Make Tokens Great Again! A Guide to Security Tokens

Disclaimer: This article, and all information contained herein, reflects only the opinion of the author, is for informational purposes only, and does not constitute, in any way, legal, tax, or financial advice. Please seek a duly licensed legal, tax, and/or financial advisor for counsel.

Introduction

Over the past few years, we have seen a huge rise in companies and projects raising money through the blockchain. According to one count, initial coin offerings (ICOs) raised over $5 billion in 2017, and have already surpassed that number in the first quarter of 2018 alone. EOS, a blockchain competitor to Ethereum, has alone raised $3.3 billion, while Telegram has raised $1.7 billion. The overwhelming majority of these tokens, however, have been what are termed “utility tokens”: they have some specific use in a network, similar to a coupon to AWS, but do not confer rights to shares, profits, or dividends of the issuer. In that way, the interests of the issuer and investors are not fully aligned.

Security tokens, in contrast to utility tokens, are digital representations of securities, which can include equity, debt, real estate, warrants, or any other type of financial asset. Their purpose is to make digital and liquid any real world asset, similar to an Apple stock, that trades on the NASDAQ and represents rights to the profits and interest of the company. With the blockchain, it is relatively easy to tokenize any asset.

Being securities, these tokens must be compliant with relevant regulation, which in the U.S. generally means adhering to federal and state laws and SEC regulations. Most of these regulations speak to how securities must be issued and how they must be traded.

In this article, I will detail the pros and cons of security tokens, what compliance means in terms of token issuance and trading, and some thoughts on how to undertake a security token offering.

Pros of security tokens

Liquidity for all issuers and securities: Where before, security liquidity was only available for large companies that went through the cumbersome and 7-figure process of an IPO, now, in theory, any financial instrument can be “easily” tokenized, and made tradable online.

Hard-coded compliance: With new standards like Harbor’s R-Token or Polymath’s ST20 being developed on blockchains (mainly Ethereum), it is possible to hard-code any compliance rules into a security token. So, for example, a company issuing a Reg D equity token can hard-code that only accredited investors that have passed KYC/AML checks can buy or trade the tokens. Lockup period rules, be it investors’ or directors’, can also transformed from law to code. Violating securities laws and regulations can be made a thing of the past.

Public trades, curbing insider trading: If security tokens are issued on a public blockchain like Ethereum, all token trades will be made public. This can curb a whole set of “asymmetric information” issues that are standard in normal financial markets, including insider trading. Everyone will be able to see the exact time and price the CEO decided to sell his shares.

Global investors : Uniform token standards across the globe make possible for companies to easily raise money from investors around the world, and for securities to be tradable globally in regulated exchanges. Securitize is a good example of an issuer platform that has worked with legal counsel from over 50 countries to facilitate global offerings.

(Potentially) lower costs: With the increasing maturity of the security tokens industry, the standardization of legal documents, and token protocols becoming open-source, the costs of issuing a tradable security can in principle drop to near zero.

Cons of security tokens

Less money and liquidity for large issuers: Most credible token sales have raised in the 8-digit (tens of millions) range, with very few issuing in the 9-to-10-digit (hundreds of millions to billions) range, which is what the world’s greatest companies typically look for when undertaking their public offerings (today, IPOs). This may change when big institutional money enters the security tokens market. At present, they do not even have a significant presence in the general crypto asset class.

Regarding liquidity, while payment cryptocurrencies such as Bitcoin and Monero have enjoyed ample liquidity on regulated and non-regulated global exchanges, the jury is still out on security token liquidity — we really can’t say, as no security token exchanges are even live!

Little changed compliance costs: Regulations don’t generally change for a security token, versus a normal security. If carrying out a public offering, it is still a requirement to comply with cumbersome (but necessary) SEC regulations, S-1 filings, and the like. The major advantage in security tokens, in this regard, is that it is possible to bring partial liquidity to investors even with a Reg D offering, which carries very few disclosure requirements.

Early and untested technology: This space is literally one-year-old! Arguably the first compliant security token offering was Blockchain Capital’s BCAP, in April 2017. Nothing has been truly extensively tested.

Regulatory uncertainty: The SEC has said, on multiple occasions, that most ICOs are securities and that there is no need for more securities laws for digital tokens. While that indicates that security token offerings are the way to go, there has been no clear statement to that effect, and specifically no details on how exactly to execute compliant security token offerings and trades. In addition, there is no highly relevant case law, as the space is so new.

Security tokens are great for early-stage companies, not yet for later-stage ones

Due to the pros and cons listed above, as of today (May 2018), it looks like security tokens will, initially, mostly benefit early-stage companies and their investors. By offering quick liquidity to investors, these companies will likely be able to attract new classes of investors, those who cannot wait 7–10 years for their early-stage investments to mature. That is how the theory goes, of course — there may also be negative effects, as the more conservative investors shy away from security tokens, due to their novelty.

