The Tokenized Truth — Pros & Cons of Security Tokens
A lot has been written about security tokens recently, including their advantages and disadvantages. With the purpose of a high-level comparison between utility and security tokens, some generalizations will be used. To briefly summarize them, the table below highlights the major pros and cons, with a deeper analysis of some aspects below.
When considering the type of token to issue and use for your business, it is important to keep in mind that security tokens can be any sort of security connected to cash flows or profits of the company.
Legal ambiguity of the token world
In the traditional financial markets, there are three ways of raising funds: Equity, Debt and Mezzanine Capital. The latter is a hybrid of debt and equity financing that gives the lender the right to convert to an equity investment, in case of default, generally, after venture capital companies and other senior lenders are paid.
All of these types of funding instruments can be replicated in a smart contract and be turned into security tokens. However, the key benefit of programmable securities is that one can structure and ‘code’ any kind of payment modality dependent on the cash flow or scaling of the business. If, for example, the payouts are dependent on the number of users, this is in essence similar to a utility token. A token that grows in value as the platform scales — this is the way many utility tokens are structured for platform-like businesses.
Now would you consider the above example security or utility? This is largely down to the country in which your business operates and where the tokens are distributed. This lesson was learnt whilst deciding on the issuance of the SMART VALOR Platform’s native cryptocurrency, VALOR. SMART VALOR is a security token exchange focused on alternative investments such as funds, early stage private companies and infrastructure projects. The VALOR token, in terms of functionality, is similar to Binance’s BNB token. It will be used for payment, staking and rewards. In Switzerland, it is considered as a hybrid utility and payment token. Yet in the United States, we had to file with the SEC for Reg. D exemption for private security offering.
The right token is the token that helps you scale
The fact is that in essence, this token is neither equity, bond, nor mezzanine. It is a new financial instrument, not comparable to anything else we have in traditional finance. Is it safer than security or equity participation? Well yes, since once you buy it to use services of the platform, you will most likely to be able to do so. Even if the value of the token will not skyrocket in value, like Binance’s token, BNB did by 24’434% or not according to your expectations, you will still be able to use it by paying for the services you would buy anyways. This is the logic of BNB: if you know that you are going to invest and trade in cryptocurrencies and digital assets and you use Binance, you are better off buying their token, because you can pay transaction fees with it at a significant discount. The same advantage is true for protocol tokens. If you buy Ethereum, you will be able to pay for the issuance of your token on the top of the Ethereum network. It is a useful mechanism to deliver value from the platform to its users.
In many cases of token design, there is a straightforward correlation between the price of the token and demand for it. This is achieved through the limitation of the amount of the token in circulation on one side, and the connection between usage of the platform and purchase of the token on the other side, e.g. every user that wants to use certain features or services will need to buy/hold the platform’s native currency.
The result is one many companies seek. As the business starts to scale, the first beneficiaries become the utility token holders, those that funded the business at the very beginning. Note that in this phase the platform itself can be — in accounting terms — still not profitable. Yet the early contributors are already financially benefiting from growing popularity of that business. At a later stage, possibly even 10 years later, the company becomes profitable and starts to pay out dividends. This is the part that does not benefit token holders directly, but mainly benefits shareholders.
It’s not black or white
Does this mean that this form of participation — utility token — has no purpose? I would like to argue that it is not black or white. Just as it is not equity or debt — It is not ICO or STO. In most cases it is a combination of both, and rightfully should be. Now we can add to this combination, a newborn fourth option, called non-security participation or utility/payment token.
Taking this argument one step further to the point of asking why the companies which business model is suitable for the usage of a utility token, such as a platform based protocol, have to make a difficult decision between issuing a security token or a utility token? It is the same as asking a company to commit to only one funding structure: debt or equity. The reality is most companies do both, some even add mezzanine capital. So why in the tech space we should not also have both, security and utility token. The key prerequisite is — the business model or technology you develop will be more successful with the addition of utility token than without it. At the end of the day, if the utility token is the thing that allows you to attract more users and grow the business faster, it would be a very bad idea not to use it. Just because there was a lot of non-serious companies using this concept before or because the cryptocurrencies markets are down? Or even because you think your users might not like the one-year lock-up period associated with RegD filing? No. The truth is if it is good for your business, you should have a utility token. Your customers will see it and once your platforms will start to scale, the token value will increase. This is when they will come to appreciate your wise decision to do so.
A security token exchange with a hybrid approach
This is why we at SMART VALOR see our platform’s own cryptocurrency VALOR, as one of the crucial elements of the business model design and the key to scaling the platform. We are firm believers that the platform will be much more successful if a wider community of users can participate and benefit from the success of it. Not only accredited investors. Not only people with lots of money or from specific countries. But everybody. Anybody that is interested in using the platform for purchasing of cryptocurrencies and tokenized real-assets. This is the reason why we are driving a hybrid model of both a utility and payment token for users of the platform (asset issuers and investors) and equity participation for institutional investors who are less interested in using the platform themselves but want to take advantage of this opportunity.
If you agree with this approach and want to learn more, check out the SMART VALOR Platform. Currently we are running an Early Access Program for the first 5’000 users with stage three of the public sale of VALOR running from 22–28th of February, offering everybody* a chance to participate!
About us
SMART VALOR is embracing a bold vision of putting real assets on the blockchain. This is something that has become known as tokenization which enables any kind of value to be owned and transferred globally, instantly, at a cost close to zero, in a disintermediated, P2P way. Our vision is to become one of the first global platforms for tokenization and trading of digital assets. Our mission is to make alternative investments more accessible and to democratize access to wealth. Our time has come to change how finance work.
*Disclaimer: users from certain countries on the FATCA sanctions list and some other restricted countries are exempt from participation in the token sale of SMART VALOR.
Originally published at smartvalor.com on February 20, 2019.
