Chapter 1: Why Security Token Offerings Matter
Before you can understand STOs and where they fit into the investment world, it’s important to understand why the industry needs them and how it stands to benefit.
IPOs and their blockchain-enabled counterpart, ICOs (which we’ll cover in detail later) let outside investors participate in the financial success derived from entrepreneurship. The simple truth of the matter is that not all people are entrepreneurs. To bridge this gap, these investment vehicles give everyday people the opportunity to benefit from entrepreneurs by providing them with financial backing.
If you wanted to participate in the value created by entrepreneurship without being an entrepreneur yourself, you only had a few options available until recently: invest in a new company, become an accredited investor, or buy stock in a public company.
Investors in newly launched businesses take partial ownership in the venture. Accredited investors (which the SEC defines as individuals who have an annual income of $200,000 or more, or a net worth of $1,000,000 or more) get to invest in a broad range of financial instruments that aren’t available to others. And publicly traded companies have shares of their stock listed for sale on the world’s exchanges. These are companies that have gone through the tedious and expensive initial public offering (IPO) process in pursuit of additional capital. They offer liquidity to early stage investors and give new investors the chance to participate in future success and growth.
The last of these generally sounds like the most viable option for outside investors to participate in entrepreneurship-powered value creation, but there are a number of shortcomings that tip the scale in favor of elite investors, making the system unfair to the average investor.
The problem with modern IPOs
The announcement of a new IPO for a trending company (think Facebook, Snapchat, and Twitter) often dominates financial market news, and with good reason: IPOs have been one of the most popular ways for companies to gain access to capital. Companies who file for IPOs have previously received backing from venture capitalists and angel investors, but believe going public will give them access to more money, a higher valuation, and more liquidity.
New IPOs are enticing because they will be publicly traded and (in theory) will allow anyone to have their share in the company’s success buying purchasing shares on an exchange. But IPOs are not as inclusive as you may think.
A majority of IPO value is taken out before the option to purchase stock even reaches the hands of the average investor. In the investment rounds prior to a company’s IPO, a number of banks, accredited investors, institutions, and high-net-worth individuals already taken their turn.
The early investing opportunities don’t even stop there. Right before a company is about to file for IPO, there is a final round of “pirates” who take their piece directly from the retail public on the stock’s way out the door. With big discounts on early buying opportunities, these guys reap huge profits on day one.
This all happens before the public even gets a chance to invest. By the time they can, they are purchasing stock at inflated prices built on buzz and hype, not profit and cash flow.
Public companies often represent the Hollywood image of a successful Silicon Valley startup: the founders might have dropped out of Stanford, launched from their parents’ garage, and become a unicorn business valued at $1 billion or more overnight. The problem is that these high-flying startups are rarely (if ever) actually generating actual profit, so their valuations are not based on hard financials. It all comes from growth and hype instead.
According to the Wall Street Journal, 3,700 companies went public in the United States in 2018, while the US Census Bureau reported that the country is home to more than 32 million businesses. This means that only 0.00001% of companies in the US are public.
What about the other 31,996,300?
Even if they boast successful operations, stable cash flow, and profitability, the cost of going public in the modern IPO ecosystem is simply not feasible for them. This means the founders and early employees will never gain the benefits of being public. At the same time, investors will never gain the opportunity to invest in such emergent, cash flow positive businesses.
The problems facing both the average investor and average company within the current IPO ecosystem have led many people to the idea that the traditional system of investing and fundraising is broken. These problems have lead to the development of what we’ll call “IPO 2.0” — initial coin offerings (ICOs) that aim to solve the problems within the modern IPO paradigm.
IPO 2.0: the rise of the ICO
ICOs were born from frustrations with the modern financial system and the emergence of blockchain technology. As a blockchain-powered fundraising mechanism, ICOs entered the scene in early 2017 and have raised over $13 billion in the short time since.
ICOs make it possible for anyone anywhere to invest in entrepreneurial ventures. The technology has also given founders the ability to raise money without relying on the usual financial and regulatory gatekeepers.
In the first quarter of 2018 ICO funding exceeded VC funding, raising $6 billion against the conventional VCs’ $2 billion. This much lesser-known investment vehicle that didn’t even exist a decade ago outpaced an industry that’s been around for over 60 years.
Although ICOs bring numerous benefits to the investing table, it’s clear that there are some major challenges. They fall into a regulatory gray area, and have quickly turned into a Wild West of investing. At best, an ICO-backed company might fail to deliver. At worst, the company is an outright scam.
According to a report by Boston College, more than half of all ICOs failed within four months of completing their fundraising. But it wasn’t just incompetence. There were a number of scammers conducting their own ICOs as well. The top ten ICO scams made off with $700 million of investment.
These bad actors are part of an unfortunate reality that exists in any industry, but we must remember not to let them deter us from the benefits that the blockchain can bring. Fortunately, many of the greatest minds from finance, economics, and technology are dedicating time, energy, and money to the continued development of the blockchain.
The blockchain industry has libertarian roots and many of the industry’s early adopters are fairly described as anti-regulation, it has matured. Many industry leaders now vocally support regulation that protects investors, provides companies with clear regulatory guidelines, and encourages innovation. It is actively engaged with regulators and governments around the world.
By combining these productive conversations with advancements in its technology, we are on our way to what we’ll call IPO 3.0: security token offerings (STOs).
IPO 3.0: STOs as an investment vehicle
STOs are the latest innovation in blockchain-enabled fundraising and investing.
There are still some gray areas based depending on your geographical location, but, STOs solve many of the problems that ICOs cannot. From a company’s perspective, they offer an avenue for a business to be more compliant with the laws and regulations. From an investor’s perspective, they’re a more secure way to invest in upcoming companies, unique asset classes, and a larger global base of opportunities with a low barrier to entry.
In the next chapter, we’ll dive into what STOs are, how they work, and how they differ between ICOs and IPOs.
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