A Guide to Launching a Security Token Offering

In the future, a majority of stocks, bonds, commodities and other financial assets will be tokenized. New issuance platforms, security token protocols, and alternative trading systems (ATS’s) are beginning to emerge on a regular basis. With companies like Stellar, Tezos, and other blockchain networks beginning to compete with Ethereum for the larger security token market, it’s becoming increasingly more difficult for companies to stay up to date on best practices. Many of our clients come to us with questions surrounding security tokens so we decided to write this guide to help answer them.

For the most part, running a security token offering (STO) can be quite costly. However, it is still on par with how much it would cost to launch a compliant ICO in 2017 (assuming they incurred legal, development, marketing, broker/dealer and exchange listing fees). From a high level, costs associated with launching an STO can be conservatively laid out as:

1. Legal — $50k-$350k
2. Token Architecture & Issuance — $10k-$50k
3. Marketing — $10k-$50k
4. Broker Dealer Engagement — 1%-8% + possible cash up front
5. Transfer Agent — $10k + $5k/month
6. ATS (Exchange listings) — Variable ($100-$250k recommended)

With this in mind, if your company is seriously considering an STO, we recommend a minimum budget of $100k to cover upfront costs supplemented by a sizeable allocation on the back-end of the raise.

Step 1: Find a securities lawyer & management consulting firm

The first and most important step in beginning an STO is finding the right securities lawyer. With the infancy of security tokens and their intersection with crypto assets, an experienced lawyer is invaluable. Seeing as the majority of security offerings target US investors, a veteran lawyer can be the crucial difference between a successful raise and a subpoena from the SEC — ultimately killing your business dead in its tracks.

Your lawyer will be responsible for regulatory filings (Reg D, Reg A+, Reg S or CF), collateral compliance and the proper disclosure of offering terms including but not limited to participation rights and warrants. Generally speaking, the filings and retainer will be the most expensive upfront costs for a security token offering.

It’s important to note that although it’s not required, we strongly suggest bringing in a blockchain consulting firm (visit our website to get started) in tandem with a securities lawyer to offer general advisory and coordination throughout the entirety of the security token process. In general, this team will have the proper resources to facilitate the offering by identifying and connecting you with the necessary execution partners (issuance platforms, ATS, etc.) In addition, these firms can be contracted to build out the proper investor collateral and ensure that the security token and the subsequent offering(s) are both enticing and properly structured.

Step 2: Identify blockchain network of choice

Once the collateral has been built out and the high level structure of the security token is in place, you’ll want to identify which blockchain network would best fit your company and the security token’s needs. As of now, it is most common for security tokens to deploy on Ethereum as it provides the highest network security for a smart contracting platform. However, over the past year we’ve seen the emergence of other smart contracting platforms which may siphon some of the security token market away from Ethereum.

In recent developments, Elevated Returns announced they will be transitioning AspenCoin, the tokenized equity in the St. Regis Aspen Resort, to the Tezos blockchain. In addition, we’re seeing an increasing amount of interest into other networks such as Stellar and permissioned networks such as Corda. In March of 2019, the urban mobility software company, VMC, announced they will be launching the first security token offering on Stellar. The company is using a dual token structure with the security token giving tokenholders the right to 40% of revenue share from corporate users paying transaction fees.

One of the main reasons for launching a security token outside of Ethereum is that the other platforms may offer higher compatibility, lower transaction cost (important for dividend distributions) or a grant/investment from the network’s foundation. The biggest drawback for launching on Ethereum is that smart contracts have a contract size limit of 24kb through the introduction of EIP #170. Embedding all the proper regulations and functionality into one smart contract is difficult and still being tested behind closed doors. Therefore, current security token smart contracts on Ethereum are fragmented into modules which may increase the execution costs and potential attack vectors.

Step 3: Engage Issuance Platform / Token Factory

Depending on the blockchain which best fits your tokens needs, the next step is to identify the best issuance platform or token factory to develop your security token while the legal team is reviewing the collateral and putting together the proper filings. The most well-known token factories within the security token space are Polymath, Securitize, and Harbor.

With that being said, there’s an increasing amount of emerging platforms and token factories with new approaches for launching security tokens. For example, Okto is a low-code interoperable platform built to work with any blockchain and any security token protocol. The company offers open-sourced modules which allow for endless customization and adaptation for security tokens. This allows issuers to deploy a security token on any blockchain they decided in the previous steps while mitigating any risks of vendor lock-in.

Generally speaking, the blockchain industry is still quite young. Ethereum may not be the best blockchain or Harbor may not be the best token factory in the next few years — the last thing you want is to have your company’s equity stuck on a dying network or an obsolete token standard. If you’re unfamiliar with interoperability and the potential applications and benefits for it in the future, feel free to refer to one of our earlier articles.

Step 4: Broker Dealer, Transfer Agent, and Money Services

In order to successfully raise capital through a security token, your company will need the help from a variety of specialized agencies including broker/dealers, transfer agents, and money services. Generally, we’ve found that this aspect of the security token process is relatively unknown and many of our clients are unaware about this portion of the process. As a result, the high level roles of each respective agency are as follows:

Broker Dealers: B/Ds will be in charge of finding the right investors for your company’s offering. They will market the deal to their network of investors which align with your company’s initiatives, industry, and fundraising goals. Hiring the right B/D will make or break a successful offering, so ensuring that they are the right fit for your offering is a must.

