The State of Security Tokens 2022 — Sample Tokenization Cases

As a supplement to the topics covered across both public and private markets, this section provides conceptual ideas for tokenization. Some concepts have been done in reality, while others have maybe just scratched the surface or are in the works. For a new weekly tokenization idea, follow my own personal column Tokenize This with 50+ editions on the Security Token Market Blog.

Real Estate

Real estate is one of the most — if not, the most outright — straightforward asset classes for tokenization. The most bare bones use case would be tokenizing a rental property to allow current investors to exit early (if desired) and enable new investors (accredited & retail) to buy-in. Assuming a well-oiled property management team is in place, the new investors who are token holders will be completely hands-off and simply receive automated distributions via rental cash flows, proportionate to their ownership amount. Tokens can be traded on secondary markets and pricing will fluctuate with supply and demand.

What’s unique is that while the token structure is fixed, the real-time terms of the token can change just like a tradable fixed income product would. Take the following example:

• Each token represents a 1/100 share in a rental property valued at $100,000
• The annual rental cash flows are $10,000, equating to a 10% annual yield
• The initial token price was $1,000

Once the tokens hit the secondary markets, they trade as a function of supply and demand. If demand for the token exceeds selling pressure, then the token price will rise to something like $1,200, which values the property at $120,000. Now, the annual $10,000 yield is only an 8.3% yield. This token is trading at a premium.

If sell pressure is greater than demand, then the token will likely fall in price to something like $800, which values the property at $80,000. Now, the annual $10,000 yield is a 12.5% year. This token is trading at a discount.

Investors can create trading strategies based on their own unique goals surrounding growth, income, or value, and can tailor these factors to certain property locations.

Additionally, this concept can be taken deeper into examples like Airbnb Properties, Restaurants, Clubs & Bars, healthcare facilities, and any level of “brick and mortar” operations. Not only can the underlying property be tokenized, but the operations can be tokenized and offered as an equity, debt, or revenue sharing agreement to investors.

The beauty of security tokens is the ability to create these additional layers in the capital stack and bring much-needed precision to markets and industries that have never had the fortune of doing so.

Tokenized ETFs & Investment Baskets

Tokenized ETFs can solve the cross-border barrier that’s hindering the ETF industry. While American investors have easy access to the majority of ETFs, foreign investors are not always granted the same access for all funds. This is why certain ETF sponsors will also issue foreign counterparts of funds. These funds hold the same shares of underlying stock, but are structured for whatever the targeted jurisdiction is. Unfortunately, this jurisdictional demarcation in the fund also demarcates the total liquidity — something that could be resealed with tokenization.

Take the Global X ETFs FinTech ETF for example. The original FinTech ETF (FINX) currently has $1.14 billion in AUM. Its counterpart European fund, called the FinTech UCITS ETF (FINX), has $2.2 billion in AUM. The underlying holdings are actually slightly different, although likely have a 95%+ commonality with each holding being off by mere bps. What’s also interesting is the various Authorized Participants across both funds. Authorized Participants are personnel who act as market makers in the ETF space, and serve to “create” and “redeem” shares to keep an ETF in-line with its NAV.

Rather than having these 2 near-identical ETFs operating separately and with separate personnel, a single tokenized ETF would solve the cross-border issue between American and European investors in real-time, and would drive the collective fund AUM upwards to $3.24 billion. This higher AUM would likely result in improved volumes and act as a positive sign for future investors concerned about liquidity. Additionally, it would potentially combine all Authorized Participants into one fund, thus resulting in a more liquid and properly-priced market.

ETFs and security tokens have many similarities as pointed out earlier in this piece. Per the chart above, investors prefer the ETF wrapper to previous baskets of funds over time — and security tokens can act as the wrapper for baskets of private assets. The functionality of the “create” and “redeem” mechanism in ETFs is something that can be used for tokenized baskets and tokenized products that contain underlying security tokens. Thematic ETFs faced (and still faces) a similar challenge when it came to garnering assets as they were so niche and new, yet a significant handful of thematic funds have proved successful and are now prominent names. As Authorized Participants and market makers enter the security token space — taking advantage of comparable mechanisms for profit — investors and issuers will feel more confident and see greater success on the secondary markets.

Private Investment Funds

Much like Blockchain Capital and SPiCE VC did with their BCAP and SPiCE tokens, respectively, investment managers can tokenzie their funds and enable early exits, a wider investor base, and more precise and tailored approaches to investment management. As of March 15, 2021, after commentary and suggestions from Security Token Group and other involved parties, the SEC officially raised the Regulation CF (Crowdfunding) limits from $1.07 million to $5 million, and Regulation A+ from $50 million to $75 million. These amendments are pretty clear indicators of the shifting investment landscape, especially in the private sector. Crowdfunding platforms like SeedInvest and Wefunder are strong current beneficiaries of this progress, but there exists a deeper root that stands to benefit even more heavily — Private Investment Funds and Special Purpose Vehicles through security token capabilities.

With firms like Allocations and Digital SPV enabling a streamlined SPV and micro-fund creation process, investment managers do not have to run the gauntlet and pay up for the typical legal fees associated with a private equity or venture capital fund. That’s not to say these elements don’t still exist — they do. Expenses are simply compressing and packages are becoming more all-encompassing. The next step in this initiative is reaching a wider investor base through placements like Reg CF, Reg A, and Reg D, rather than the traditional method of tapping into one’s direct network, which usually consists of the same cohort of ultra-high networth investors.

Just like the precision security tokens can bring to real estate and brick and mortar businesses, security tokens can improve the capital stack associated with private fund investments, including but not limited to:

• Reduced liquidity premium for investors looking to exit early
• Automated periodic distributions or collections, such as Carried Interest and Capital Calls
• Easily coded, non-manual investment instruments for a blend equity and debt
• Agostic across different types of investments such as Metaverse Funds, DeFi Funds, and traditional funds

Pre-IPO Shares

Stemming from Pre-IPO marketplaces like EquityZen, SharesPost, and ThElephant, the Pre-IPO industry is huge. Think of all the VC-backed companies and dollars poured into them (below chart for reference across the 2010s decade). EquityZen estimates a collective market cap of $1.2 trillion across private companies supported on its marketplace alone. The real kicker is that “Pre-IPO shares” aren’t limited to early or growth-stage companies. The category encompasses Pre-Seed, Seed, Series A, Series B, Series C, Series D, …, Series H (Stripe as a prime example in its 9th round of funding), and however long a firm stays private.

As these shares both 1) exist for angel investors, venture capitalists, and private equity firms and 2) vest for employees from early stage to growth stage to late stage, they typically stay locked up until a true exit — usually when the company is acquired or goes public IPO. As companies choose to stay private longer due to favorable financing terms, employees and investors are forced to delay the liquidity event that would unlock all of their vested capital.

The security token industry phrase “go public while staying private” could not be more applicable to these scenarios. Rather than locking employees and investors up out of tradition, tokenzied shares can trade freely among the market without affecting company operations, management, and growth.

It simply allows early liquidity for a portion or whole amount of shares while allowing other investors to invest prior to an IPO. This is especially powerful for retail and non-institutional investors who have never truly had the opportunity to participate in growth before a company goes public.

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