An Overview of STOs and Private Offerings in the US
You own a startup, or an office building in Manhattan, and you’ve heard a lot of buzz about turning your asset into a security token. You likely have many questions, such as “What is a security token?”, “Why should I use a security token?”, and “How do I do that?”. I am going to help answer those questions and explain why issuing a security token is just a faster, more modern, and more valuable extension of a traditional security issuance.
What is a security token?
A “security token” is legally identical to a traditional security. The only difference between a security and a security token is the manner in which ownership is recorded. Simply put, a security token is a security that has been turned into a digital asset on a blockchain. If that sounds foreign to you, take a look at this helpful primer put together by Deloitte that explains the basics of blockchain technology.
To give a quick overview: a blockchain is a permanent ledger of transactions shared across a network of computers (nodes). In order for a transaction to be added to the ledger, it must be verified by other members of the network, after which it is stored in an entry “block” at the end of a sequence “chain” of all previous blocks. Because of the nature of how data is verified and stored on the blockchain, there are a couple characteristics that make it an ideal mechanism for recording and transferring ownership of assets:
It is trustless — because the ledger is shared between all nodes in the network, there is no single party responsible for honestly entering each entry. Instead, the members must work together to come to a consensus, eliminating the need to place trust in a central authority.
It is transparent and immutable — Records of all transactions are stored on the “chain” of previous blocks. These cannot be changed. By using blockchain, there is no longer a need for all parties to maintain their own ledgers: instead, they can use the shared record of the blockchain.
I heard a useful analogy for the tokenization of assets from Harbor CEO, Josh Stein. He equates the difference between a security token and a security to the difference between email and snail mail. Before email came along, written correspondence was slow and inefficient. Because of the effort that went into sending a letter, people simply did not send them that frequently. Not only that, but the recipient of a letter had to wait several days before the message got to them.
Email has made communication more efficient and more common. Think of all of the emails you send. For how many of them would you have taken the time to write a letter, address an envelope, put the letter in the envelope, lick, seal, stamp, and send? Tokenization offers the promise of both a more efficient securities market, and a larger and more active securities market. Much like the evolution from snail mail to email caused written communication to be more efficient and more common, tokenizing securities will make trading more frequent and more efficient, and will make more asset classes accessible to investors.
Why should issuers use a security token?
There are many advantages that issuing a security token has over a traditional security. The primary benefits can be broken down into transparency, automated settlement, fractionalization, global availability, and liquidity.
Transparency:
The transparent nature of each transaction means that the blockchain serves as a public record of ownership for your security token. Currently, private issuers are required to maintain a capitalization table recording the ownership of their security, which can be expensive. Companies are also only permitted to have a maximum of 2,000 shareholders before they are required to go public. Because of this, most private companies restrict their shareholders from transferring shares, which harms investors and employees by denying them liquidity. Through tokenization, it is possible to code regulations into the token, allowing issuers to authorize trading without having to worry about running afoul of SEC regulations. Issuing tokens instead of certificates eliminates recordkeeping costs and increases shareholder liquidity.
Automated Settlement:
Settling trades via blockchain reduces transaction costs. In a traditional securities transaction, there are several parties responsible for acting as a trusted intermediary to help settle the trade. For instance, central counterparty clearing acts as a trusted third party in the middle of trades to protect against either party defaulting. It is impossible to default in a security token trade, as the transaction can only be confirmed if both parties have sufficient funds to cover their obligations. Therefore, there is no need for rent-seeking third parties to participate in the trade.
Tokenization also greatly reduces transaction time. Traditional public equity trades settle T+2. This means that a transaction is confirmed 2 business days after it is initiated. So if you purchase shares on Monday, the transaction is not actually completed until Wednesday. Private equity trades can take anywhere from 30 to 90 days to settle. A security token trade is confirmed as soon as the exchange of tokens is confirmed on the blockchain. Nearly all security tokens are issued on the Ethereum network, and the average time for a block confirmation on Ethereum averages 10–20 seconds, so tokenization reduces settlement by orders of magnitude.
