Cost Benefits of Tokenization vs. Traditional Private Placement
Key discussion points:
· The following update is the third version (second update) of this article
· Tokenization has been much slower than expected by Issuers and service providers
· Entoro’s offering analysis shows savings may be 40% less expensive using tokenization versus a traditional method of raising capital
· The tangible and intangible benefits of digital securities versus traditional private placement
· How existing capital market participants are integrating with blockchain technology to support the new age of securities
At Entoro, the belief that the introduction of digital securities offerings (DSOs) or digital financial instruments (DFIs) into the financial services sector will not only stabilize and improve the investment landscape but will continue to radically disrupt Wall Street’s incumbent operating processes. Forward-thinking technology players are excited that software decentralization will be the disruption catalyst; however, that can only hold true if the intrinsic and extrinsic benefits outweigh the cost. Put simply, do DSOs save time and money? When the original article was compiled in July 2019 (pre-pandemic), there was no independent analytical review or assessment, so we decided to tackle it ourselves. Subsequently, the market has matured, and various authors have tackled part of the question, but given the lack of history and limited offerings it’s difficult to provide empirical evidence.
Based on our high-level analysis, the issuances of digital instruments may only rule the securities world and enable us to create faster and more cost-effective financial instruments. Many conditions and technologies (existing or developing) will determine a solid and verifiable review. The table below captures our attempt to summarize the relevant costs of tokenization compared to traditional methods of capital raising.
Like all financial compare and contrast studies, there is an intellectual debate of the assumptions. In comparing digital securities offerings and traditional private placement costs using a traditional paper process, there could be countless factors that significantly change the outcome of any simple analysis. Our analysis showcases that economic savings may be 40% less expensive using tokenization versus traditional methods of raising capital. At Entoro, we believe the number of structures, costs, and benefits are limitless. However, the purpose of this analysis is not to state a final answer, but to ignite debate.
All discussions regarding the purpose of tokenization and digital financial instruments ultimately benefit all stakeholders by being faster, better, cheaper, standardizing format, increasing compliance, and reducing friction for investors globally.
Barring that, we are still in the beginning stages of this decentralizing evolution, but great strides have been made in 2021 and the years prior with regards to the digital securities infrastructure, technology, and market participants being created to meet these conditions.
Below is a list of the tangible and intangible benefits of tokenization. The overarching theme is that tokenization will be beneficial in the long run but is still a process with additional costs at the start of an issues that needs to be amortized over the life of an instrument.
Tangible Benefits:
1. Legal — Are legal costs going to save you money on day one? No, but will it save the issuer and investors $3.3 million over five years on a $50.0 million private placement? Yes, and ultimately that’s what matters. Even if the answer is $1.0 million in savings, tokenization is worth it.
2. Blockchain Technology — The infrastructure necessary to seamlessly and compliantly conduct a DSO from issuance through secondary trading is here. Companies that integrate Know Your Customer (KYC), anti-money laundering (AML), and custody solutions directly into a digital security offering fuel market growth and adoption.
3. Automated Compliance — Money spent on regulatory compliance can be saved using smart contracts and the immutable recordkeeping that a blockchain offers. Lockup periods, investor count, and other rules and regulations can be embedded in or alongside digital securities, allowing them to follow, enforce, and adapt to various jurisdictions automatically. In the instances presented in the table above, this could save a company ~$200,000 over five years. However, this amount could rise as compliance management continues to become more costly. Note: This assumption presumes that recordkeeping, audit standards, and methods of reporting are stored on a blockchain with integrated automation software.
4. Time — The time senior executives spend in oversight and handling the administrative tasks related to their investors’ securities can be extremely costly. If 30 hours per month were cumulatively spent on this oversight, at an annual salary of $400,000, the cost adds up to $440,000 over a five-year period. However, if those same assets were issued, held, and transferred leveraging the efficiency of a blockchain, it could reduce the time they spend on: a) legal counsel, b) Investor communications, and c) compliance processes.
5. Administrative Costs — Administrative costs of shareholder conflicts and other miscellaneous issues can save the company ~$50,000 in time and legal fees; records stored on a blockchain are immutable. There can be conflicts if the data entered stored or transmitted using the blockchain is in error. Garbage-in/garbage-out still presents a risk; however, a blockchain should minimize that risk.
6. Up-to-date Shareholder Listings & Cap Table Management — Issuing securities via blockchain allows for accurate management of shareholder lists. Not only is ownership recorded in real-time, but all transaction records from investor onboarding, KYC/AML checks, and secondary trades can be time stamped with an immutable record stored on a blockchain for the public eye.
