WHAT IS A SECURITY TOKEN OFFERING (STO) AND HOW DO YOU LAUNCH IT?

SECURITY TOKEN OFFERINGS (STO): AN ALTERNATIVE WAY OF FUNDRAISING FOR BUSINESSES

Security Token Offerings (STO) are the future, the future of how we’ll buy shares, bonds or any form of securities.

In this article, we will explain to you exactly what a security token offering is and its advantages. We’ll also discuss how you can launch your own security token offering in Europe, fully compliant with the European securities law, and at the same time, giving your investors the opportunity to invest in an attractive financial instrument. This article is intended for innovators and entrepreneurs who want to raise funds for their business through alternative methods.

Distributed Ledger Technology (DLT/blockchain) enables the secure and transparent transfer of values on the internet. Blockchain-based Initial Coin Offerings (‘ICO’) promised to provide an alternative and novel source of venture financing using unique features of ‘tokenization’. The phenomenon dates back to 2013, which was mostly used by ventures having blockchain-based business models. Since then, the number and funding of projects have been growing exponentially until the trend took a halt in late 2017. While ICOs provide a promising financing option for certain companies, such as decentralised business models or blockchain protocols, they typically don’t suit regular businesses. This is primarily because most businesses might not require a blockchain-based business model and even if they do, most of them don’t require a token for their day-to-day operations. Additionally, a lack of proper regulatory clarity on the ICOs made it hard for various ventures to pursue the same.

However, one thing that the ICOs have shown us is the usage of tokens. Tokenization offers a viable solution to issue financial instruments via blockchain-based tokens. With ICO, you can say that the genie is out of the bottle.

Utility tokens and payment tokens

Tokens are simply a digital representation of value on the blockchain. European Securities and Markets Authority (ESMA) also refers to them as crypto-assets, a type of private asset that depends primarily on cryptography and blockchain. They can be divided into three categories, which are so-called: utility tokens, payment tokens and security tokens.

Utility tokens provide digital access to an application or a service (e.g. a software license or a voucher). Most ICO tokens are utility tokens. An example of a payment token would be a complementary currency for a blockchain-based distributed network for computing power: the only way to access the network is via the use of the token. Investors of such tokens don’t receive any stake or share of the company building the product, but only an early option to purchase the future products or services.

One fundamental flaw of the ICO model, or the sale of utility and payment tokens, is that the mechanism only fits a very small fraction of the market:

1. A company has to make use of blockchain technology.
2. The sold tokens need to have a relevance for the business model.
3. Investors are not protected, as their contributions may be classified as donations.

PHOTO BY TOBIAS SEIDL

Security Tokens 

Security tokens are blockchain-based tokens that qualify as ‘transferable securities’ (specific to EU classification of securities). In security token offerings (STO), ventures sell tokenized financial instruments, like equity, debt, profit sharing rights or any other instruments in the form of a cryptographic token. In theory, this has a number of advantages:

1. These tokens can be issued by any venture: both digital and non-digital.
2. Clearing and settlement can be done in a matter of a few minutes.
3. Tokens can be held personally, i.e. brokers and custody accounts are technically no longer required to store the assets.
4. The underlying blockchain ensures transparency of all transactions at all points of time and also provides a consolidated transaction ledger.
5. Regulatory statuses of such tokens are quite clear - as compared to the ICO tokens (utility and payment tokens).
6. Tokens are immediately transferable and can be traded 24/7 on secondary markets, on a peer-to-peer basis.

A new era of the capital market

Startups and small to medium sized enterprises (SME) often face barriers to access capital markets due to financing options. Two major factors can be responsible for the same - high costs associated in fundraising through capital markets, and complicated processes in managing relations with various parties in capital markets. Security tokens can enable ventures to access the capital market by increasing the operational efficiency and by reducing the cost associated with the same.

Organisations like OECD and World Bank have time and again mentioned that SMEs must be able to access capital market instruments in order to have a better financial inclusion. The current capital market is dominated by a limited number of ventures. Tokenization is a way through which every venture can issue financial rights attached to it through crypto-assets or tokens. With an emphasis on cross-border, harmonised capital market laws in Europe, time has never been better for a new era of capital markets to take off.

Security tokens combine the elements of blockchain technology, especially transparency and security, with the legal certainty of traditional financial instruments. Offerings of security tokens promise to better fit ventures and investors at the same time. If you want to follow the market of security with us, please subscribe to our newsletter tokens here.

HOW TO LAUNCH A SECURITY TOKEN OFFERING IN EUROPE

KEY MILESTONES OF A SUCCESSFUL STO LAUNCH:

1. STO pre-planning

2. Planning (rights attached to the security tokens, legal and tax considerations, selecting the right target audience)

3. Before the STO

4. During the STO

5. Post-STO compliance and investor relation

1. STO pre-planning

At the time of writing this article, us at STOKR have received over 150 queries regarding STOs. Oftentimes, we have seen that founders want to jump on the STO hype in the hope of raising “easy cash”. We appreciate entrepreneurial spirit but discourage such a hasty decision.

