Security Tokens: Venture Capital 2.0

In his widely cited “Security Token Thesis” University of Oregon Finance professor Stephen McKeon defines Security Token Offerings (STOs) as “any blockchain-based representation of value that is subject to regulation under security laws.”

As with traditional securities, the tokens issued through STOs represent ownership in an underlying asset. The difference is that by being designed for the automated digital world, security tokens offer great potential to dramatically ease access to and liquidity of capital. In this article, we will focus on three points: comparing them with ICOs, outlining the structure and benefits of STOs as well as look at the current STO market.

I. STOs do not replace ICOs (but may compliment them)

While it may appear that STOs have arisen in response to the failures of ICOs, to suggest that STOs are a replacement for ICOs is misleading. A brief explanation of the difference between ICOs and STOs, therefore, is in order:

By claiming their offering is not a security because the tokens serve a function (utility) on the issuer’s platform, many founders in the ICO boom felt free to advertise their offerings directly to global retail investors. Whether or not this turns out to be legal, the fact is that a huge percentage of businesses looking for funding simply do not have a need for a utility token, and so are better served by the STO model.

Rather than having a utility function in a token-based economy, the main function of security tokens is instead streamlining and automating the issuance, monitoring, and reporting of tokens that typically represent equityin a company (but could also represent debt or reserve assets). STOs remain within the regulatory framework of securities, and so are — for the most part — only able to direct their offering to accredited investors.

STOs should not be seen as an alternative to ICOs per-se, but rather as an alternative to traditional fundraising methods. For those building decentralized projects with token-based economies, therefore, conducting an STO is likely not the answer. That being said, an emerging two-token modelmay eventually pave the way to combining the utility features and token-economics written about in ICO whitepapers with the decidedly legal funding mechanism that is the STO.

A venture could raise money with a security token that then pays dividendswhen a separate but linked utility token gains adoption in the venture’s expanding ecosystem. An early example of this is proposed by MintHealth, whose security token is said to entitle holders to a) a 10% royalty percentage of revenues generated through the sale of VIDA (the utility token) by MintHealth, and b) equity ownership in MintHealth.

II. Securities 2.0

Back to the real advantage of security tokens: as digital tokens issued on public and/or permissioned blockchains, security tokens come with all the benefits of programmable money. In the context of securities trading, this can translate to reduced costs, increased convenience, and additional features for the both issuers and buyers of tokens. The result should be the easing of capital allocation and the democratization of access to capital.

Accredited Investors and Secondary Trading

For any security, it is imperative that only those who are permitted by law be allowed to purchase, trade, or hold it. Programmable security tokens can facilitate compliance by “baking” it into the token. For example, security tokens can be built on a smart contract that permits them to only change hands with accredited investors and only under the specific conditions that are written into the smart contract.

This automation of compliance should dramatically reduce intermediary costs, making much smaller scale offerings available to a wider variety of investors and for a wider variety of businesses. It should even be possible, for example, to issue regulatory compliant security tokens for the funding of a local small business like a restaurant.

Liquidity

Private equity offerings are by far the most common source of funding for startups (at least 20 times bigger than public offering according to PWC). However, despite the huge size of the market, private equity assets (unlike publicly traded assets) are mostly illiquid, with private equity secondary markets virtually non-existent.

This means that innovators who have gone the venture capital route cannot, for the most part, access the value they have created through their company. Even for a founder whose company is valued at $20 million, the lack of liquidity often means they are stuck on a startup salary until exit. Shares of private companies, meanwhile, are not fairly valued due to the difficulty of trading them. The illiquidity discount, as it’s known, has been estimated at 20–30% by financial economists.

When the secondary trading ecosystem for security tokens is fully developed, it will finally be possible to efficiently trade private equity. When that happens, there should be a large release of previously locked up capital.

Founders Retain More Control

While traditional private funding is a perfectly acceptable way to raise the money needed to start or expand a venture, accepting venture capital typically comes at a cost. The investors, who are likely to have a conflicting long-term vision for the project, typically use their board seats and financial dominance to assert control. Venture Capitalists also tend to take a big chunk of the company, reducing the profit available for founders and limiting the potential upside for later investors.

