ICO mania was at an all-time high at the tail-end of 2017 — we all know this. As a wary investor in the space, I had a front row seat to the mayhem and watched as most issuers threw caution to the wind with the expectation of raising a boatload of cash now and figuring everything else out later.
On the surface, this seemed opportunistic (make hay while the sun shines?). However, underneath, the process by which most of these companies were raising funds gave little attention to some really important foundational components such as proper corporate structuring, capital formation, and securities laws that carry grave consequences if not carefully thought through up-front. Compound this with the fact that a large portion of these new ICOs were being led by inexperienced operators and you have a recipe for disaster, a lot of which we’ve seen play out before our very eyes here in 2018.
My intent for this post isn’t to discuss ICOs or some of the scars the frothy 2017 market left on our industry (cough cough … greedy advisors praying on unsophisticated issuers) but rather the shift in market and investor sentiment that occurred as a byproduct of the 2018 bear market. Long gone are the days of spinning up a utility-coin ICO and selling out in an hour, at least in the western hemisphere. Investors, at least the ones that have capital remaining and are actually deploying that capital, are starting to demand much more.
From talking with over a hundred different investors in the space over the last few months, ranging from crypto hedge funds and VCs to family offices to angel investors, there is a recurring theme. They still have heartburn from 2017, most of them have been hit really hard by the bear market (forcing them to be much pickier with their new investments), and almost all of them are reworking their forward-looking investment thesis to focus on pre-existing businesses that embody the following characteristics:
1. Experienced operators / management team
2. Product market fit
3. Scalable business model
4. Actual blockchain utility
5. Proper structuring
6. Compliant offering (Reg D, Reg S)
7. Sensible fundraising plan and granular use of funds
8. Reputable legal counsel
9. Reputable co-investors
If you look at the list above, you’ll notice that it’s the same rubric that most traditional VCs and family offices follow. What do traditional VCs and family offices invest in? Equity. Why? Because it provides them with assurances around governance and ownership and allows for certain investor protections and rights.
How can these investors get access to equity in early stage blockchain-enabled companies and still feel like they’re participating in the “crypto” space? Security Token Offerings / STOs.
There’s quite a bit of content out there that describes what an STO is and how it differs from an ICO, so I won’t go into the nuts and bolts other than the fact that an STO is a fundraising mechanism that allows an issuer to sell tokenized equity in an asset or business. Tokenizing equity has some perks compared to the more traditional approach of selling paper stock certificates such as:
1. Deeper liquidity and wider access to capital for issuers
2. Lower issuance fees
3. Fractional ownership capabilities
4. Easier and more transparent cap table administration for the issuer (real-time ‘who, what where’ of compliance)
There’s one big problem though. Even though there is a growing trend among funds to invest in STOs, there’s only a small percentage that seem to really understand the actual components of a security token protocol and the considerations that need to be made in order for it to remain in compliance. Compound this issue with the fact that there aren’t any solid liquidity options available yet and you have a relatively muddy situation that has forced a lot of funds to sit out until there’s more clarity on everything as a whole.
It’s not surprising, honestly. There is a lot going on in the industry with regards to security tokens. However, I can assure you that things are moving quickly. Some of the brightest minds in the industry have been laying the pipes that will serve as the foundational framework for everything from issuance to compliance to trading. Companies like Securitize, Harbor and Polymath have all been hard at work over the last year building their own security token protocols which embed regulatory requirements into the tokens themselves so that they can be traded freely amongst investors across different exchanges. Alternatively, companies like tZero embed the regulatory requirements directly into the centralized exchange itself. As an issuer, this means you have choices for token liquidity while still ensuring compliance.
The way I see it, the smart funds are biting on STOs now with the expectation that exchange liquidity and security token protocol maturation will come. That may be 3 months from now or it may be 12 months from now. Regardless, the funds that have patience and understand the value in getting in before the impending boom aren’t having trouble opening up their wallets. It’s no longer a matter of if security tokens are coming, it’s when.