Over the past year, regulators have increased their scrutiny of initial coin offerings. As a result of this increased pressure, many blockchain companies have undertaken a new token issuance model. In an effort to be fully compliant to investment regulations in multiple countries, security tokens now openly admit that they’re investment vehicles.
Of course, most ICO investors realized that the projects they supported were raising money. Those projects generally stated that they were offering a “utility” token with future value on a platform – like a coupon. However, most backers treated these initial token sales as investments, expecting returns on their initial contribution. As it turns out, most of the world’s regulatory bodies agree. These tokens were not utility vouchers for future platforms. For the most part, they were investments and therefore ought to be regulated under securities and exchange laws.
Now, new blockchain projects are increasingly looking at security token offerings (STOs) as a way to offer tokens as investment vehicles in a compliant manner. To date, the major challenge with offering financial security has been the enormous up-front cost of registration and underwriting. New STOs seek to make the process easier for startups.
Traditionally, when we think of securities we think of stocks. When you purchase shares of stock in a company, you’ve effectively purchased a small piece of the company itself and you are a part owner. Owning part of the company means your shares rise in value when the company does well. You don’t even have to do any work for the company in order to see the benefits. Passively, you make money just by being an owner and investing capital.
However, this typical model of ownership doesn’t apply as cleanly when it comes to cryptocurrency and blockchain projects. The challenge, of course, is most blockchain projects are open source and supported by a public network of nodes. You can’t own a blockchain project in the same way you can own a company. While some cryptocurrencies do give owners a voting share in the project, ownership certainly isn’t the same in a decentralized crypto system.
To be clear, most cryptocurrency investors do expect a profit from their investments. However, when they invest in a token, they don’t actually own anything substantial. A token is only worth what the market will pay for it at that time, and it could drop to zero value.
2. Defining a Security
The fact that a cryptocurrency’s value could drop to zero or skyrocket overnight is a key factor that makes it seem like an investment security. However, there are key differences between tokens and stocks, that complicate the comparison. Chiefly, the fact that token holders don’t own shares in an underlying business.
Despite these differences, regulators in the US have been content to characterize tokens as securities under the rules of the Howey Test. Other regulators around the world follow a similar rule. The Howey Test involves three key components:
Is it a transaction where you’re investing money in an enterprise along with other people?
Does the investor expect a profit from his/her investment?
Can the investor merely contribute capital without needing to do any work on the enterprise itself?
If the answer to all three of those questions is yes, then it’s likely a security. While you could try to argue that cryptocurrencies aren’t built for profit, clearly the majority of people treat cryptocurrency investing that way. Crypto meets all three of these criteria in most cases. As such, token offerings are undergoing a shift into a new realm of regulated securities.
3. Regulatory Burden
Many in the crypto community have applauded the trend toward security tokens. The ICO craze of 2017 and early 2018 was insanity, with tons of scams and bad investments. The truly good projects were few and far between. And they were difficult to find. Security token advocates see STOs as introducing a hurdle that makes the ICO process more difficult for scammers and dud projects.
Nevertheless, that doesn’t mean that securitization is a magic bullet. Nor is it an easy burden to bear. As a token creator, declaring your token a security brings along with it a host of regulations. If you want to truly operate your security token offering fully above board, then you’ll need to file registration paperwork, hire lawyers, track investor identity, and keep meticulous compliance records for every country where your STO is offered. Additionally, it must be clear to your investors that they are speculating on the value of a tradable security, and there is an inherent risk in the investment.
4. Security Token Compliance
Specifically, what are the compliance requirements for operating an STO?
As the issuer of a security token, the team has certain obligations to both investors and to regulators throughout the process. Of course, those obligations vary widely based on the jurisdiction and the way you structure the token offering. Indeed, the complexities and specifics of each offering is one of the main reasons to hire a lawyer early in your token offering plans.
Still, at a minimum, the STO team must keep clear and open communication with both investors and regulators. There’s no scenario in which it’s okay to provide false or misleading advertising. Or, to promise guaranteed returns. As we saw so often in the ICO craze, those tactics came back to bite the projects that tried to use them. Openness and transparency are the touchstones of a successful STO. The companies that misled investors have been the first to get audited or brought to court by regulatory bodies.
In fact, most regulators will require public reporting on the status of the funds raised, or at least reports to investors involved in the deal. Additionally, maintaining investor privacy is critical, so data security should be a top concern.
It goes without saying that all funding agreements need to be honored in a timely manner that gives investors full control over their assets and does not limit their ability to sell or trade, except when explicitly agreed to in the initial purchase agreement. Finally, keep detailed records of all transactions for compliance reporting before, during, and after the token sale. There’s no excuse for missing or mangled documentation.
5. SAFTs & Accredited Investors
Each jurisdiction has different rules, but most major countries have provisions for the sale of equity in a company to accredited investors. While not open to the general public, these types of sales have always been popular for technology companies (think venture capital). Now, private pre-sales are a key part of any blockchain project’s path to funding.
As part of this trend toward private, accredited investor sales, cryptocurrencies have tried several different structures for the deals. By far, the Simple Agreements for Future Tokens (SAFTs) are the most popular. Under these agreements, accredited investors participate in a project with the expectation of receiving tokens once the project launches. Until then, proceeds from the pre-sale are startup capital for the project. SAFTs typically introduce income requirements, essentially limiting them to high-wealth individuals that could be accredited investors.
Another option we’re seeing with increasing frequency is companies dividing tokens into a utility offering and a security offering. The idea is to limit the security token to qualified investors while allowing anyone to purchase the utility token. This scheme has yet to come under the scrutiny of regulators officially. However, it seems like a thinly veiled attempt at circumvention and may be unreliable as a legal structure.
6. Timeline to Launch an STO
Because of the extra compliance burdens involved in an STO, they’re not nearly as quick to launch as the ICOs of a few years ago. Instead, there’s significant startup cost and considerations. Of course, these considerations vary by jurisdiction and offering structure. However, it’s reasonable to expect that getting regulatory approval for an offering could take a year or more.
However, if your offering is only limited to private accredited investors, then that timeline could be much shorter. Additionally, depending on the jurisdiction, again, there may be other exemptions to which you could match your token offering in order to launch with fewer or no regulatory approvals.
7. Launching an STO
STOs are, by far, one of the most dominant current structures for new token offerings. For many blockchain projects they make a lot of sense. Working with an expert in your jurisdiction, you can offer a token with the peace of mind that your token offering is fully compliant and fair to you and your investors.
skalex is one of the leading Security Token Offering Platform Providers that can help you launch an STO successfully. From platform hosting to creating security tokens and building custom landing pages, our team can assist you through every step of a Security Token Offering launch.