With an STO, the issuer has the potential to retain full control of the venture. As an example, a venture conducting an STO could issue a thousand tokens representing 49% of the company (leaving the founders with 51% control). If more funds are needed, another thousand tokens could be issued but with stipulations such that, for example, no single token holder could possess more than 10% of the total issued tokens.

Accuracy Improvements and Cap Table Management

A well-known example of the accuracy problem in the existing financial infrastructure is illustrated by the case of Dole Food shares, and explained at length in this Bloomberg article.

To summarize: after a 2013 class-action lawsuit triggered by an unrelated matter resulted in a full audit, it was revealed that somehow shareholders owned 33 percent more Dole Food shares than Dole Food shares existed. Since such a complete audit is rare, it is now widely suspected that all major publicly traded companies have a wide discrepancy between number of actual issued shares and number of claims to issued shares.

As the rules of security tokens and the history of their trading are baked into the tokens and the smart contract that governs them, reporting can be done globally, automatically, and on-chain — resulting in a huge reduction in operating costs.

Other Features of Programmable Securities:

• 24/7 trading: When digital asset exchanges permit the trading of security tokens, it will of course be conducted around the clock.
• Reduced settlement time: The settlement of traded securities typically takes days and incurs significant intermediary cost. Automated security token trading and settlement can be facilitated almost instantly, at greatly reduced cost.
• Automated Dividends: The smart contracts that govern security tokens can be programmed to automatically pay out scheduled dividends to all verified token holders.
• Voting Rights: Security token smart contracts can enable some or all token holders to vote. For example, they can give rights to only preferred tokens, which can be transferred to only whitelisted individuals.
• Lockup Period Enforcement: Security law obviously varies by country but a common regulation is that buyers must hold the security for at least a year before selling. Programming such a feature is again trivial for security tokens.
• Automated Buybacks: Buybacks of outstanding shares could potentially be written in the smart contract such that when a certain level of revenue is generated, the buyback is triggered.

Security Tokens as Utility Tokens

Value can be added to a security token offering by integrating some features of utility tokens into security tokens. For example, if a vacation resort issued a security token to fund its construction, people who purchased a certain threshold of tokens could be entitled to a 10% discount on their stay at the resort.

A security token could also be designed to have utility that incentivizes growth in the company, providing value for the tokens above and beyond their appreciation with the underlying asset they represent. For example, a security token contract could enable long-term token holders only to be eligible for discounts above and beyond, as in the above example, the initial 10% off the stay at the resort.

III. The Current State of the STO Space

In the nascent security token space, there are currently only a handful of established players, but dozens of new entrants on the way.

Protocols and Issuing Platforms

Some of the leading issuing platforms for security tokens have created open-source protocols for the regulatory compliant issuance and management of security tokens. Examples include R-Token standard, which was created by issuing platform Harbor and has been adopted by other security token platforms, and the DS Protocol, which has similar capacity and was created by rival Securitize.

Existing Tokenized Securities

SPiCE Venture Capital is an early example of a tokenized VC fund. The offering entitles token holders to the full net revenues of future exits of companies in the fund’s portfolio. Another well-known example is Aspen Coin, which represents equity in the St. Regis Aspen Resort through a single-asset real estate investment trust, or REIT.

Secondary exchanges

Practically all of the big crypto exchanges have announced plans to offer the trading of security tokens, including Goldman backed Circle/Poloniex and Coinbase. Outside of the crypto-space, established traditional exchanges are also building security tokens trading platforms. In Europe, these include the Gibraltar Blockchain Exchange (GBX) and Switzerland’s principal stock trading exchange SIX Swiss Exchange. Finally, niche exchanges are emerging that will exclusively handle security tokens. These include TZero,Templum and OpenFinance Network, which claims to already have a “listing pipeline of 130+ security tokens with a total market cap of $6B+.”

STOs: A Bridge to Crypto Assets

Time will tell if the first wave of financial products introduced by the blockchain revolution will stand up to regulatory scrutiny. It’s entirely possible that ICOs will be wiped off the map as dozens of founders are jailed or fined by regulators. Meanwhile, security tokens, with their baked-in compliance, may well be the bridge that can at last bring regulatory legitimacy to crypto-assets.

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