Derek Edward Schloss (TDW): Dave, great to have you on The Digital Wrapper. Let’s jump right in. What were you working on before security tokens?
Dave Hendricks (Vertalo): Well, I’ve had a long business career. I got into blockchain through a side door. When I graduated from college, I went to work as a technologist for a company called Arthur Andersen — at that time, the world’s largest accounting firm. I came out of school with a lot of computer skills when people didn’t know how to do computers. They didn’t understand networking or databases, and I started doing all that stuff really young. I got involved in projects related to securitization and building databases for securitization projects. Over the years, I spent time at Arthur Andersen, JE Robert — a securitization joint venture with Goldman Sachs — Oracle Corporation, and eventually wanted to be more entrepreneurial. I went to work with my now Co-Founder William Baxter at a company called CheetahMail. At that company, we built the world’s largest email service provider, and it was sold in 2004. We learned how to build massively scaling systems that housed competitor data on the system, but those competitors could not see each other’s data. There was a lot of caution around identity and privacy.
Derek Edward Schloss: What came after CheetahMail?
Dave Hendricks: My next big project was building a company called LiveIntent, out in New York. In our last round of funding for that company, a $32 million round, we nearly lost our lead investor because they asked us to produce proof of the signed agreements between the company and its employees and contractors. It was a mess. We ended up having to get all these documents signed and it almost blew the round. I never forgot about it — in 2016 I thought, “Wow, I think distributed ledgers might be a way to solve this problem.”
Derek Edward Schloss: Enter blockchain.
Dave Hendricks: Right — in 2016, we started working on a distributed ledger project for human capital data.
Derek Edward Schloss: To clarify, when you say human capital data — what are some of the inputs here?
Dave Hendricks: For example, what we were trying to do is figure out whether I signed an employment agreement with Derek. Or a stock option agreement. Or an NDA. What I wanted to do was have that data available for both parties. I wanted both parties to be a signatory to it, and I wanted to put it on a ledger — then I would put it on a blockchain. This was Vertalo version one.
Derek Edward Schloss: Got it — and you were building this first version in 2016 and 2017?
Dave Hendricks: Yes — we worked on this through the middle of 2017. After developing the first version of the product, we said, “Oh, we should think about running an ICO¹ to raise money for the project.” My other Co-Founder is a former SEC attorney, and he and our law firm said, “No, I don’t think that we’re going to run an ICO.” The compromise that we came to was running an exempt offering in a Reg D² format, but with a token. That’s when we started working on a Reg D security token in October of 2017. We started designing a two-token structure, an equity token and a utility token, and in March of 2018 we issued a security token — it was one of the first security tokens that we know of that was actually delivered to shareholders. And the first that we know of that properly complied with SEC Reg D
Derek Edward Schloss: I think that’s great background. I’m sure when you’re trailblazing a path like this, there’s a lot to learn on the fly. What were some of your findings being one of the first to fundraise through a security token model?
Dave Hendricks: Actually, the biggest learning we found is that there were no technologies on the market to help us manage our investor base. Our investors who owned the Vertalo security token owned equity, and our team needed to know who owned it and how much. We also wanted to give compensation to our team members in the form of tokens. Well, if you do this, you have to restrict the transfer and sale of those tokens — you have to restrict most trades in those tokens. As a result, we had to develop technology using smart contracts to give tokens to people, but not actually allow them to trade them or sell them or transfer them. We had to actually distribute our tokens, and we couldn’t be in a position to revoke them either. This led to our development of our ‘V-Token’ technology that we recently announced.
Derek Edward Schloss: You had to solve these interesting new problems on your own now that these securities were taking a digitized format.
Dave Hendricks: Exactly — when we got through this whole process, I realized that something other projects need is a cap table³ that connects to exchanges, and helps control the transfer and trading of issued tokens. So we decided to shelve the original project and the Vertalo that you know today was born — built on all of this learning that we gained about securities laws as it now pertains to tokens, the practical considerations of investor relations, tax issues, securities issues related to token transfer and token compensation for team members. There’s all these issuance platforms that exist. There’s all these trading platforms that exist. But there’s no investor relations platform. There’s no cap table platform. Let’s build that — we decided. It was a gut decision that was supported by our own experience and analysis of market offerings and white papers.
Derek Edward Schloss: You entered the space, you started building, you took a look around — and you realized that there’s these required picks and shovels that need to get created and serviced before folks coming from behind you would be able to grow within this new ecosystem. You saw these problems going through the process yourself, and you pivoted to solve them.
