As originally published on: medium.com
It is clear by now that crypto companies who seek capital are not going to use utility tokens to raise that capital—not if they would prefer to avoid the consequences of breaking securities laws anyway. Gone are the days when entrepreneurs sold tokens that had no dilution effect or no payment obligation on the company. And those were the good old days.
Entrepreneurs could raise millions with no responsibilities to uphold to investors. Yet after thousands offered utility tokens to the public, and billions of dollars were raised, most of the utility tokens sold have either no value or no liquidity today. What happened?
The ICO Fever
It all started with the first ICO, Mastercoin, in July 2013. This was followed by Ethereum in 2014, which raised roughly 3,700 BTC in the first 12 hours of its presale. At that time 3,700 Bitcoin was worth $2.3M. By the end of its ICO, Ethereum would raise over $18M.
Then came 2017 and its deluge of ICOs as entrepreneurs realized they could conduct ICOs via the Ethereum blockchain and the sale of ERC-20 tokens. Billions were raised as the prices of Ethereum and Bitcoin soared, creating thousands of newly minted millionaires who reinvested some of their newfound capital into new ICOs. Many of these ICOs in 2017 were pure fraud, raised by founders who had no intention of building a business, and most of those that weren’t outright scams violated US securities laws. And so of course, the SEC analyzed the situation and eventually piled in, stopping the music.
What really happened is this: entrepreneurs were convinced they could get capital without giving away any equity or taking on debt. ICOs were an avenue to free money, so why not take it? The entrepreneurs who conducted these ICOs now claim that the SEC rules were not clear, yet the SEC issued its first bulletin regarding ICOs in July 2017. Many more followed.
For those that conducted the ICO before July last year, it’s possible they have a line of logic to hide behind, but for those that raised money through an ICO at the end of 2017 or in 2018? That defense begins to look a lot more flimsy, and the possibility that they were aware of the laws but did not want to follow them becomes a lot more likely.
A Light at the End of the Tunnel
Yet there is always a silver lining in any tragedy, including this one. Retail investors lost billions. So what? The good news is that through this loss, and the frothy market that birthed it, we discovered a new way for entrepreneurs to raise capital.
In fact, entrepreneurs can use cryptocurrencies to raise capital legally and in turn offer investors the protection they need for their money. This means entrepreneurs can avoid the SEC suing them or requiring a full rescission, in which all of the capital must be refunded to investors. This new phase of ICOs conducted within securities laws I once described as ICO 2.0, but the nomenclature is shifting. This capital raising model is now becoming known in the marketplace as an STO, or Security Token Offering.
What is different this time around is that the STO is here to stay. The model is similar to raising capital in the old days but with a new crypto twist. Investors receive their securities in the form of a smart contract, or token, but the securities themselves are the same thing that investors received in the days before crypto. Equity or debt, convertible note or revenue share, or numerous others.
There are many benefits of securities taking this new tokenized skin and no downsides. Most companies have been raising capital using Regulation D (a) or (b) and were issued the shares in book-entry format, which means investors never received a stock certificate. Let’s look at the upside for tokenizing securities in contrast to this format:
- Public view of the capital table — every shareholder will have a blockchain address, whether on Ethereum or a different chain. Each address contains a number of securities. On-chain, these tokens are not the actual ownership, just the representation of it (i.e. if you lost your tokens, you could get them reissued to you just as you could get a new deed to your house if you lost that). Call this on-chain representation a ceremonial display. Investors like the idea of knowing how many shareholders really exist and how many securities are out there. Those in the security token space will often reference the Dole Foods case, in which it was discovered there were more Dole Foods investors than the cap table had accounted for, as a reason why this is beneficial.
- Access to liquidity — currently, the majority of investors who purchase securities in a private enterprise or limited partnership do not have liquidity until the company is sold, goes public or the partnership is dissolved. This may be great for rich investors, but a capital lockup of 7–10 years is not acceptable to the general public. Through tokenization, securities can be traded on Alternative Trading Systems (ATS) in small trades without requiring an attorney for every transaction. The ATS can handle these trades, assuming every investor has the same agreement and their holdings do not have transfer restrictions other than the SEC-mandated ones.
