Security Tokens Transform ICOs. 2017 was arguably the year of the initial coin offering, with over $4.6 billion raised through startup financing. 2018 looks like it will become the year of regulations for the cryptocurrency industry. In fact, the tremendous growth in ICOs is one of the reasons why financial regulators across the globe have decided to hone in on the crypto asset market.
For the most part, startups launching token sales claim that they are issuing a utility token, which would preclude them from the realm of securities law in most jurisdictions. However, many of these tokens have the characteristics of securities, which is why financial regulators are taking a closer look.
To continue using this method of funding, a new form of token sale has emerged that marries the benefits of initial coin offerings and the sale of regulated financial securities in an initial offering.
What is a security token?
Issuing a security token is a new form of financing that enables companies to raise funds from investors through issuing a fully-regulated “digital share” of its equity, assets or part of its revenue. Security token offerings combine aspects of ICOs with IPOs to provide the seemingly perfect balance between gaining access to capital at a low-cost while remaining compliant with securities laws.
Furthermore, security tokens can go beyond the current cryptocurrency-based crowdfunding model to also incorporate other types of financial securities such as debt offerings, for example. Tokenized securities projects such as Overstock’s T-Zero exchange are banking on security tokens becoming the next big thing and they may be correct.
Through issuing digital tokens that provide similar rights to shares, companies have the potential to access more investors and at a lower cost than if they were to list shares on a stock exchange, making them more appealing to younger investors.
However, before that can happen, the digital token trading ecosystem must mature to the level where exchanges are secure and liquid enough to be able to handle trading volumes approaching those found on international stock exchanges.
SAFT: The predecessor to security token ICOs
Before securities tokens started to appear in the ICO market, we saw the utilization of so-called Simple Agreement for Future Tokens (SAFT) by startups that wanted to ensure that they remain fully compliant with U.S. securities law.
SAFT agreements enable accredited investors to purchase contracts during a token offering for which they will be rewarded with the newly-issued tokens that the startup is launching, once the company has developed a fully-functional utility token that is being actively used in the project’s platform.
SAFT agreements are based on the idea behindSAFE (Simple Agreement for Future Equity)contracts, which were spearheaded by San Francisco-based tech accelerator Y Combinator as an alternative to convertible notes. SAFE contracts allow angel investors to put cash into a startup and then receive their shares once a specific trigger event has happened such as a new funding round or the sale of the company.
The first high-profile SAFT contracts that were sold to investors was during the ICO of the decentralized cloud storage platform Filecoin in mid-2017, which raised over $257 million. Messaging giant Telegram also made use of SAFT agreements when it raised $850 million during its token pre-sale in Q1/2018.
How security tokens will transform utility ICOs
Financial regulators are keeping a very close eye on initial coin offerings due to a large number of scams that have flooded this market. Moreover, many regulators consider ICOs that sell a utility token should still fall under securities law as most are effectively securities.
For many issuers the risk that their ‘utility token’ will be considered by regulators as a regulated security will become too great to bare. Accordingly, many will choose to issue utility tokens in a compliant way (as if they were securities).
Additionally, the introduction of truly compliant security token exchanges like TZero will enable a new breed of token issuer to come to the market that offers economic incentives similar to dividends in shares, or other revenue streams that are undoubtedly categorized as securities.
Issuing a security token will, eventually, become more straightforward than launching a utility ICO from a regulatory and legal standpoint, with the caveat that the overheads will probably be higher as it involves regulatory compliance and more legal fees. A “normal” token sale can be conducted with very little upfront capital, especially if the startup has an exciting product that the cryptocurrency community is willing to invest in. A security token ICO, on the other hand, will require more capital regardless of the quality of the company’s product.
It is thus unlikely that utility token ICOs will be replaced entirely by security tokens as smaller startup projects will choose to either run the risk of operating in a regulatory grey area or will merely engage in regulatory arbitrage and base their operations and crowdsale in countries that have ICO-friendly regulations.
The future of security tokens
Having said that, security tokens have the potential to become the go-to form of funding for more established startups and for companies that want to tokenize their securities offering instead of listing shares on a stock exchange.
Security ICOs will thus likely become a real competitor to traditional IPOs as the costs for an ICO remain cheaper and as more investors realize the advantages of digital tokens over “real shares”.@BPI