Dave Hendricks: It’s definitely a hard pivot when you’re in the moment — but I’ll tell you that it was a very strong gut conviction to do this. This wasn’t an abstract problem. It was a solution that we knew would be very interesting to other projects, and it turned out that it was. Once you get on a cap table — you’re on it for a long time. Funds are typically 10 years in duration. Right now if you’re an investor in an early stage company, you better be prepared to be there for seven, nine, eleven years before there’s liquidity. Going even further we thought — “What if we create an on-chain cap table that also connected to sources of secondary liquidity?” That would solve another set of problems — investors wanting to gain access to secondary liquidity.
Derek Edward Schloss: Can you walk through how Vertalo is tackling this second piece — providing cap table investors access to downstream liquidity?
Dave Hendricks: The reason why people got into ICOs originally was because they could buy in at early stage valuation but have late stage public-style liquidity⁴. You could buy some tokens in a project and they would be salable almost immediately, as compared to venture investments. And by the way, you didn’t have to be an accredited investor to participate in ICOs. That’s why the sales were so big — it sped up the typical VC funding timeline. At Vertalo — we’re borrowing this idea, but we’re doing it in a compliant manner. The cap tables we manage represent ownership in a typical company. Think real estate or a venture funded company. That’s what’s on the cap table, in the form of a token. But we connect the cap table by API⁵ to an ATS⁶ or exchange — to places like tZERO, Open Finance Network, VNX, or any other source of secondary liquidity. In our system, if you’re an investor and you hold some tokens, you can see those tokens in the interface. And next to the token there’s a button that says “Trade”. That trade button represents an API that connects to an ATS or exchange that the issuer has decided to list on.
Derek Edward Schloss: So token holders can see the tokens in the Vertalo interface, but are investors holding their tokens in their own designated wallet⁷?
Dave Hendricks: Yes — we believe in self-sovereign ownership of the underlying asset. It’s really a key component to why this stuff is on blockchain to begin with. We believe that you, Derek, should actually own the asset. Not just be listed on a cap table with a certificate that you have to go ask for, but actually own the token that represents the equity asset that is held in your wallet. At Vertalo, we’re connecting your sovereign ownership to the secondary liquidity source. And we are wallet agnostic.
Derek Edward Schloss: Logistically, let’s say that a security token holder relying on Vertalo for cap table management wants to move out of a position. How might that work?
Dave Hendricks: In order to make that happen, you need to have three things in your possession — the issued token, a wallet, and credentials. Let’s talk about that third part. Those credentials are proof that you passed KYC and AML to purchase the security token in the first place. After that initial KYC and AML, the investor will now have possession of proof that they passed KYC and AML. When the investor hits the “Trade” button, the payload that goes from investor to the ATS or exchange will contain all the things required to compliantly trade — no whitelist required. You’re taking the assets, and you’re doing a peer to peer trade because you have proof of credentials, proof of ownership, all held in a wallet that contains currency used to pay commission on the trade.
Derek Edward Schloss: Can you explain the currency portion of the trade as it relates to trading commissions or fees?
Dave Hendricks: Yes. Secondary trading platforms will want you to pay them in USDC, BTC, ETH, or USD — platforms won’t take a piece of your security token as commission because they’ll have to be on the cap table. And for regulatory reasons, issuers aren’t going to want fifty trading platforms on their cap table.
Derek Edward Schloss: That makes sense. Issuer compliance might be pretty difficult for some of these instruments if that were the case. When it comes to compliance, will Vertalo be protocol-agnostic? Do you envision Vertalo being compatible with security tokens issued on different chains, or using different compliance standards?
Dave Hendricks: By design, Vertalo is protocol and chain-agnostic. Vertalo will work with all security tokens, even ones that weren’t done through a Vertalo-onboarded process. Simply, we want to make security token lifecycle management and trade easier for every security token investor. That’s what we’re building at Vertalo — something compatible with today’s issuance platforms and tomorrow’s developments.
Derek Edward Schloss: Speaking of lifecycle management, I appreciate the Vertalo Security Token Ecosystem Map that your team updates frequently. In the map, you list out many of the major companies and teams building within the security token industry. It’s a map I typically send to people who are looking to learn more about how the industry may be developing. Why is curating and updating an ecosystem map like this so important to the Vertalo project?