- Larger shareholder group — with the JOBS Act, a tokenized offering can be sold to the general public — the same people who were participating in ICOs. ICO participants now have crypto, but most of them are still non-accredited investors (meaning they have a network of less than $1M excluding their primary residence or they have an annual income of less than $200K over the last two years). Non-accredited investors can purchase security tokens in a Regulation Crowdfunding or Regulation A+ offering. Regulation D, the other exemption mentioned above, won’t work if you want to offer the sale to the entire public.
- Automation and price reduction — the robot killed the broker, the floor trader, the assistant, the attorney and many others. Using tokenized securities, the costs for issuing and trading securities will go down. Think of the ATM machine, which droves banking costs down more than 95%.
- Lower cost dividend distribution — imagine this: you could get a $100 dividend from a company but get charged $15 for the processing. With cryptocurrencies, that charge could be 50 cents! This is a significant improvement. The company would pay investors in a stablecoin currency, and those investors can decide when to convert it into fiat.
The next big challenge with security tokens is how to reconcile the dozens of different standards being offered to the marketplace. A few of the major players are below:
- R-Token — a standard developed by Harbor that focuses on real estate and accredited investors. Harbor has built a smart contract for partnerships and larger corporations that checks users against a whitelist at the token level. While the Harbor team is baking in compliance into their R-Token, the smart contract still dictates communication with a “Regulator Service,” meaning that ownership is stored off-chain, which at present for R-Tokens means on the compliance platform Harbor itself.
- ERC-1400— a standard developed by Polymath, formerly known as ST-20. Polymath is working on tokenizing any kind of asset that is offered only to accredited investors. They automated the services required for issuing a token and then trading it. ERC-1400 works as an umbrella that interoperates with several other token standards to handle fungible and non-fungible trading restrictions. They promise on-chain ownership but have not made the case why this is legally binding.
- ERC-1450— a standard developed by StartEngine (full disclosure: this is my company). The proposed standard ERC-1450 is more of a dumb contract than a smart one. It is simply a digital stock certificate. The investor can take possession of their tokenized certificate but cannot transfer it. Ownership is also stored off-chain with a registered transfer agent. It is that registered transfer agent that will initiate the transfer after a trade was completed on an ATS by a broker-dealer. This process ensures trading follows the rules of Regulation Crowdfunding and Regulation A.
- SRC20— a standard developed by Swarm Fund. Swarm is an asset tokenization platform that runs on a utility token (SWM), and Swarm users can buy security tokens (SRC20) on Swarm’s private blockchain on a cold fork of Stellar. Trading of SRC20 tokens also occurs on the private blockchain to ensure that Swarm can monitor trades and ensure compliance. These tokens are also designed to interoperate with other compliant platforms.
- DS Token— a standard developed by Securitize, a company that focuses on the primary issuance of securities, so their standard can handle issuance, paying dividends, and voting rights. However, Securitize understands that secondary trading must be compliant as well, so their DS Protocol breaks the peer-to-peer transfer function of ERC-20, and all trades must be approved by their ‘Compliance Service,’ an on-chain control unit, that references an on-chain registry to verify investor status before executing the trade. To buy and sell DS Tokens, you must first be onboarded to the DS Protocol and have an identifying hash in the registry.
- ERC-884 — a standard developed by David Sag, in which each ERC-884 token represents a single share in a Delaware corporation. The standard is designed for equity sales, and the owner of the token must be white-listed, a process written into the smart contract itself. However, in order to comply with securities laws, issuers of ERC-884 must maintain an off-chain private database.
- ERC-1404 — a standard developed by Tokensoft. ERC-1404 adds one simple function to ERC-20 tokens with a few lines of code. With ERC-1404, the token issuer can restrict the transfer of those tokens, depending on the offering’s needs and the regulation of their jurisdiction.
The future for security tokens is bright. However, there will be a process of transition as the 7 standards listed above (and the many more that I did not get into describing here) transform from proposals to implementations in issuance and trading infrastructure. Once adoption begins to occur, a few security token standards will begin to emerge as market leaders, and the rest will fade into the past as platforms back into standards that achieve success. Such is the nature of capital markets.
Rome was not built in one day, and the same will hold true for security tokens.