The State of Security Tokens 2022 — Private Market Upgrades & Value Adds
Security Token Upgrades & Value-Adds
What I find particularly interesting when it comes to financial data & software is not how many firms and organizations are using new SaaS products, but rather how surface-level these products tend to be. An early partner at Insight Partners took the foray into software VC in 1995 for one straightforward reason — “everything about it sucked — a lot — and people used it anyways.”
As we will cover in a later section (“Primary Issuance Market Snapshot”), there are trillions of dollars locked up in private assets and investments. Trillions across numerous industries and verticals, and the vast majority is subject to near-decade long lock-ups, high barriers to entry, and a lack of transparency.
And yet there are STILL trillions of dollars locked up in the field. Given this, and thinking about one of the pillars of Insight Partners’ thesis, the value that digitization is bringing to private markets is immense — and security tokens provide the most holistic solution to the numerous drawbacks associated with private investments.
Private Company Shares & Assets
A great deal of investors assume that public markets account for the lion’s share of assets. Yet, according to the SEC in 2019, Regulation D private placements accounted for $1.5 trillion worth of investments while public offerings accounted for $1.2 trillion. Reg D placements are merely one type of private exemption, and primarily cater to accredited investors. There is even more wealth curated across the private placement market when bringing Regulation S (international), Regulation CF (retail, crowdfund), and Regulation A+ (retail, crowdfund) into the mix. Despite only 10% of Americans qualifying as accredited, these households represent nearly 75% of the wealth in the US ($75 trillion in 2020). There is still room to run when it comes to retail access in the private markets — and this should be exponentiated through security tokens.
Transparent & Real-Time Valuation
One of the main differences between private and public shares and assets is the asymmetry that exists among owners, investors, and consumers. Owners usually have the upper hand here since they’re not obligated to report certain sensitive data that public firms do. This puts them at an advantage and a couple steps ahead of investors and competitors at times. For example, commercial real estate owners are not required to report changes in valuation even if they are indeed aware of any. Similarly, private company owners, while they do have a duty to their investors, may have more of a grace period when it comes to reporting in certain instances. And of course, private fund managers have a responsibility to their Limited Partners but benefit from both of the aforementioned aspects.
Security tokens reduce this information asymmetry as the assets and shares can be priced in real-time per the market. Company-level reporting varies based on the offering exemption used by the issuing company (i.e. Regulation D, Regulation A+, Regulation CF, etc.) as well as the investment instrument (i.e. Equity, Debt, Profit-Share). While this isn’t perfect, combinations of offering types and instruments can bring clarity to investors in private companies and assets, which is certainly an improvement on the current landscape. The goal is for this reporting to guide investors in their market decisions and better-price assets in the freely-trading markets, much like public equities. More on this in the future “Data Providers & Networks” section.
Fractional Ownership
Regarding the differences between accredited and non-accredited investors, one aspect that seems to truly make a mark is the minimum investment amount across the two cohorts. Offering that displays minimum investments of $10,000 are typically reserved for accredited investors via Reg D or Reg S, while minimums of $500 usually signal retail interest.
The beautiful part of security tokens and tokenized assets draws on one of the beauties of cryptocurrencies — fractional ownership. One does not need to spend $50,000 for a full Bitcoin. That investor could instead spend as low as $100 for a super small share. Likewise, one does not need to contribute $200,000 as a downpayment for an investment property. That investor can purchase $500 worth of the asset, diversifying their portfolio without breaking the bank.
The fungibility of security tokens means assets can be fractionalized as low as necessary depending on the goals of the offering and the targeted investor base. For example:
- $1,000,000 asset targeted towards accredited investors could be fractionalized into 100 tokens at $10,000 each
- $1,000,000 asset targeted towards retail investors could be fractionalized into 10,000 tokens at $100 each
With over $7.5 trillion across 100 million Americans in defined contribution pension plans, it’s estimated that over 6% of that retail wealth will shift towards alternative investments as they become more accessible per Triago. This paints a bullish picture when it comes to retail interest and execution in alternative assets facilitated by security tokens.
Liquidity and Transferability
Fractionalization is just one piece of the puzzle. In fact, investment platforms that enable fractional ownership have gained impressive traction over the past few years. Prominent examples like Yield Street and Fundrise have garnered $2 billion and $4+ billion in assets, respectively, covering hundreds of thousands of registered investors. These firms have paved the way for alternative investments access, but still don’t encompass the full potential of the addressable ecosystem.
Redemptions and sales do not typically happen in real-time through these platforms, and rather occur like an extended mutual fund redemption. Mutual funds do not trade throughout the day; instead, they reprice after market hours and take into account all new buy-ins and redemptions. This is unlike an ETF, which trades in real-time.
Similarly, Fundrise uses a quarterly redemption mechanism whereby investor sales are booked and executed at the end of the quarter in which they were made (or even at the end of the month after a 6-day waiting period). This delay is where the “extended mutual fund redemption” phrasing originates. This is unlike a security token, which trades in real-time.
The chart below depicts the differing growth rates between mutual funds and ETFs in the public asset management space. Recognizing that platforms like Yield Street and Fundrise have paved the way for tokenized assets and maintaining the “mutual fund vs. ETF” narrative (while hedging for the early-stage nature of both fractionalized alternative asset managers and security tokens), it’s feasible to project that the magnitude of annual assets invested in the industry as a whole will continue to increase, but the rate of investment into security tokens will trump that of investment into alternative platforms.
Secondary Trading
The reason for the aforementioned liquidity and transferability of security tokens rests on the shoulders of secondary marketplaces and peer-to-peer asset swaps. Rather than being locked into investments or at the mercy of a centralized party to allow for the transfer of shares, security token investors can find early liquidity on the various ATS and secondary venues that exist in the industry. Since tokens can be developed with the proper KYC/AML guidelines in mind, on-boarded and whitelisted investors can freely trade or even interact with each other in the secondary venues through a peer-to-peer swap, which can be thought of as a targeted Over-the-Counter sale. Additionally, investors may not have to flock towards certain assets during times of inflation and deflation, as they have greater precision over their tokenized assets through the secondary trading functionality.
These solutions are usually one of the premier motivations behind asset tokenization, so expect this secondary aspect of the industry to build itself out further in 2022.
Employee Access
As a final tidbit, it’s important to recognize that not all employees are compensated equally. Specifically, just because a firm is private does not mean it offers equity or upside participation rights. While we will discuss tokenized pre-IPO shares in the future Sample Tokenization Cases section, the shares need to exist first and foremost.
While an employee may not receive any equity, profit-sharing, or similar benefits, that employee may be eligible to receive them in the future. This would indirectly provide an employee to align interests even further with the job at hand since ownership in the company would now be possible.
Envision a company that raised $60 million in a Regulation A+ offering and considered that its Series B round. It is possible that a new Sales hire has a strong commission-based compensation package with limited equity participation. While a bit disappointing, that employee could technically buy into the firm’s offering via the Reg A+ and get on its cap table officially. This would provide the same (or similar) exposure to an equity compensation package. Again, this is not a perfect solution but it is a better solution than traditional compensation packages that leave a portion of employees on the assembly line even after a successful exit. At least with a tokenized offering on the horizon, there would be some peace of mind and access to upside in that exit.
Next week’s edition will cover Public Market Upgrades & Value Adds.
