A Security Token Offering (STO) is a form of raising capital for a startup by distributing tokens to investors. While ICOs mainly deal in utility tokens that grant their holders access to services and products associated with respective blockchains and dapps, security tokens can be thought of as digital documents representing the investor’s rights to equity, a revenue share, debt, etc. STOs provide a better investor protection as they need to be compliant with appropriate regulations
Last year Bitcoin saw a massive price appreciation hitting an all-time high of $19K in December. The wild success stories of early bitcoin enthusiasts attracted a wider audience hoping to get their slice of the pie. Token sales became a popular capital-raising method for blockchain startups. The ease and freedom that ICOs offered is what brought many retail investors into the space. Never before has investing been as easy as it is with ICOs, for buying tokens is a matter of only a few minutes. However, the lack of regulation means that that token sales offer minimal investor protection and, naturally, many ICOs turned out to be blatant scams.
Utility of utility tokens
Utility tokens sold during ICOs represent the holder’s access to the services offered by the dapp or blockchain in question. However, these tokens have no intrinsic value outside the blockchain. The value of utility tokens outside their system is usually subject to speculation. For example, bitcoins are utility tokens in that they are tokens native to the Bitcoin system. Bitcoins represent the holder’s ability to transfer value. And Bitcoin’s value largely depends on whether people believe it is useful.
The return on investment in utility tokens comes only as the tokens appreciate. In an ideal world, this happens when the dapp or blockchain proves its usefulness and creates a demand for its tokens. Sadly, this is not the world we live in, and the cryptocurrency market, young and ambitious, is subject to manipulation and fraud.
Security token as claim to securities
Like utility tokens, security tokens are issued on a blockchain. However, unlike their predecessors, security tokens represent the holder’s claim to an equity, debt, a share of revenue, etc.
The term ‘Security Token Offering’ was first mentioned in April 2017 in a blog post by Manhattan Street Capital. Of course, the idea of tokens that are tied to real assets was not new to the blockchain space, as we saw various startups hold regulated ICOs and ICO 2.0, which were essentially STOs. The first official STO was held by St. Regis Aspen Resort on Indiegogo platform. The company raised $18M.
All STO must comply with appropriate regulations. For example, in the U.S. an STO is required to be registered with the U.S. Securities and Exchange Commission (SEC) or use an exemption from said registration.
Regulation D and S
STOs are typically held using an exemption called Regulation D (506c), which is a public offering of securities to accredited investors (anyone with a net worth of $1 million or more or an annual income of $200,000 or more for the past two years—$300,000 in combined annual income for spouses). This means that retail investors can participate in the STO but they first must verify their accreditation status with the SEC.
Regulation S is similar to Regulation D with an exception that this type of STO will not be extended to non-US investors.
Regulation Crowdfunding, an offering for the general public, meaning both accredited and non-accredited investors can participate in the offering, but there is a limit to how much an STO can raise in a given year, the limit being $1,070,000.
The last and most important exemption is Regulation A+. Like Regulation Crowdfunding, it allows everyone to participate in the STO but in this case the company can raise up to $20M for Tier 1 and $50M for Tier 2 annually. Such STO must be qualified by the SEC, which is different from the other exemptions.
One of the crucial reasons as to why Regulation A+ is important for the blockchain space, besides a higher limit, is that there is no lock-up period for trading these security tokens, meaning you can buy and sell them on the same day. Regulation D, S, and Crowdfunding STOs have one year lock-up before the tokens can be traded on cryptocurrency trading websites, which is the main attraction for small-time investors. Additionally, exchanges usually do not hurry to list security tokens as those lack liquidity and imply a large amount of legal compliance to be done.
STOs have been on the rise for some time now and many believe this is the right direction that blockchain landscape needs to take in order to have a more robust and secure token economy.