Dave Hendricks: Thanks for asking about the ecosystem map. The digital asset space we’re building is a team sport. It’s impossible to be end-to-end, and there’s no fewer than four players in any security token deal — probably more like five or six. You’re going to have a broker dealer, an issuer, an issuance platform, and someone like us at Vertalo. You’re also going to have KYC and AML. You will have a custodian⁸— especially if you want to issue without investors knowing about wallets. Also, there’s probably a separate ATS if it’s not the same broker dealer — or an exchange. If you think that you’re going to be able to do an interesting deal in this space without working with several or more people, you’re wrong.
Derek Edward Schloss: Is that where the ecosystem map comes in — providing issuers with the web of platforms, vendors, and service providers required to get new assets to market?
Dave Hendricks: Yes, and we see ourselves at Vertalo as the glue for the security token ecosystem. We’re an API-driven platform, and we want to connect these players. You can use our interfaces or you can use our APIs. We’re designed to connect every player, which we think will allow the industry to grow faster. Additionally — being a clearinghouse of ecosystem information teaches us stuff along the way. There’s new projects all the time, and our team has to keep up with it.
Derek Edward Schloss: Can you tell me about some of the security token challenges you’re dealing with today?
Dave Hendricks: At this stage it’s the overall puzzle — this industry is a confluence of technology and finance and business. It’s also why it’s so endlessly interesting. I am particularly lucky that one of my Co-Founders, Gautam Gujral, is a former SEC attorney. He co-wrote the first paper on ATSs while at the SEC. He was also a securities lawyer in prime brokerage and prime solutions for fifteen years, so he’s got a handle on the legal piece of the puzzle. My other partner William, our CTO, is a PhD from Berkeley with a knack for very knotty math problems. As a team we have worked together for decades.
Derek Edward Schloss: Any knotty problems building the platform you can share?
Dave Hendricks: We’ve had to design and build technology around things like Rule 144⁹, Reg S¹⁰, Reg D, Rule 12(g)¹². For example, some of these rules can be done through operator and transfer functions within smart contracts. Some, not all. I think Rule 144 is generally pretty easy to deal with, but here’s a fun fact we’ve had to work through. Let’s say that you make a token and you issue it to your holders. Unfortunately, you mess up somehow, and now you have to fully reissue that token. Once you reissue that token, that actually restarts your restriction period. How do you work through this? In practice, you need to make sure you’re only upgrading the token and not reissuing the token.
Derek Edward Schloss: That’s an interesting technology problem. How did Vertalo solve for this?
Dave Hendricks: What we did is invent a thing called V-Token. The V-Token can act as a placeholder token that can be issued at the time of capital formation. Let’s say you finish a round, and now you want to issue a token to prove to your holders that they’re getting a token. That’s great — you issue the security token, but you can’t reissue later as we’ve already determined. The V-Token is a token that you can issue at the time of capital formation, and then you can later upgrade that token with any additional trading parameters. The V-Token uses Rule 144 restrictions to limit trading and transferability, and allows us to then bring in an issuance platform — like our partners at Securrency or TokenSoft — who can then write the fully tradable token during the restriction period. Then, using our system, we can go upgrade that token simultaneously and instantaneously within Vertalo.
Derek Edward Schloss: Without resetting the clock?
Dave Hendricks: Without resetting the clock.
Derek Edward Schloss: That’s interesting. Are there any other use-cases you envision V-Token solving for?
Dave Hendricks: The nature of the V-Token design allows us to place a cap table for any private asset on the blockchain, regardless of whether or not the asset has been tokenized. Not only does an issuer automatically get a cap table that leverages DLT, but because Vertalo connects to secondary markets, there is the opportunity to dramatically enhanced asset liquidity.
Derek Edward Schloss: This idea of the V-Token aligns well with your overall focus on smoothing the friction around the security token ecosystem and digital assets generally.
Dave Hendricks: Yes — we want to reduce the risk, complexity, and cost for issuing digital assets. Ultimately, we want to make sure that every issuer, even a company ten years old, has the option to tokenize. Our system at Vertalo will allow any company to think about tokenization, and use the mechanisms we’ve built to issue tokens to existing shareholders at a much lower cost and risk. It’s very exciting right now to be able to tackle these legal issues that people are now oddly familiar with — who knew about these obscure requirements before, right? It’s all pretty cool, but maybe a bit nerdy.
Derek Edward Schloss: [Laughs] I think that’s probably right.
