9 things to check before launching your Security Token Offering (STO)
The last couple of years have seen a massive explosion of the Initial Coin Offerings (ICOs) in the blockchain niche. However, the fact that these ICOs are not regulated has made the center of various controversies. Giants such as China and the US have already raised red flags regarding ICOs. In fact, China banned ICOs considering most of them as Ponzi scheme.Now, the next reliable and effective option after ICOs are the security tokens. And as ICOs exit the stage, people start being curious and inquisitive about security tokens. So, for all that and more, let’s look at 9 key considerations before launching your STOs:
1. Type of interest being tokenized
Security tokens are often flexible in terms of what they represent. Depending on the way a token is structured, it can represent either of the following interests:
- Ownership of a physical asset;
- Ownership of an equity interest in a business entity/fund;
- Ownership of a debt; or
- A right to receive distributions of income from a physical asset, business entity, or debt.
The type of interest being tokenized affects not only the token’s appeal to the investors, but also the legal attachments required to be attached to it. For instance, governing debt securities impose different requirements than laws governing equity.
2. Place of incorporation
The jurisdiction in which the token is being issued can have a profound impact on the STO structure. Choosing appropriate jurisdiction of the issuer depends on various factors, including:
- The physical location of an asset/interest that has to be tokenized;
- The countries where the founders of the issuers are considered resident for tax purposes;
- Type of interest being tokenized and classification of such interest;
- Marketing strategy;
- Relevant security regulations and other applicable laws;
Further, the token issuers must be aware of and discuss various jurisdictional factors with a knowledgeable attorney or a tax advisor before choosing where to incorporate it.
3. Corporate structure & governance
A proper corporate structure and governance are imperative when launching STOs. For instance, the issuance of security tokens should be authorized by the issuer’s corporate documents — especially if the tokens are going to resemble traditional equity securities.
In addition to this, the number of holders of security tokens might be limited by law. For example, some of the US-based tokenized funds are limited to 99 US investors. Similarly, if the US issuer has more than $10mn in assets, then its equity securities can only be held by up to 2k investors without triggering the Exchange Act reporting requirements.
The corporate structure of the issuer can range from one entity with a second class of securities being tokenized to classic securitization structure that involves a special purpose vehicle and a trustee, to various fund structures, to even hybrid structures.
4. AML / KYC
It’s 2018. Almost all the countries impose Anti-Money Laundering (AML) and Know-Your-Customer (KYC) requirements on financial business — including security token issuers. These requirements ensure that the funds used to invest in these tokens have not come from illicit sources.
KYC screening is essential in complying with securities and other laws. For instance, some exemptions from securities registration in the US require that token is sold only to “accredited investors”. The KYC process is extremely crucial in determining which investor must undergo the accreditation process.
In addition, the KYC process allows issuers to determine whether any U.S. resident is participating in the token sale. The sale of unregistered securities is a strict liability violation in the US. The only way to protect against the possibility is to engage in KYC efforts. There are various online services, like IdentityMind, that offer flexible KYC / AML compliance solutions.
5. Tokenization platform
If you’re looking to launch STOs, you have more than a dozen online tokenization platforms. Some of the most famous ones include:
- Token IQ
Each of these platforms has a unique approach to the process of tokenization, ongoing support after the tokens have been launched, and even secondary-trading issues. In addition to these, each platform has a distinct pricing model. For example, in some cases, depending on the complexity of an offering, the price of partnering with a tokenization platform could even exceed $100,000, plus a percentage of the funds raised.
But with so many options available, it’s important to know the questions you should be asking before partnering with any of the platforms:
- The number of offerings that have already been launched on the platform?
- How does the platform track token holders during secondary trading?
- Does the platform provide tools for KYC/AML checks, not only during token issuance but also during secondary trading?
- Does the platform hold a broker-dealer license? What services does the platform perform and how is it being compensated?
To this date, there are only a few crypto-friendly banks in the world. That gives those banks a wide degree of discretion in setting their requirements for onboarding new clients.
For instance, in the Cayman Islands, establishing a crypto-friendly bank account requires a thorough KYC review, and once the account is open, the bank requires its own custodian to hold the cryptocurrency raised through the STO.
Token issuers should understand their banking needs and be well-researched in terms of their banking options way ahead of time, if they’re to ensure a smooth banking process at the time of the STO launch.
7. Exchanges/ secondary trading
In order to accommodate the shift in the blockchain community to compliant STOs, many companies have launched (or are in the process of launching) compliant security token exchanges. These are more accurately referred to as alternative trading systems or online trading platforms. Specifically, in the US, these systems include Templum, OpenFinance, and tZERO.
When considering a platform for secondary trading, the token issuers must determine whether or not such platform is compliant with the local laws of the country where it operates. Token issuers should also research the platform’s listing and KYC requirements in order to avoid any hassles later.
8. Maintaining cap tables and tracking secondary market trades
As we’ve talked earlier, various legal restrictions apply, especially in the US, to investors who can hold certain types of tokens — including the quantitative, residency, and time limits. To ensure a complete compliance with these limitations, the token issuers must be able to maintain a current cap table that lists all holders of record of security tokens.
In general, this will require the issuers to communicate with the various exchanges on which their tokens are sold. Doing so, they’ll be able to track secondary market trading, or even place certain restrictions via smart contract.
9. Token custody
One of the most glaring issues in the security token industry is custody. Traditionally, online trading platforms have served as both marketplaces to link buyers and sellers of blockchain assets and even custodians of those assets. But international investors have always been reluctant to purchase digital assets from online trading platforms. The reason for this is simple — the security concerns and legal requirements to use qualified custodians when holding clients’ funds or securities.
The issuers of security tokens must be sensitive to developments in the custodial solutions in order to be able to appeal to a broader range of potential investors and ensure their own compliance with the law.
Launching a security token offering isn’t a straightforward process and requires thorough research, careful planning, and due diligence from the part of the issuers. The 9 key considerations we’ve talked about are by no means exclusive. These are just to help you find a solid starting point for a successful token launch.
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Originally published at MindDeft Technologies Blog.