulations internationally. Their legal situation more apparent than for an ICO. You would engage legal experts to help steer your business in the right direction when launching an STO. For an ICO, the hours of work that your lawyer would have to put in, is a lot higher for an STO, due to their regulated nature. This would involve increased costs for your business.
5. Limitations: Due to the regulations surrounding securities, security tokens would be slightly more limited, in regard to the breadth of their target market. Due to the unregulated nature of ICOs, there is no restriction on who can invest. Someone with $10 could invest in an ICO from anywhere in the world. STOs have to comply with anti-money laundering (AML) and know-your-client (KYC) regulations. These regulations place barriers in the way of certain investors, depending on the securities legislation in their country. On the flip side, this can be seen as a good thing, since it means that, generally, STO investors would be more reputable.

In essence, STOs are more similar to floating on the stock market, than they are to ICOs.

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STOs vs. Traditional Public Offerings

STOs make it easier for smaller businesses with less spending power to market themselves and attract public investment.

1. Speed: It is much easier for a business to market themselves to the public using an STO, as opposed to going public through the more conventional means of floating on a stock market or Alternative Investment Market. The latter can be very complex and take a considerable amount of time to finalize. STOs, generally, are of interest to global investors seeking to create a good return with a higher level of liquidity in comparison to traditional stocks. This helps to raise large sums of money very quickly and can effectively market your business to many different parts of the world.
2. Cost Efficiency: An STO can be used to place a value on an asset so that it can then be quickly traded on an online platform. This helps younger, smaller business to rapidly gain substantial amounts of capital, without the high costs eating away at the profits from the offering. Traditional public offerings entail much higher costs and do to the many specialized professionals involved with each step of the process.
3. Flexibility: When a company wants to list publicly, there are rigorous compliance checks. Some businesses become trapped in a pattern of overly focusing on quarterly numbers and following the recommendations of analysts with disregard for the long-term. Without this pressure, you may find your long-term vision to be clearer, and you can make changes to your business more freely.
4. Global Appeal: STOs are a great way to attract investors from around the globe. The standards required of an STO are fairly regular across different regions. Security tokens also tend to be a more liquid investment, in comparison to private company shares which can be cumbersome and expensive to trade.
5. Fractional Ownership: STOs are also good, in the sense that they can allow you to divide any of your underlying assets into smaller assets. This acts as a facilitator for fractional ownership. Fractional ownership can help to make your offering more affordable to investors. It can also make your tokens easier to transfer on a secondary market.
6. Innovation: Matters of compliance with STOs are a little more complicated than they would be with ICOs. However, compliance can be designed into an STO using new standards that have been introduced by certain blockchains such as Ethereum. An example of this is a measure can be inserted when making the STO whereby only trusted investors can buy or sell them.
7. Accessibility: As the legal situation surrounding blockchain technology becomes less of a mystery and the facilities to create tokens become more accessible, the costs of running an STO will decrease. This will make it viable for businesses that are even smaller and will help to foster in the rapid development surrounding blockchain through this new wave of investment.

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The Negatives of STOs

Like anything, there are some negatives to using STOs. The following are some key issues to consider when you are thinking about using an STO.

1. A New Vehicle: Securities in the traditional sense have brokerages and various other outlets, all over the world which can trade for you, or create securities for you. With an STO, you have to create your own security tokens to trade, in addition to building your own platform for them to be traded on. If this isn’t managed correctly, you could end up losing a lot of money or violate securities regulations.
2. Complexity: Creating one of these platforms can be incredibly complex, which means you may have to bring in an external expert to create and manage it for you. This will incur a cost. However, the decreased risk of financial or regulatory complications is definitely worth both the start-up and maintenance costs.
3. Changing Environment: STOs are very new, with the first only being completed in the last couple of years. Regulators could move in a different direction at any point. If new regulations were brought in, the liquidity of your token and the stability of your STO might be put at risk.

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Examples of STOs

Below are two examples of STOs. A lot can be learned from these early offerings.

LXDX

According to ccn.com, former SpaceX engineer, Joshua Greenwald’s crypto exchange, LXDX will be among one of the first companies to issue their stock using an STO.