7. Distributions & Payments — Currently, for a traditional security, if a company needs to issue a dividend they go through transfer agents, who will typically mail a check to investors. However, this process is slow and inefficient. Using blockchain technology paired with a custodial solution enables a registered transfer agent to issue dividends to shareholders instantaneously with the click of a button.
Along with the tangible costs and benefits, there are numerous intangible benefits to motivate an issuer to want to digitize their offering.
Intangible Benefits:
8. Removing Friction — For traditional securities issuance, a major obstacle is the collective time, money, and energy put into a mostly manual and paper-based system. Issuing a digital security offering on a blockchain technology digitizes the entire process, removing friction and dramatically speeding up the process.
9. Liquidity — Investor liquidity increases with secondary market trading after one year as opposed to waiting for a multi-year exit, which is typical in a traditional private placement, depending on relevant laws. Also, on a regulated secondary marketplace, investors can trade globally, 24/7, with T+0 settlements through a more efficient and transparent process.
10. Fractionalization — Although real-world assets can already be fractionalized, the current method is inefficient. Security tokens allow for easier fractionalization of assets and the revenues they generate.
11. Transparency — With public blockchain technology, the investment process is as transparent as it comes. All transaction records from the onboarding process through the transfer of securities can be stored on the blockchain (if stored on an Ethereum public blockchain). These public records protect both the investor and issuer. For investors, they can be assured their data wasn’t tampered with at different stages of the offering. For issuers, shareholder management and immutable transaction reporting is available for internal checks or any regulatory oversight that may occur.
12. Security — Securities on a blockchain provide regulatory certainty, increased due diligence, legal review, quality documentation, and peace-of-mind that the offering has multiple levels and layers of review.
13. Brand Awareness — This is not a direct result of digital securities but all digital securities offerings to date have been conducted using Rule 506(c) of Regulation D, Regulation S, Regulation A+, and attempts have been made for Regulation CrowdFunding (“Reg. CF”) digital securities offerings to be qualified. These capital raising vehicles allow for companies to market their offering directly to investors online, which opens the door for both a company’s followers, fans, and a broader investor audience to participate.
Market Participants Starting to Adapt
Because of changes in guidance and understanding of the regulatory framework since the start of 2021, certain market participants are proving critical to conduct a truly compliant digital securities offering while reaping all the benefits mentioned above.
One key market participant originally thought to be replaced by a smart contract’s ability to program certain features is the transfer agent.
Transfer agents are required in most Regulation A+ offerings and while not explicitly required in a Regulation D offering, utilizing a transfer agent in a Reg D offering sets up an issuer’s digital securities for compliant and efficient secondary trading. After any relevant holding period, digital securities can be seamlessly moved from custody to “street-name” for secondary-trading on a US SEC-regulated ATS.
For example, two of the most well-known digital securities are the Lottery.com token and Aspen Digital Token. Lottery.com’s LDC security token entitles holders of such to royalty payments, much like shareholder dividends or interest, of the company’s raffle revenue recognized through the company enabling consumers to participate and play in state sanctioned lottery games from their mobile phones. On the other hand, the Aspen Digital Token is an asset-backed digital token distributed via a private Reg D offering representing fractional ownership in the St. Regis Aspen Resort in Aspen, CO. A true testament to the ability of digital tokens allows for fractionalization and ability for retail investors to own typically unavailable and illiquid assets.
Summary
In summary, we believe the hard costs of undertaking a digitized securities offering are currently lower than traditional ways. From our analysis, the cost difference over a five-year period may be 40% less, more than compelling to move to a digital format for private placement securities. As tokenization continues to be the driving force behind capital formation, we believe the cost and additional benefits will replace today’s current methods.
Blockchain technology has demonstrated its ability to greatly improve the ways in which we issue, trade and manage securities. The benefits will continue to become more prevalent as the market matures. This doesn’t mean that we have to, or should, completely absolve all former processes that exist in today’s capital markets. Instead, we can combine the two to create effective, efficient, and user-friendly solutions for the next generation of securities.
About Entoro
Entoro is a global investment bank and advisory group for traditional and digital securities. Entoro offers a range of comprehensive placement and capital raising solutions for businesses interested in reaching family offices for funding or accredited investors to analyze and review projects and opportunities. The team’s strength is in bringing highlight vetted projects to investors globally, with maximum efficiency, end-to-end security, and seamless execution, delivering total confidence in each investment.
Connect with us here and on Linkedin: https://www.linkedin.com/company/entoro/