Dave Hendricks: So as academic as this stuff might be, our mission at Vertalo is pretty simple. We want to bring secondary liquidity to illiquid private assets, and we want to do it for all varieties of private assets. We want to rescue investors who are stuck in illiquid venture-funded companies, in assets that suffer from huge liquidity discounts. We’re building a spaceship to escape a prison planet of our design. Everything that we’re doing here is purpose built to solve repeatable and generalizable problems in private asset ownership and liquidity.
Derek Edward Schloss: Is the current security token industry facing technology hurdles, regulatory hurdles, demand hurdles? You’re on the front lines right now. What are the areas that need solving as you look across the landscape?
Dave Hendricks: Regulatory hurdles are certainly strong. The other thing I hear being said all the time is, “Where are the deals? Where are the investors? When is there going to be liquidity?” Let’s make one thing clear — people need to understand that this technology brings liquidity far faster than this technology not existing at all. Security token deals structured using this technology will have a far greater chance of improved liquidity than any typical VC funded deal that’s been done in the last couple of years.
Derek Edward Schloss: You’re saying that on a spectrum where one pole is “Poor Liquidity”, and where the other pole is “Strong Liquidity”, tokenized deals will be much closer to the “Strong Liquidity” pole than non-tokenized VC deals that exist today.
Dave Hendricks: Yes — security tokens are a liquidity enablement technology — they are ‘programmable liquidity’, not guaranteed liquidity. Leading with “token” to investors and issuers may not be the best idea. Let’s lead with the potential for liquidity. I’d also like to see more risk-taking from this industry. Look, Uber took risks. AirBnB took risks. The scooter companies are taking risks. In order to push the security token industry forward, there may need to be a bit more risk taking, so long as you’re still striving for compliance.
Derek Edward Schloss: What does the rest of 2019 look like for this industry — what happens next for the security token industry, Dave?
Dave Hendricks: There are more people entering this space every day — today, Vertalo is maxed out with projects. We’re incredibly busy. I really think that this is a legitimization year. You’re seeing thoughtful players working on solutions for compliant deals. You’re seeing regulators look favorably on this space as we continue to operate in good faith. The SEC and FinHub will attract industry input. You may see a number of ICOs get remediated and turned into security tokens. With all of that said — there’s so much talent flowing into this space right now.
Derek Edward Schloss: Dave, on behalf of The Digital Wrapper, thanks for your time.
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¹ ICO is an abbreviation for Initial Coin Offering, a fundraising mechanism where individuals purchase digital tokens to help bootstrap new token-based networks. In the US, the SEC has released ICO comments to help provide guidance around compliant token-based offerings.
² Reg D provides exemptions from the securities registration requirements under the Securities Act of 1933, and is intended to make access to the capital markets possible for small companies that could not otherwise bear the costs of a normal SEC registration.
³ Cap Table is a spreadsheet or table that shows the equity capitalization for a given company.
⁴ Liquidity is the ability to find someone on the other side of the market, at a reasonable price, for the size that you’re looking for. It’s both the size of the “bid-ask” spread, which is the difference between what people are willing to sell and buy for, and also how deep those markets are.
⁵ API is application programming interface — a set of subroutine definitions and tools for building software. A good API makes it easier to develop a computer program by providing all the building blocks, which are then put together by a programmer.
⁶ ATS is a non-exchange trading venue that matches buyers and sellers to find counterparties for transactions. Alternative trading systems are typically regulated as broker-dealers rather than as exchanges, and must be approved by the SEC.
⁷ Wallets are used to store cryptoassets of all types. Categories of wallets include cold wallets (offline), hot wallets (online), hardware wallets, and paper wallets.
⁸ Custodian refers to third party ownership of one’s assets. In blockchain, holding custody of a wallet and its assets also means holding the private keys and the responsibility of keeping funds and assets safe.
⁹ Rule 144 provides the most commonly used exemption for holders to sell restricted (privately sold) securities. Broadly, the idea is that investors can publicly resell restricted securities if they have been held for a required period of time, and a specific process/manner is followed according to Rule 144 of the Securities Act of 1933.
¹⁰ Reg S is a “safe harbor” that defines when an offering of securities is deemed to be executed in another country, and therefore not be subject to the registration requirement under the Securities Act of 1933.
¹¹ Rule 12(g) of the Securities Exchange Act of 1934 states that an issuer is required to register as a publicly reporting company with the SEC if and when specific conditions are met — subjecting the company to specific reporting requirements.
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