LXDX’s security tokens will give the purchaser direct ownership within the exchange. Reportedly, five-million tokens are going to be issued by LXDX, that would provide the owners the right to a collective 10% of their quarterly adjusted gross revenue. These tokens were issued at one Euro per token, which brought LXDX to a $57 Million valuation for this financing round. The current COO and co-founder, Will Roman has commented that this would be the only round of funding used through STO for the foreseeable future.

This STO is being marketed to the public in Malta, which has a more lenient stance surrounding cryptocurrency and blockchain technology. Although, investors will still have to abide by their own local securities legislation.

LXDX are keen to cast off the stigma surrounding the blockchain industry, where some estimates have claimed that in 2017, over 70% of ICOs were scams. They are claiming to do this by operating with a policy of radical transparency to avoid any potential for dubious practices being carried out.

Furthermore, LXDX have announced that they will not enact the practice of automatic liquidation. Automatic liquidation is the process in which a company will take back profits from successful traders to help the platform with paying for losses that they cannot pay off themselves.

What we can learn from this early STO is that, by offering shares through an STO, you can display to investors that you are committed to looking after their investment. The heavily regulated securities market, combined with LXDX’s claim that they will not be carrying out automatic liquidation, shows the market that they are different. This demonstrates that a blockchain platform seeking to gain capital can be a legitimate enterprise.

Furthermore, it has displayed that businesses do believe that STOs are a viable and effective way of gaining capital to finance their projects. This is evidenced by the fact that LXDX, with a $57 million valuation, has managed to market 5 million tokens, at one euro each. This means they are offering out 5 million Euros in tokens. That is no small achievement.

Polymath

Another excellent example of a platform facilitating STOs would be Polymath Network. Polymath uses a system that brings securities to their blockchain platform. As previously discussed, Polymath will create tokens, that are backed by real assets with monetary value.

They have also claimed that their system, has a safeguard, meaning that only accredited investors that pass local legislative requirements may invest.

Having received thousands of applications, they decided to initially go for just five blockchain projects: 7Pass (cannabis industry finance), BlockEstate (real estate), Corl (corporate fundraising), IPwe (patent platform), and MintHealth (health).

Polymath has also been working to try and help set a standard for this space, hiring external experts. These standards will be made accessible to other people within the STO space, such as investors and issuers.

What we can learn from this project, is that many companies are wanting to market themselves to the public by using an STO. This is evidenced by the thousands and thousands of initial applications that Polymath received for their launch.

Furthermore, the lengths that Polymath are going to, to ensure that STOs are accessible and have clear standards of best practice, help to increase the speed in which STOs can grow. When clear standards of best practice are defined, and more people have access to STOs, a multitude of new wave investors will appear. Investors will have more confidence in the fact that their investment will be going to a legitimate business and the financial barriers to investing in STOs will decrease due to the simplification of their legal status over time.

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How Will STOs help the Blockchain Ecosystem Grow?

There is a firm belief that STOs will play a pivotal role in helping the blockchain ecosystem to continue its rapid growth into a behemoth of an industry.

Security tokens are backed by real assets and thus provide assurance to investors and would be regulated by their respective countries. This should lead to a safer blockchain market.

If the blockchain market shifted towards STOs, even cautious investors who are dubious about the legitimacy of some blockchain projects would be a lot more likely to take the risk, knowing that if anything goes wrong, the law is on their side.

The number of people investing in blockchain projects would then increase dramatically. This increased investment into the sector would allow for rapid expansion and the faster development of new blockchain technologies. Eventually, the legitimacy of security regulations could serve to bring blockchain technology into the mainstream.

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Conclusion

An STO is a secure way for projects to raise funds and investors to participate. The added security will bring credibility to blockchain companies at a time where the industry is mired in controversy and there is a belief that there are more sharks than serious players.

Due to the infancy of STOs, it is definitely worth referring to experts for both the marketing and compliance aspects until the relevant regulations become clearer.

If you have any questions, please send us a private message, and a member of our dedicated team will be on hand to help you with your query.

Originally published at GuerrillaBuzz.com on November 9, 2018.