Transfer Agents: If you are raising under a Regulation A, a transfer agent is necessary in order to be fully compliant according to SEC regulations. The transfer agent will oversee the issuance of the tokens and ensure all legal requirements are met. Transfer agents maintain records to track the issuance, transfer and ownership of issued securities. The most important role of the transfer agent is to establish a system for handling claims regarding the theft or loss of tokens. These claims can generally be addressed and appropriately reported to the SEC. An experienced transfer agent will save you and your company a lot of unnecessary stress. If your goal is to issue a fully compliant security token, a transfer agent is strongly recommended.

Money Services: Money services are essential to receiving capital. These agencies are directly responsible for payment processing and keeping a ledger of payment history and how much of an asset they’re entitled to. Transmitters often work closely with preferred KYC and AML providers to process accreditation checks. Money services process all ACH, wire, check processing and act as a fundamental bridge between receiving cryptocurrencies from the sale of security tokens and converting the capital into fiat and to a traditional bank account.

Step 5: Open Token Offering

Once your legal team has completed the necessary filings, the security token has been developed and you have hired a broker/dealer to find the proper investors, it’s time to start fundraising.

Generally speaking, most STO’s are catering to a sophisticated audience in which check sizes will range from anywhere between $50k-$1M per investor. As with traditional private markets, we cannot overemphasize the importance of a strong lead investor. While most companies are eager to start accepting capital, it’s important to note that your lead investor will likely be a strong signal to the quality and strength of your offering. While some early investors may be eager to fill a large piece of your round, vetting your investors is equally as important as them vetting you.

Similarly, it’s generally accepted for STO’s to utilize the full landscape of emerging blockchain broker dealers to reach as many investors as possible. Whether it be outreach to syndicates such as Crowdfunder or SeriesOne or on-boarding smaller broker dealers that cater to private audiences, exposure is key. One of the biggest benefits to hosting a Reg D offering is the ability to utilize as many BD’s as you’d like. This theoretically makes your offering more accessible, but as many BD’s will attest to, actual investment turnaround time will generally take anywhere from 3–6 months for a check to close. If raising capital through a security token is more urgent, we recommend looking into Reg CF for the ability to raise up to $1.07M through a syndicate such as Republic or WeFunder.

Step 6: Market STO

While on-boarding multiple BD’s and listing the offering on a few syndicates might be a great start, marketing will often play a vital role in ensuring that your offering reaches all corners of the globe. The investor collateral your team has prepared from Step 1 is perfect for when someone is interested, but it’s likely not going to bring any new participants to the table outside of your BD’s existing network.

Drawing from some of the tactics from traditional ICO’s, we strongly recommend that your team put together a list of short articles explaining your STO and why you chose to pursue the tokenization of your asset(s). Similarly, it’s important for your core audience and end user’s to be aware of the fact that they will likely be able to purchase equity in your company in the not so distant future. A number of STO tracking sites have started to pop up and are a quick and easy way for you to let the industry at large know about your offering.

In our opinion, the biggest advent of security tokens is the ability for retail investors (who have passed KYC) to purchase equity from private companies following a mandatory one-year vesting period. As such, the more transparency and awareness your audience has about your project from the very start, the more well suited your token will be when listing on secondary exchanges.

Step 7: Exchange listing strategy

Liquidity is key. While it’s a bit preemptive to discuss the proper exchange listing strategy for your security token, we’ve been keeping a close eye on a number of existing security token exchanges who have stated that they will be launching secondary markets in the future.

Seeing as security tokens utilizing a Reg D filing (which the large majority of STO’s are currently using) are restricted to whitelisted accredited investors for the first year post-offering, we expect security token market interest to really start picking up in 2020. With this being said, the 90-day mandatory vest provides accredited investors with an interesting opportunity for first mover advantage.

We highly recommend beginning discussions with security token exchanges as your offering is preparing to close. While investors likely won’t be looking for the same turnaround time that people came to expect from ICO’s, tangible liquidity goes a long way in instilling investor confidence.

Conclusion

While we recognize that not every STO will follow the same procedure we’ve described in this article, we hope this will give interested entrepreneurs a better understanding of what happens behind the curtains.

From a blockchain-startup perspective, recognizing that STO’s have a bit more yellow-tape and slightly higher up-front costs compared to an ICO is a very important consideration to keep in mind. At this current stage in the game, the SEC is intentionally being very cautious about approving any Reg A token offerings. While Reg D’s do not need to be explicitly approved by the SEC, we strongly advise STOs to take legal precautions when preparing their filings and beginning to take in capital.

At Fitzner Blockchain, education is key. The blockchain industry at large will benefit tremendously from the gradual adoption of tokenized securities and we want to do everything in our power to help inform people of this movement in the most intuitive way(s) possible. If you or your company are interested in creating a security token, please don’t hesitate to reach out. We’re happy to walk you through the process and connect you with some of our amazing partners who have helped facilitate this process as stress-free as possible.

Writers: Lucas Campbell — https://twitter.com/0x_Lucas
Cooper Turley — https://twitter.com/Cooopahtroopa