For the time being, until institutional players are comfortable with security token offerings (STOs), later-stage billion-dollar companies will likely enjoy more benefits from traditional markets, where 9-to-10-digit IPOs are common.

Compliant issuance of security tokens

In principle, from a regulatory point of view, carrying out a security token offering in the U.S. should be very similar to issuing any other security, something VCs and startup founders are already very accustomed to. Below is a summary of the most popular ways to issue a security. For more information, the SEC’s exempt offerings page is the best resource.

As explained below, regulations and disclosure requirements increase when offerings include non-accredited investors and general solicitation (advertising to people without a preexisting business relationship).

Most security token issuers likely want to someday have their tokens tradable by all investors, but there is still a lot of regulatory uncertainty, especially around public offerings (which involve more “public risk”, as any investor can buy in). Therefore, what we are generally seeing today are issuers first undertaking offerings for accredited investors (Reg D 506b or Reg D 506c), and planning to carry out public offerings later in the game, when things are more clear.

This structure also makes sense in terms of timing for security token exchanges, as Reg D offerings have a 12-month investor lockup, which will give time for regulated security token exchanges to do their public launches (most are currently in closed beta).

Reg D 506b (most common one for startups)

• Accredited investors mostly (35 non-accredited allowed)
• No general solicitation
• No fundraising limit
• 12-month investor lockup
• Simple, few disclosure requirements

Reg D 506c

• Accredited investors only, with “reasonable checks” to verify status
• General solicitation allowed
• No fundraising limit
• 12-month investor lockup
• Simple, few disclosure requirements

Reg Crowdfunding (CF)

• All investors allowed
• General solicitation allowed
• 1.07M fundraising limit
• Individual investor limit (read more here)
• No investor lockup period
• Medium disclosure requirements

Reg A+

• All investors allowed
• General solicitation allowed
• $50M/year fundraising limit
• No investor lockup period
• High disclosure requirements: 2 years of audited financial statements, Form 1-A and qualification from SEC, etc.
• SEC has not authorized any Reg A+ token offerings to date

Normal registration with the SEC (S-1)

• All investors allowed
• General solicitation allowed
• No fundraising limit
• No investor lockup period
• Super-high disclosure requirements (100+ page S-1, quarterly and annual obligations, etc.)
• SEC has not authorized any S-1 token offerings to date

Reg S

• For offerings outside the U.S.
• Issuers must abide by regulations in each foreign country

Compliant trading of security tokens

In the U.S., security tokens can only be traded on exchanges that have registered with the SEC as a national securities exchange or are exempt from registration. Several players (e.g. tZERO, Templum, OpenFinance) are coming into the space, at high speed, to launch Alternative Trading Systems (ATSs), on which security tokens can be traded in a compliant manner.

Unlike payment cryptocurrencies or ERC-20 tokens, security tokens will not be freely tradable across wallets. Issuers will have to hard-code into their tokens all the necessary compliance listed in the section above, such as KYC, AML, and accreditation.

In addition, issuers will need to have the power to issue more tokens (in case of a new offering), and even delete and restore tokens, in case of losses or hacks. Of course, this means that these tokens will not be decentralized — here, the blockchain is bringing transparency, standardization, globalization, and possible cost reductions, rather than decentralization.

“I want to issue security tokens”

Advisers, advisers, advisers, providers, providers, providers! As is the case with any securities issuance, an issuer needs to combine expertise from several key players, the four most important being listed below. Included are examples of top-tier firms for each category, in no particular order.

• Legal counsel: Katten (Allison Yacker), Cooley, Latham & Watkins. It is important to talk to the SEC as well, as according to the agency’s Enforcement Division Cyber Unit chief, they have an “open-door policy”
• Financial and marketing advisors (in theory optional, in practice rarely): Morgan Creek, CrowdFundX, TokenMarket, New Alchemy
• Technology protocol for token issuance: Securitize, Harbor, Start Engine, Polymath
• Regulated security token exchanges (all still in beta): tZERO, Templum, OpenFinance

As the space is still new, expect the total costs to be in the low 6-figures, significantly lower than an IPO, but also significantly higher than a standard Reg D private placement (which can be done for free, with standardized and well-tested SAFE/convertible note contracts).

As the industry matures, expect costs to decrease significantly. Reinforcing points above, in the near future, with standard legal documents, open-source security token protocols, and competitive market exchanges, the cost of a security token offering could approach zero!

Conclusion

In conclusion, security tokens are a digital expression of real-world assets, which allows for securities issuance and trading at lower costs and increased transparency, at a global scale. It is clearly here to stay and grow over the following decade, giving more options not for only startups, but also for large enterprises.

We at Front Seat Capital are really excited about the possibilities in securities markets that have been brought by blockchain. We hope that with securities tokens, startups will have an even greater access to innovation capital, to be used to move the world forward!

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