IEO vs. STO – key differences you should know
The world of blockchain and cryptocurrencies is developing so rapidly that keeping up with its new development can be challenging. If you’ve been following this area of tech closely, you’ve probably heard that Initial Coin Offerings (ICOs) are now being replaced by new initiatives such as Initial Exchange Offerings (IEOs) and Security Token Offerings (STOs).
But what do they mean exactly? And how are they different? When should you choose an IEO and when will STO be a better alternative?
In this article, we take a closer look at the key differences between IEO and STO fundraising methods for startups. Read on to find out everything you need to know about these two different schemes to pick the one that matches your business model and objectives best.
Let’s start with ICOs
It’s impossible to discuss IEOs and STOs without considering the Initial Coin Offerings first. ICO is a type of fundraiser which in the early days of blockchain, allowed the rise of all sorts of interesting technologies. One of the best examples of that is Ethereum.
An ICO works like a crowdfunding campaign. As part of an ICO, the organizer would issue tokens, which then would be sold to investors for cryptocurrency. Tokens themselves served as a sort of internal currency for projects. For example, they would enable holders to activate certain features on the project’s platform.
In the beginning, it seemed that ICO was the best way of raising funds. However, the lack of regulations resulted in many scams, fraudulent schemes, or situations where projects made a lot of empty promises. You might have heard about the Pincoin and iFan scam that scored a record of $660 million or Plexcoin that resulted in losses amounting to $15 mln.
Despite the shortcomings of the ICO, the community was hooked. Blockchain-based fundraising became so popular that removing it completely from the tech scene would be impossible.
That’s why the community decided to reform the practice and solve the most important problems of ICO with new solutions that would protect both investors and token issuers. This is how Security Token Offerings came to be.
What is a STO?
A Security Token Offering is a fundraising method startups use to sell tokens that function like traditional securities. The primary benefit of STO lies in transparency and security.
First of all, the tokens need to be issued according to rules and regulations that apply to all securities. Moreover, their issuance needs to be blockchain-based. That’s why STO tokens can only be issued once there exists an infrastructure that supports such practice. The platform dedicated to managing security tokens needs to adhere to a number of different policies such as KYC and AML. Such platforms need to be regulated and licensed to trade commodities too. To sell security tokens, projects need to abide by the legislation recommendations of the local authorities in many different aspects, starting from marketing to KYC/AML.
The rise of STO gave birth to a number of sub-economies within the sector. For example, it powered the development of STO exchanges and gave rise to STO providers. Unlike ICOs, STOs come with specific regulations that hold token issuers accountable for their actions. Moreover, unlike regular utility tokens, STO deals with security tokens which are real-world digital assets that operate within well-defined legal boundaries.
What are security tokens?
To understand what STOs are all about, it’s important to know what security tokens are. A token can be classified as a security when it works as an investment contract – they represent legal ownership of digital or physical assets. And this ownership needs to be verified within a blockchain.
The holders of security token can trade their tokens for other assets, use them as collateral for a loan, or store them in digital wallets.
Note that thanks to fractional ownership security tokens redefine the meaning of ownership itself. It’s possible to use them to democratize assets and distribute them among people all over the world. For example, buying a piece of gold would be impossible for many people because it’s way out of their budget. Security tokens make it possible for a number of people to own fractions of that piece of gold.
It seems that STO is a perfect solution to the limitations of ICO, especially when it comes to investor’s safety, security, and transparency. However, there is still one unsolved problem, liquidity.
What’s the point of having a safe token, a verified project, and a great team to back it up if the investor doesn’t know when the project will be listed or whether it will be listed at all? This is where STOs require a lot of patience. Since it takes time for investments to turn out, this also gives the STO model time to mature and for the local regulators to catch up with the technology.
Benefits of STOs
Lower costs than IPOs
Companies that want to go public need to make a large upfront investment. That’s why only a handful of companies do that beyond the crypto world. And as a result, investors can buy the shares of relatively few companies.
An STO is much cheaper to carry out. Since it removes all the middlemen such as brokers, exchange fees, and due diligence activities, the cost of running an STO is much lower. And by organizing more STOs, investors will have a greater chance of buying assets.
Moreover, an STO makes it easy to tokenize any asset or financial instruments for trading online. This means that smaller and early-stage businesses can raise large amounts of capital quickly without having to pay huge fees. As more token protocols become open source, the costs of running STOs will become even lower in the future.
Security tokens can easily divide one large asset into smaller subdivisions. As a result, it’s possible for an investor to own a fraction of an asset instead of having to buy the entire product. As a result, security tokens are going to render high-priced assets much more accessible to regular people.
Listing a business is a complex process. Most of the time, it involves initial compliance checks as well as ongoing compliance work. These issues often force business owners to run their businesses in a way they don’t really want. They end up tied to a single exchange and dependent on the analyst recommendations. As a result, they may be driven into short quarterly cycles rather than having the flexibility to focus on their long-term vision.
This is where STOs provide an advantage. They allow businesses more freedom into how they run their business compared to a privately held company. Security tokens can be traded after the initial sale, which makes them much more liquid investments. Moreover, they have more transparent value because it’s based on underlying assets, which means that the business is less likely to be shorted – even if it attracts a small number of very large investors.
Since token standards are uniform across all the regions of the world, it means that buying and trading tokens is very easy. Investors can do that in any country they want. Security tokens are more liquid than privately held shares – which, in fact, can be time-consuming and costly to trade.
That’s why STOs usually appeal to a slightly different investor profile than stock markets. They often attract global investors who want to make a good return with greater liquidity, helping projects raise large sums quickly and spread awareness of their business around the world.