Fractionalization:
Let’s go back to that office building in Manhattan. Assume it’s worth $100MM. Trying to sell a hundred-million dollar asset is always going to be difficult, and ultimately results in you selling the asset for less than full value. There are a couple of reasons behind this discount: first, because the number of buyers willing to purchase such a large asset is limited, and second, because buyers understand the illiquid nature of the asset, and are not willing to pay as much for an asset that is difficult to resell. Now imagine you can split up your office building into a million freely tradable shares. Through tokenization, nearly all investors can afford to own a piece of New York real estate, increasing demand, and because the shares are liquid, investors are willing to pay more for each fraction of the real estate. You have just sold the building for more than you would have otherwise, simply because the ownership was tokenized.
Global Availability:
Tokenizing your security not only opens up investment opportunities to smaller investors within the US, it also provides easier access to investors of all levels throughout the world. Buying foreign securities in the traditional manner is a complex process. If the securities are even available, they are often offered with layers of costs and obscurity wrapped around them. Through tokenization, your offering can be easily purchased by an investor in China or Belgium, increasing global demand and liquidity.
All of these benefits result in security tokens being more valuable than their traditional counterparts. As I mentioned when looking at the tokenization of the building in Manhattan, increased liquidity often results in an increase in value, because investors are willing to pay more for assets they know can be traded easily. Increased divisibility, reduced fees, faster settlement, and global availability all do their part in making the tokenized asset marketplace liquid, therefore increasing token value. Automated settlement and automated recording of ownership also increase the value of tokens, as much less of the value is lost to middlemen and administrators in token trades.
How is a security token offered?
Technology
The benefits of tokenization should be evident, but the path to tokenizing an asset may not be so clear. Without a background in blockchain programming, it will be difficult to turn an asset into a usable token. Fortunately, there are several platforms that have been created specifically to aid in the creation and issuance of security tokens. From a technical standpoint, the vast majority of security tokens are ERC-20 tokens — tokens that are built on top of the Ethereum blockchain in adherence with the ERC-20 technical standard. Essentially, the ERC-20 standard introduces a set of rules that tokens should follow to ensure that they will interact properly with each other and the Ethereum network. This has the added benefit of creating a simple and widely available code template that can be used to create ERC-20 tokens. The act of creating an ERC-20 token on Ethereum is fairly simple from a technical standpoint, and with the help of a security token issuance platform, it can be as simple as selecting a name, ticker symbol, and token supply.
In addition to the ERC-20 standard, there have been new proposals for security token standards on Ethereum, such as ERC-1400 and ERC-1450.
Compliance
In the early days of cryptocurrency, initial coin offerings (ICOs) were offered without regard for US security regulations. This is largely because the tokens issued through these ICOs were so called “utility tokens” that did not represent traditional securities. This does not mean that they were not securities themselves, as evidenced by results like this cease and desist order directed at CA-based food app Munchee. Recent SEC statements have brought a bit more clarity to the regulation of token offerings. Statements like this from SEC chairman Jay Clayton indicate that the determination of whether a token is a security is done on a case-by-case basis. This determination is made primarily through the application of the Howey Test.
There is no uncertainty surrounding the classification of security tokens. Security tokens are, by definition, securities. Therefore they must follow the same regulations as any other offering. Navigating the regulatory framework surrounding security issuances in the US is a confusing and difficult process. Many of the security token issuance platforms will also help you with this. Choosing which exemption(s) to pursue is largely dependent on the security being offered, how much money is being raised, who can invest, and a variety of other factors, so I have prepared a quick summary of the most commonly used fundraising exemptions to help clarify the differences between each.
Reg CF
Pros:
Reg CF offerings are open to all US investors.