We strongly recommend considering the following few things before thinking of an STO for your business or venture:

a. Do I need external finance?

b. Do I need investment from a large pool of investors?

c. Can an STO help my business other than fundraising? Will an STO campaign help my brand or business to gain a wider user base?

2. Planning 

Once you have the right reasons for an STO, consider the following steps crucial during the planning phase.

a. Turn-key or white labeling: which fits the best?

The security token service market is broadly divided into two segments: service providers that provide whitelisting technology solutions and service providers that provide turn-key solutions. If you are only contended by getting the technology for the issuance of security tokens, white labeling solutions are best suited for your needs. You can customise your requirements and reach out to various service providers on your own. In most cases, you will require an in-house tech team to update the solution to keep your platform up-to-date.

Turn-key solution providers provide the technology, integrated payment gateway, regulatory support, and compliance support, all under one umbrella. This standardizes the process for your investors and helps you to focus on your investor acquisition. In case you don’t want to have a technology team on your payroll and you want your investors to have the best experience, turn-key solutions are the right fit.

At STOKR, we provide you the turn-key solution. From technology support to payment gateways, and investment structuring to wallet registration, STOKR enables the opportunities for both the issuers and investors to have the most secure, advanced, and user-friendly investment experience.

b. The economic nature of the security token

Which economic rights will the security tokens give to the investors? Is it a debt instrument, or an equity, or a preferential equity instrument?

It’s very important to structure an instrument which provides an upside potential to your investors. We recommend setting up a few discovery calls to understand them and their interests better. Frankly speaking, if your instrument is not attractive for the investors, tokenizing the same will not bring any added value.

On STOKR, you as a founder can issue two kinds of security tokens: one is revenue sharing and the other is profit sharing.

c. Legal

First, analyse which country you want to choose the issuance of the security tokens from. Then narrow down your target market. Thirdly, consider what rights the security tokens will provide to the investors. All of these factors will influence the legal requirements you need to fulfil for the issuance and management of your security tokens.

Currently in Europe, we have seen Luxembourg, Germany and Liechtenstein as the countries of choice to issue security tokens from. As an issuer, you must be aware that few European countries allow you to maintain the investor register fully on the blockchain. Luxembourg is one country where you can do this. Once the investor register is on the blockchain, issuance, trade, and settlement of security tokens can be all done on the blockchain itself.

A proper legal consultation is highly recommended. As the security token market is currently developing, a case-by-case legal analysis is currently required for every issuance.

3. Before the STO

In this stage, we recommend you to decide on the technology you want to use for the issuance of security tokens. As of date, Ethereum is the most widely-used platform. However, we expect that this may change in the coming months. Other blockchain infrastructures are getting more and more popular. For example:

1. Liquid Securities Network
2. Algorand
3. R3
4. Dusk

Once you decide on the technology, it’s important to fix the numbers concerning the security token offering. The exact security tokens to be issued and the total security tokens in supply must be properly mentioned - not only in the offering document of the security token, but also in the code itself. Auditing of the code is a must.

It is important as a founder that you make yourself available for your prospective investors to answer all the queries. We recommend taking professional support in organising investor meetings if you are looking for a bigger STO round. Companies like KrestonRS and Apollonian are already supporting European companies in managing investor relations.

Compliance is key. As an issuer you will have the responsibility to identify your investors. Based on the services you choose during your planning phase, you may receive guidance from your solutions partner.

To target investors from various backgrounds, you need multiple payment gateways, with multiple currencies (Euro, Dollar, stable coins like Tether, Bitcoin, Ether etc.). Choose your payment provider carefully and don’t forget to check the regulatory approvals they have.

As a turn-key support, STOKR provides you integrated payment channels through our partners at Lemonway, Bitfinex, and Kraken.

4. During the STO

Now you’re at ground zero. The following steps correctly are very crucial during this phase.

a. Proper support channel for the investors who are signing up and investing in your project.

b. Regular communication with your investor community and updating them about any achievements.

c. Coordinate with your compliance team on a regular basis.

d. Organise investor roadshows and provide them with proper documentation.

e. Organise webinars.

f. Brand visibility at key events.

5. Post-STO compliance and investor relations

After the STO is concluded, check with your team/service provider whether the security tokens have been issued to the right addresses of the investors.

Remember that security tokens can only be transferred to another address if they are properly identified. As an issuer, you must have the visibility of all your security token holders at any point in time. Therefore, there must be a possibility for a constant KYC/AML process even after the issuance of the security token is done. This will enable secondary trading.

If you have created a Special Purpose Vehicle, it’s important that you choose the right partner to administer the legal entity. This is the vehicle that will engage with the investors. The right partner is relevant for investor confidence.

We recommend you to provide your investors a bi-annual update about the business progress and the roadmap. With security tokens, you can simplify the corporate governance processes and the compliance processes. No need to employ a huge secretarial staff for such activities.

As the European security exchange market will develop in coming years, finding the right exchange for your securities will be crucial. We are expecting some developments at the end of 2020.

Want to set up a demo call with us? Please follow the link here, or write us an email at [email protected].

Did learning about STOs tickle your fancy? Are you interested in using an STO platform, like STOKR? To invest in innovative companies or raise investments, click here. 

BY LENNART ANTE & ARNAB NASKAR