It’s possible to hard-code compliance
In general, compliance issues are more complex with STOs than ICOs. However, you can hard-code compliance into the security tokens with new standards developed on a blockchain. For example, KYC checks can be coded in a way to allow only accredited investors to buy or trade tokens. That way, you can automate the ongoing compliance checks and make it impossible to violate securities regulations.
Challenges of security tokens
Since security tokens fall under the existing securities regulations, businesses running an STO will need to comply with the same regulations as they would when running an IPO. The slight benefit here is that some of these aspects can be hard-coded into the token and smart contracts. As a result, the tokens will be more tradable after issuance.
Still, the complexity of legal regulations over multiple jurisdictions carries some risk. Businesses looking to create security tokens will have to rely on experienced teams who know what they’re doing. You should also get legal expertise that covers every region where you want to sell your tokens, as compliance with local securities regulations can be tricky. However, specialized STO platforms like Tokeny often provide this type of expertise to businesses.
Creating the platform for managing tokens
Traditional securities rely on a number of mechanisms, such as exchanges and brokers established around the world. Creating security tokens requires much more effort. Businesses not only have to create their own tokens, but also the platform for managing and selling them.
Any mistakes in this technological part could have serious legal and financial consequences for your project. Creating a secure and reliable platform often means that you need to bring in middlemen to manage the platform and tokens – and that will generate additional costs.
However, if you team up with a trusted partner, you can avoid dealing with all the complex technologies and simply concentrate on creating value through your business.
Lack of maturity
STO is still a relatively new space. And as such, it carries all the risks that young markets do. For example, no approaches have been extensively tested during long periods of time. Moreover, there aren’t many legal precedents businesses can rely on. It also means that regulators can change their minds anytime. For example, if a trader found a way of cheating a token sale, the securities commission could decide to introduce new regulations that jeopardize your STO or limit the liquidity of your tokens.
What is an IEO?
We don’t know what the long-term impact of STO will be. However, many heads are now turning to another innovation in the scene: Initial Exchange Offerings (IEOs).
An IEO is always carried out on a currency exchange platform that acts on behalf of the startup that wants to raise funds with the newly issued tokens. Since the entire process of selling tokens happens on the exchange platform, token issuers need to pay a listing fee together with a percentage of the tokens sold during the IEO. In return, exchange platforms provide the process with more reliability and credibility than ICOs.
The participants of IEOs don’t send contributions to a smart contract like in an ICO. Instead, they need to create an account on the exchange platform where the IEO is carried out. They can then top up their wallets with coins and use the funds to buy the fundraising campaign’s tokens.
Benefits of IEO
Support from the exchange platform
In IEO, the business joins forces with the exchange platform to make crowdfunding happen. The exchange will help the project with the listing, marketing, smart contracts, and more. Investors who want to participate in the IEO need to create an account at the exchange and then by tokens at the sale. As a result, businesses enjoy the support from exchange platforms and get to reduce the costs of their fundraising campaign. Projects also take advantage of the credibility such exchanges bring to them, as well as the existing user base of potential investors. The exchanges benefit from the fees and the influx of users. It’s a clear win-win situation.
Businesses that choose an IEO as their fundraising model will have to invest a massive sum of money at first. But they might be looking at a great return of investment in the long run. The partnership is beneficial for exchanges as well. They often get flat fees or percentage fees, token fees, and engage in fruitful marketing collaborations.
Security and trust
Since exchanges can’t control projects enough to make sure that they deliver the product from their whitepaper or prospectus, many large exchanges decide not to carry out IEOs. The exchange’s reputation will be severely damaged if it causes great losses for investors who participate in an IEO. All of that means that getting listed is a solid mark of credibility. If an exchange decides to list a project, it really means something.
Challenges of IEO
IEOs are expensive
The fees for launching an IEO tend to be very high. Since exchanges are in a very strong position in such collaborations, they can charge hefty prices for having a business listed on their platform.
Moreover, IEO comes with other limitations. The most significant issue in IEO is that it usually results in too few people owning the majority of the token circulation. That’s because an IEO is usually limited to one or a few exchanges. All of the people who don’t have accounts on these exchanges will be excluded from the sale. As a result, a small number of investors will gain access to tokens. Setting up an account on an exchange requires background checks, identity verifications, Know Your Customer procedures, and more. And all of them take a lot of time. If the user doesn’t have an account a day or a few days before the IEO, they probably won’t be able to participate.
Potential for price manipulation
This risk is directly related to the one mentioned above. If you constrict a token circulation to a few exchanges, you will open it up for more potential for price manipulation. After all, no one can stop the giants. And this vulnerability may turn off other investors because of the risks it carries. That’s why smart investors always look at the total token circulation before investing in the project. If the token supply is small or unevenly distributed, it might be susceptible to price manipulation.
Another potential risk projects face in IEOs is related to the fact that it’s centralized exchanges which carry them out. Most of them have access to the private keys of the wallets and transactions happen on the exchange and not on a blockchain. In the end, investors don’t really own their tokens. In fact, that’s why many of them don’t trust centralized exchanges.
We hope this article highlights all the key differences between IEOs and STOs to help you choose the best fundraising form for your business. If you’re an investor looking to participate in the project, this article gives you all the pros and cons of the two fundraising alternatives.
Note that there exists another type of tokens – RTO (Regulated Token Offering) that has been qualified by the US Securities and Exchange Commission under the Regulation A+ framework. The Regulation A+ is an alternative to traditional that was set up with the idea to help early-stage startups raise money. We have already seen some successful RTOs take place.
Do you have any questions about IEOs or STOs? Reach out to us in the comments; we’re happy to share our knowledge about the current trends on the crypto scene with you.