In 2017, initial coin offerings (ICOs) became the preferred method for funding new entrepreneurial ventures, outperforming venture capital funding with more than 5.6 billion dollars raised. 435 projects successfully launched out of 913 attempted, and the average successful project raised close to $13 million. Filecoin, which focused on using blockchain technology to create a decentralized data storage solution, was the most successful of the ICO projects and raised a mind-boggling $257 million in September of 2017.
Even as ICOs flourished in number and size, it became apparent that ICOs have many important shortcomings. While diehard blockchain and crypto enthusiasts are still scurrying around trying to understand ICOs and how to use them to their advantage, we are seeing startups turning to an even better way of securing funding: security token offerings (STOs).
A close look at ICOs
To help understand why STOs are more effective and may be considered the next big crypto trend, we must first take a close look at ICOs. With ICOs, startup owners can sometimes eliminate the traditional methods of early seed investment and raise funds from mainstream investors with a direct interest in their projects. A key advantage of this type of fundraising is that instead of selling equity and diluting early shareholders, the company issues digital tokens or coins that allow supporters to benefit from the success of the business in ways more akin to partnership or agency. While in theory the idea of having so-called functional tokens that are not securities and that power the company’s business network sound great, in practice very few projects are truly selling functional tokens in the eyes of most regulators leading to the perception that many if not most ICOs are either skirting or flouting securities laws.
One of the primary problems we are seeing with ICOs is that some of them are scams. And then there’s the major issue surrounding the fact that some of the tokens being sold are actually securities, which comes into a direct violation of the U.S. securities law. And if you thought the Securities and Exchange Commission (SEC) was going to sit back and let this issue be swept under the rug, you’re wrong.
In light of this emerging trend and due to the fact that many projects have either been abject failures or outright fraudulent, in July of 2017, the SEC published a detailed report outlining their position that most if not all tokens being sold should be classified as securities and would thus be subject to regulation. Their follow-on actions that began in earnest in February of 2018 have created a dramatic increase of interest in compliance and the opportunities presented by STOs.
What are STOs?
There are several drawbacks to crypto including “abuse of opportunity by certain actors, misconception of decentralization, and unknown territory for regulators.” STOs help address both the abuses and uncertainties of ICOs by embracing the fact that the tokens being issued are securities. STOs provide a smarter and more innovative approach to capital funding that democratizes access to both investment and capital while providing greater transparency. STOs allow issuers to eliminate “the middlemen” and enjoy the benefits of tokenization: reducing fees, expediting deal execution, and ultimately, enabling access to a much larger number of potential investors. It also comes with the added benefit of not being able to be manipulated by a financial institution.
While STOs still represent a tiny fraction of tokenization transactions today, this will be a rapidly expanding segment moving into 2019 and beyond. Not only will STOs overtake ICOs as a fundraising mechanism, STOs will eventually overtake traditional fundraising arrangements as well. As public markets continue to dry up, significant Wall Street capital is predicted to flood the crypto-assets ecosystem in search of new places to invest, and this capital investment is going to come in the form of securities coins rather than utility coins.
What can go wrong with ICOs?
A quick look at a few projects from the past will give you a clear understanding of just how problematic ICOs can be. Take, for example, BitConnect. Due to a lack of liquidity, its token has been completely de-listed from all cryptocurrency exchanges. Everything from bad press to regulatory scrutiny and class-action lawsuits have contributed to its inability to stay afloat.
And then there’s Tezos, a crypto project that raised more than $230 million on its ICO in 2017 alone. Ever since, however, the project has rolled downhill. From lawsuits to being labeled “the crypto world’s biggest scandal,” Tezos continues to see its valuation decrease. In fact, on August 13, 2018, it dropped down to $7.5 million, which is far from where it had steadily remained at $1 billion.
To see what a crypto scam looks like in practice, check out this helpful link.
Distinguishing utility tokens from securities tokens
In spite of continued attempts from some quarters to muddy the water and imply that there is a lack of certainty around the classification of tokens as securities, there is clear precedent in the U.S. around what investments are deemed securities. The Howey Test was established in 1946 (SEC v. W. J. Howey Co., 328 U.S. 293 (1946) to distinguish securities from other forms of investment and can be used to differentiate securities tokens from utilities. According to the Howey Test, the following criteria identify an investment as an investment contract (and thus dictate if it is a securities token):
- The user is purchasing the token as a way to invest money
- The user has an expectation of making money from the investment
- The investment must be in a “common enterprise,” however a “common enterprise” has yet to be precisely defined
- The profit made from the investment comes through the hands/effort of a third-party/promoter
Many token issuers often assume that their token is a utility as long as a token has a specific use case to power the ecosystem. They also believe that if nobody controls the circulation of them and an exchange of these tokens occurs outside of “common enterprise” involvement it would further solidify them as utilities. In addition, they tend to be certain that it is an absolute necessity to issue their native token to promote, incentivize and motivate users. Many ICOs may actually be incorrectly operating under the guise of a utility token when, in fact, they should be structured as a STO. However, some possible examples of clear-cut utility tokens or coins, such as Bitcoin and Ethereum, exist.
Securities tokens on the other hand, give their holders equity/debt position, profit sharing, dividends, voting rights, and other benefits in the company. In other words, they represent an intrinsic value. Some recent examples of specifically designed STOs include tZERO, an alternative trading system for securities tokens. Aspen Coins is another example. These coins represent tokenized shares of St. Regis Aspen Resort real estate project. And, of course, Token IQ, a SaaS blockchain platform for tokenization of securities, which offered its investors tokenized equity ownership in the company.
STOs, when they comply with regulatory requirements, are certainly more attractive to sophisticated investors due to reduced risks, efficiency, transparency of the ledger, and an enhanced level of protection for all parties involved in the transaction. As we get farther into 2018, we will likely witness the increase of enforcement by SEC on non-compliant ICOs, which will greatly expand the preference and use of STOs.