A Comprehensive Guide to Security Token Offerings

Until mid-2018, the initial coin offering (ICO) was the default method of crowdfunding a new venture for blockchain startups. However, due to a convergence of factors, the ICO boom died down. Now, the security token offering (STO) has emerged as the next evolution in token-based crowdfunding. This article will explain the mechanics of an STO, how it differs from an ICO, and cover some of the considerations for startup founders thinking of launching their own STO.

Defining a Security Token

To understand if any particular token offering is an STO, it’s necessary to define the type of token on offer. In doing so, it’s useful to look back at how the definition of security tokens came about in the first instance.

Back at the start of 2018, investors were pouring money into the ICO market. In the first quarter of 2018, ICOs raised over $6.3 billion worth of capital. However, the bubble soon burst. The critical challenge was around whether or not a particular token offering constituted an offering of securities.

For example, in the United States, the Securities and Exchange Commission (SEC) uses a test, known as the Howey Test, to determine whether or not a transaction meets the criteria of being an investment contract. The Howey test asks whether “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

In an ICO, most investors were putting their money into projects with an expectation that their investment would appreciate over time. This expectation was, in part, what led to the ICO boom in the first place. Furthermore, founders were actively encouraging their token buyers into the view that they would hold a stake in the project, even if those same founders held the conflicting view that the project they’d created was their own.

The US SEC has been slow to implement any formal legislation around token offerings, although it has made several pronouncements on the topic. The most notable of which came from SEC Chief Jay Clayton, who declared that “every ICO I’ve seen is a security.” Other regulators, such as the Swiss FINMA, have issued guidelines which classify tokens according to existing securities legislation.

The STO vs. the ICO

In response to this, many founders protested that their projects weren’t offering securities, they were offering utility tokens — a digital token which grants access to a particular digital ecosystem. However, the critical question generally isn’t the intent of the founder, it’s the expectation of the investor.

With the regulatory shadow hanging over the market, both investors and founders started to retreat from the ICO. But securities legislation didn’t seek to prevent token offerings from happening at all. It only required that a token offering remain compliant with existing securities legislation applicable in the location that the token is seeking investors.

Thus, the STO was born. The STO is simply an ICO that’s compliant with securities legislation wherever the token is being sold to investors. Furthermore, an STO provides investors with the same legal rights as if they were buying stock in the company.

Due to the compliance requirements, an STO creates additional legal obligations for token issuers compared to the ICO. For example, in the US, this may mean offering tokens for sale only to accredited investors. In most jurisdictions, it will mean seeking professional legal advice and filing the STO with the financial regulators.

However, the STO opens up exciting new possibilities, particularly for existing enterprises. A company could tokenize its equity instruments for a new means of raising capital for business development, such as smartmo AG, which uses CoreLedger’s Token Economy Operating System (TEOS) to raise capital and operate parking spaces across Switzerland. Or, it could tokenize an asset like a piece of real estate and sell it off to multiple investors. Virtually any financial instruments or physical assets can be tokenized, creating unprecedented new investment opportunities for people all over the world.

Considerations in Launching an STO

It’s worth noting that because the STO is still a relatively new concept, the infrastructure around security tokens is still in development in many cases. For example, regulated secondary markets are needed. Coinbase has obtained US regulatory approval for a security token exchange, and Swiss SIX is in the process of creating a national digital asset exchange.

However, the STO is here to stay, and companies are already starting to use it as a tool for funding their ventures. For anyone considering setting up their own STO, there are a few things to think about. Firstly, it should be determined whether or not an STO is the right avenue for fundraising. Investors will want a return, so the token issuer should be reasonably confident that this can be fulfilled.

Another decision is around the type of token to offer. An equity token will provide equity in the company, whereas an asset token will be backed by a real-world asset.

The regulatory requirements of the jurisdiction where the token will be offered is critical. In the US, an SEC filing will be necessary, and which type of filing depends whether the tokens are being sold to accredited or unaccredited investors. In the EU, a prospectus filing may be required depending on the number of investors and the sums in question. It’s sensible to take legal advice on these matters. Finally, there are several security token issuance platforms to choose from.

Once all these decisions are made, and the necessary paperwork is filed, the project can start work on bringing in investors. The STO may create more administrative work than its predecessor, but overall, it’s a far more sustainable and trustworthy way of raising capital.

This article is brought to you by CoreLedger.

As a prominent blockchain infrastructure provider, CoreLedger is making blockchain technology simple for businesses to use. With CoreLedger’s offerings, clients can readily tokenize their offerings with fast-to-implement resources that will allow them to modernize their services. Thanks to our in-house developed software solutions and experienced blockchain specialists, CoreLedger is ready to help you make your next move with blockchain technology.