Is a Security Token Offering Your Best Choice?
The crypto community reacted to the many failures of Initial Coin Offerings (ICOs) by developing an alternative fundraising model called Security Token Offering (STO). The fraudulent ICO activities and notorious scams intensified the regulatory initiatives from authorities such as the US Securities and Exchange Commission. This is driving the trend towards STOs.
However, even if STOs are increasingly popular, many startups still may not fully understand the implications of carrying out an STO or whether it’s the best choice for their business.
In this article, we take a closer look at Security Token Offerings to show you everything you need to know about them to decide whether it’s the best choice you have for fundraising.
Let’s start with the basics.
What is an Security Token Offering?
It’s impossible to define Security Token Offering without first defining security tokens. Security tokens are a type of tokens that have the attributes of traditional security.
For example, they represent or give the rights to equity shares in the company, to share in profit, or ownership in the company. They can also represent the loan or any other debt obligation. Security tokens are also tokens backed by real-life assets such as real estate or artworks. Tokens representing a unit of a mutual fund or collective investment scheme can be considered as security tokens as well.
What’s more, security tokens are regulated by the same laws that govern traditional securities. That’s why they offer such a viable alternative to utility tokens, which are released during ICOs. They’re safer, more reliable, and trustworthy.
Pros of security tokens
Low barrier for entry
Entering a stock exchange or an Alternative Investment Market (AIM) through a traditional IPO is a time-consuming and complicated process. It only makes sense for large companies looking to target more than $10 million to go through it. Naturally, the process requires many middlemen, such as brokers, exchange fees, due diligence, etc. As you can imagine, all of that costs a lot of money.
Contrary to the traditional methods, an STO can be used to tokenize any asset or financial instrument for online trading. It’s relatively straightforward, meaning that smaller and early-stage businesses can raise substantial capital quickly without having to pay huge fees.
Moreover, as token protocols become open-source and legal documentation becomes standardized, the cost of running an STO is expected to go down in the near future. That way, even more businesses, and startups will be able to raise the required capital to make their ideas a reality.
To list your business, you need to go through a set of compliance checks and ongoing compliance work. This often means that business owners can’t run their business the way they really want to. Instead, they’re tied to a single exchange, rely completely on analyst recommendations, and may be driven into shorter quarterly cycles.
Here’s how STOs address this problem. They provide much greater flexibility in how the business is run. Unlike a privately held company, security tokens can also be traded after the initial sale. That way, they function as much more liquid investments. On top of that, security tokens come with a far more transparent value because it’s based on the underlying assets.
Since tokens are uniform across various regions of the world, it means that they can be easily bought and traded by investors, no matter their location. In fact, security tokens are usually much more liquid than privately held shares as the latter can often are time-consuming and costly to trade.
That’s why STO generally appeals to a slightly different investor profile than AIMs or traditional stock markets. They often attract global investors who want to make a return but achieve greater liquidity while doing so. STOs, help businesses to raise large sums of money quickly and spread the awareness of their projects around the world.
Security tokens are regulated like other securities. That’s why compliance tends to be more complex for STO than for ICOs. However, the good news is that compliance can be hard-coded into the security token and smart contract. This is all thanks to new standards developed on blockchain.
For instance, Know Your Customer checks can be coded in a way to allow only accredited investors to buy or trade tokens. That way, you can automate the ongoing KYC checks. And with the improvement of these standards, it’s going to be virtually impossible to violate securities regulations.
Another undeniable advantage of security tokens is that they allow dividing assets into smaller units. That way, more investors can contribute to your STO. Naturally, that also makes the token easier to transfer on the secondary market.
Fractional ownership means that you no longer have to wait until one large investor comes in. In fact, a group of people can simply buy an asset such as real estate or a piece of art, and become its fractional owners.
Cons of security tokens
Since security tokens fall under the existing securities regulations, companies that want to run and STO will have to comply with the same regulations as they would when running an IPO.
As mentioned before, one way to address this problem is by coding some of the compliance factors into the token and smart contracts. That way, the token will be more easily tradable after issuance.
However, legal regulations in various jurisdictions still present significant complexity and risk. That’s why you need to consult with an experienced team that knows their way around the topic and the assets you’re planning to securitize.