Easy Filing Process — A Reg CF offering requires the issuer to file SEC Form C
Cons:
$1.07MM/year maximum
Securities are restricted for a year
Financial statements are required
Reporting — Companies that perform a Reg CF offering become reporting companies, and must file annual and semiannual reports.
Reg CF is great fit for companies seeking to raise a small amount from an active and engaged client base. Reg CF allows companies to approach fundraising in the same way other entrepreneurs have used Kickstarters in the past, though for instead of iPhone accessories or board games, they are selling equity or some other security. Using Reg CF benefits the issuer, as it creates an engaged and active group of investors that act as free advertising for the project. The downside is that it is a complicated process relative to the amount of funding that can be raised. The issuer then becomes a reporting company upon completion.
Reg A+
There are 2 tiers of Reg A+ offerings. Tier 1 allows for raises of up to $20MM. Tier 2 allows for raises of up to $50MM.
Pros:
$50MM maximum
Open to accredited and unaccredited investors.
Securities are unrestricted
Test The Waters — Companies utilizing Reg A+ can take indications of interest from potential investors to determine if it is worth it to proceed with the formal Reg A+ approval process.
Cons:
Difficult Qualification Process — The qualification process for Reg A+ is both expensive and time consuming. The SEC review process typically takes around 3 months, and companies performing a Tier I offering must also undergo state review.
Reporting — Companies that perform a Tier 2 offering under Reg A+ must file annual and semiannual reports with the SEC (Tier I offerings do not require reporting).
The major benefit of a Reg A+ offering is the fact that the securities sold will be unrestricted. The securities are immediately tradable, allowing investors to capitalize upon the liquidity benefit tokenization provides immediately. Additionally a Reg A+ offering is open to everyone, not just accredited investors, which is great if you are trying to reach a broad investor base. The downside of using Reg A+ is that it is difficult and expensive. The registration process is by far the most difficult of any of the exemptions, and it can take a very long time — often over 90 days.
Reg D Rule 504
Pros:
Anyone can invest
Easy Filing Process — Issuer must file Form D with the SEC
Cons:
Maximum of $5MM
General Solicitation only allowed under specific circumstances
Securities are usually restricted
Reg D Rule 504 is great for issuers who are would like to raise $5MM or less. It’s relatively easy, and it’s open to the general public. The downsides are that the securities sold through Reg D are generally restricted, and general solicitation is usually not allowed. This is great if there is a lot of investor interest already, but not so great if you were looking to publicize your offering and build excitement around your business.
Reg D Rule 506(c)
Pros:
Unlimited Raise Amount
General Solicitation Allowed
Easy Filing Process — Issuer must file Form D with the SEC
Cons:
All investors must be accredited — Essentially you can only raise money through institutions and rich people.
Securities are restricted
Reg D 506(c) is the most commonly used private fundraising exemption in the US. It is popular because the filing process is simple, you can advertise, and you can raise an unlimited amount of money. The only downsides are that the securities will be restricted, and you have to ensure that all investors are accredited.
Reg S
Pros:
Unlimited Raise Amount
General Solicitation is allowed as long as it is not targeted at any US investors
Cons:
Cannot sell to US investors
Securities are restricted — generally, securities sold under Reg S cannot be resold to US investors for a year
Reg S is the regulation placed upon US issuers and foreign companies looking to sell securities to investors outside the United States. This is not really an exemption. It is more of a way for the US to extend their jurisdiction to securities offered outside their borders in an attempt to keep the securities from flowing back to US investors. Reg S is often used in combination with one of the other exemptions when issuers are selling to both US and international investors.
Putting it Together
Hopefully this article has convinced you of the merits of tokenization. The next step is finding the right partner to help you take your asset and turn it into a token. Platforms like Securitize, or the aforementioned Harbor specialize in the creation and issuance of security tokens. And once they are issued, these tokens can be listed on secondary exchanges, increasing liquidity for token holders. Tokenization shouldn’t be scary or foreign, it is simply a faster, better, and cheaper way to represent ownership of an asset.
