Chapter 2: Security Token Offerings 101: Everything You Need to Know
For many years, IPOs were the primary way for investors to participate in entrepreneurship value creation. But there was a problem: they were (and still are) exhausting their value to wealthy investors through private funding rounds before average investors have a chance to participate. The vast majority of other profitable companies still lack the resources necessary to participate, and investors will never gain access to those either.
To bridge this gap, companies began using initial coin offerings ( ICOs) to lower the barrier and to make investing more accessible for all. Anyone could theoretically participate in an ICO if they wanted to, and the blockchain technology powering it made investing in these new startups easier than ever. But ICOs suffered a few blows as they became more popular: low returns, empty promises, and scams that took an estimated $700 million from investors’ pockets into the hands of frauds.
Although ICOs were a step in the right direction, the system remained flawed. It needed better management and regulation to succeed.
Then, in July 2017, the SEC clarified with their ruling on The DAO that nearly all ICOs were considered securities, and all ICOs were beholden to the same regulations as conventional securities.
That’s when the concept of security token offerings (STOs) was born, and the idea has only gained momentum ever since. STOs will solve the problems that plagued the old IPO ecosystem: high barriers to entry, limited geographical access, and inflated valuations that make wealthy investors richer and leave average investors holding the bag.
STOs will also address the problems that ICOs faced, such as unclear regulations and a Wild West mentality that deterred many.
Before you can understand the impact STOs stand to make on the investment world, we need to address some token basics: what is a token, what classifies a token as a security, and why STOs are more effective investment strategies than IPOs and ICOs.
What is a token?
Let’s address one thing right away: tokens are not physical items. You can’t hold them in your hand, and they don’t go into arcade machines.
Just as you might purchase ownership in a company via IPO or ICO, tokens represent digital shares in a company or asset. This ownership is stored and verified on the blockchain.
The underlying nature of blockchain technology gives token holders the ability to trade quickly and cheaply without any of the middlemen or gatekeepers that traditional investing requires.
But not all tokens are created equally. They can be divided into two broad categories:
Utility Tokens allow the holder to perform a specific function on the token’s native platform: think online arcade games or slot machines.
Security Tokens entitle the holder to a share of a company’s success: think of it as similar to equity and dividends from conventional investing.
These definitions of token types can be murky, but the SEC determined in July 2017 with their ruling on The DAO that most (if not all) ICOs were beholden to regulations. The world’s regulatory agencies generally followed suit and took the same stance. Many countries allowed them if the ICO abided by specific regulations, but countries like China and North Korea went so far as to ban them all outright.
In June 2018, SEC chairman Jay Clayton reiterated that a token is a digital asset in which “I give you my money and you go off and make a venture, and in return for giving you my money I say, ‘you can get a return.’ That is a security, and we can regulate that. We regulate the offering of that security and regulate the trading of that security.”
To avoid any future misunderstandings or mislabeling, the SEC emphasized the importance of the Howey test. This test determines whether or not something is considered a security. It says something qualifies as a security if:
- It is an investment of money.
- There is an expectation of profit from the investment.
- The investment of money is in a common enterprise.
- Any profit comes from the efforts of a promoter or third party.
The Howey test makes it clear that most tokens, despite claiming to be utility tokens, are actually securities in the eyes of the regulators. The conversation around STOs only became more popular as a result.
How do security tokens work?
A security token is any asset that has been “tokenized.”
Suppose you want to invest in Joe’s Pizza Shop down the street. Under security laws, your ownership interest is considered a security. Let’s further suppose had quite a bit of money to invest, but now you need some cash and want to sell your ownership. The questions are: who will buy your shares? How do you find these people?
This is where security token offerings come into play.
Because your ownership is represented by a digital token, you have far more options for selling your shares to anyone around the world versus limiting yourself to the people within your network or town. Security tokens are of little interest to big companies like Apple because they already have access to lots of global liquidity. But for small businesses, startups, and select assets classes like real estate, liquidity is often a major challenge.
Security tokens meet this challenge head-on by giving investors the opportunity to sell their shares to anyone in the world in the fastest and most efficient way possible.
[To read more about the benefits of security tokens, jump to chapter three]
What are the different types of security tokens?
There are different types of security tokens, including:
- Equity: partial ownership of a company or project.
- Debt: a company’s outstanding liabilities, comparable to a bond or mortgage.
- Royalty: a return on your investment, and a form of passive income.
All security tokens need to abide by the compliance rules set forth by the regulatory party in each country. This ensures that all tokens are lawful and secure, therefore protecting the token holder’s investment.
The versatility and regulatory nature of the different types of security tokens shows a lot of promise for the future. But what excites us the most at 81-C is the potential for asset-backed security tokens.
What are asset-backed security tokens?
Unlike the majority of ICOs (which were startups without a proven business model and oftentimes didn’t have a product on the market), a lot of the excitement around security tokens comes from their ability to create tokenized securities backed by digital assets.
Asset-backed security tokens are based on established real-world assets. This means they open up the avenues for investors to purchase and trade assets that were previously very difficult to access.
Small businesses are a strong example of the potential here. Investing in a local business was previously limited to people within that geographical location. Someone in China was highly unlikely to invest in a grant writing business in Florida. It’s likely that the investor would never have discovered the opportunity in the first place, and even if they did, they would have a hard time finding a buyer when the time came.
Another use case for asset-backed securities is in property and real estate. These investment classes generally struggle with liquidity. But if the investment were tokenized, this would stand to solve that problem gracefully. For instance, an investor in South Africa could purchase digital shares in an apartment building in San Bernardino, and then turn around and sell to an investor in Australia the next day.
The ability for anyone to invest in securities that are backed by true assets, and then easily trade them with anyone in the world, represents a major shift in the financial landscape.
What’s the difference between an ICO and an STO?
In simplest terms, an ICO is “crowdfunding on the blockchain.” Founders create their own tokens and sell them on a platform like Ethereum, Waves, or NXT to raise money for their projects. Investors can purchase these tokens on the premise that their value will increase over time.
This sounds like an effective on-paper solution to the problems faced by IPOs, but ICOs land in a regulatory gray area. Many companies abused this loophole in order to take advantage of investors.
STOs were created to close these gaps. Similar to an ICO, they completely lack that Wild West nature. STOs are a regulated investment instrument.
In the United States, the Securities Exchange Commission (SEC) regulates STOs and provides investors with more rights and better protections that are completely missing from ICOs. Outside of the US, each country has its own version of the SEC, which provide similar guidance to encourage STOs over ICOs.
Why security tokens matter
ICOs were a way to transform how people invest in companies, but ultimately fell short due to how they interact with regulations. IPOs were designed to provide people with the ability to invest in entrepreneurial ventures, but they favor wealthy investors and are geographically limited.
STOs deliver on the promises that IPOs and ICOs couldn’t. They take the public funding aspect of IPOs, mix it with the global, decentralized nature of ICOs, and deliver a new wave of global investing opportunities to the public.
Now that we’ve covered STOs are at a high level, we’ll dive into the core benefits of security token offerings and what they specifically provide to investors.