Expert tip: If you’re planning in STO, make sure to get legal expertise covering every region where you want to sell your tokens. This is the best way to ensure compliance with local securities regulations. Note that this service is often provided by specialized STO platforms such as Tokeny.
The need to create a platform
STOs require businesses to create their own tokens, as well as their own platforms for managing sales. If you make any mistakes in this area, the legal and financial consequences of your mistake will be dire.
Creating a suitable and secure platform is complex. It means that you need to bring in a middleman who will manage the platform and the tokens, which comes at the cost. However, using a trusted partner like Concise brings benefits too. That way, you can avoid dealing with complex technological frameworks involved in the process and focus on creating value for your business.
At Concise, we have experience in creating such platforms. Together with Scerri, we can also audit them and help businesses set their platforms up on Malta.
Lack of maturity
STO is a relatively new fundraising alternative on the market. No approaches have been extensively tested in the long term, which means that there’s always some risk present for both businesses and investors involved in the process.
Moreover, businesses can’t rely on much legal precedent. And regulators can change their minds easily following a scam or fraudulent scheme. Securities commissions can enact new regulations, potentially limiting the liquidity of your tokens or even jeopardizing your STO.
Here’s what you need to know before carrying out and Security Token Offering
Now that you know the pros and cons of security tokens and Security Token Offerings have a look at these tips for businesses looking to launch an STO.
- Don’t forget that security token holders may not gain access to liquidity
Due to regulatory restrictions, no crypto exchanges are currently listing security tokens. These exchanges need to obtain a special license to be able to operate a security exchange. At the moment, none of them have it. Moreover, traditional stock exchanges that could potentially list security tokens still wouldn’t be able to do that. That’s because they lack the infrastructure required for clearing and settling blockchain-based digital assets.
- Security tokens aren’t like utility tokens
Security tokens are securities. That’s why you can’t use them as utility tokens. What does it mean? Basically, you can’t use them as your platform currency or medium of exchange. Also, you won’t be able to use them to gain access to platforms or incentivize users to use the platform. But that’s not everything. You also can’t airdrop them or use them for bounty campaigns. That’s all because securities are subject to a number of restrictions and can’t be used the same way as utility tokens.
- You can’t convert a security token into a utility token
It’s a common belief that a security token is a Simple Agreement for Future Tokens (SAFT). Many people believe that once the network is operational, the security token will be converted into a utility token. But this is not what happens.
Even if both SAFT and security tokens are considered as securities, they work completely differently. Theoretically, a SAFT is an agreement to purchase future tokens that will come into existence once the network is operational. The proponents of SAFT believe that once that happens, tokens will already be functional and not going to be treated as securities under the Howey test.
However, security tokens are designed to function as securities. They’re not going to change their character once the network is operational.
- Regulations that impact STO
If you’re looking to launch an Security Token Offering, you need to have a clear picture of all the STO regulations. That’s especially important because the regulations tend to be strict and rigorous. They apply to everyone without any exceptions.
The community has introduced Market Access Protocol as a new standard in the trading of security tokens. The idea is to help businesses solve all the difficulties and existing inefficiencies that token qualification providers, investors, and token issuers encounter today. MAP will ensure that the flow of security transactions on the blockchain complies with SRC20, the security token cryptographic standards.
This protocol is a must because we still don’t know all the consequences of security tokens. That’s why it’s smart to keep your activities in compliance with the regulatory environment. For example, countries such as Malta or Switzerland have legislation in place that allows launching STOs.
All investors need to obtain permission or qualification to invest according to the regulations and laws that apply to securities. MAP also indicates the identity verification standards and makes it easier for investors to participate in STOs.
When to use an STO?
One of the key advantages of security tokens is that their treatment comes with a lot of regulatory certainties. However, the regulations are also the source of its limitations. Higher compliance costs, a smaller pool of eligible investors, lower liquidity, and restrictions of transferability – these are all the challenges you need to be aware of before launching an Security Token Offering.
For some business models like REITs, security tokens are a great match. For others, utility tokens might be better. Security tokens and utility tokens come with their specific advantages, and deciding which one is more suitable for your business model is critical.
You need to have a holistic look at how this choice will affect your entire business model. If you resort to quick fixes and blindly follow market trends without fully understanding their implications, you might be compromising your business idea.
Reach out to us if you have any questions about STOs and other recent trends in the blockchain scene. Our experts will be happy to advise you on technical and legal matters.