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SECURITY TOKEN OFFERING

The Security Token Offering (STO)​

There is a lot of hype surrounding security tokens these days, especially as the SEC has almost entirely suffocated the usage of utility tokens as unregistered securities. Security tokens are evolving as a new strain of cryptographic tokens, that are not only fully compliant with the SEC's regulations, but also backed by real-world assets.

Even though the security token market is evolving at a rather fast pace, the industry is still in its very early days. As such, there are numerous grey areas lying in both the market presented to token buyers, as well as the business models adopted by entrepreneurs and business owners looking to raise capital via regulated blockchain-based means.

Throughout this guide, we will walk you through and explain some of the basic concepts and definitions related to security tokens and security token offerings (STOs).


What are security tokens?

What does security token mean? Quite simply, security tokens are cryptographic blockchain based tokens that represent financial assets such as bonds, notes, debentures, shares (stock), options, and warrants. Holding security tokens representing company shares is a way to own a part of a company, without actually taking possession of it.

Governmental financial institutions and companies can utilize security tokens to raise money for various investors via security token offering (STO) based crowd sales. STO investors are promised gains in the form of dividends, staking rewards (interest rates), or increase in the value of the company.

Security tokens have minimal liquidity issues when compared to conventional securities (paper backed securities such as bonds, stocks, futures, etc). With security tokens, investors' dividends can be paid on a predefined date in the form of tokens via a specifically designed smart contract.

Another security token definition is that security tokens have to pass "Howey's Test", which was developed by the Supreme Court for determining if a transaction qualifies to be considered a form of "investment contract". As per the Securities Act of 1933, as well as the Securities Exchange Act of 1934, cryptographic tokens passing the Howey Test will be considered security tokens, rather than utility tokens. As such, security tokens are subjected to specific registration and disclosure requirements.

The Howey Test considers a cryptographic token to be a security token if it involves:


1- Investment of money
2- A common enterprise
3- Profit expectations
4- Work efforts of others

Observers of the cryptocurrency market can mark the occurrence of three waves of security tokens:

The first wave of security tokens: Security tokens exempted from the US SEC regulations. Security tokens from this category utilize regulatory exemptions for reputable, wealthy investors. These tokens have been used by cross-border investors. This wave of security tokens began in 2017.

The second wave of security tokens: Security tokens that will revolutionize identity management to yield a wave of security tokens that are compliant with US SEC regulations. Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations are automated via a new technology that sits on top of the blockchain layer of smart contracts. Hashing of AML and KYC regulations on a country-by-country basis can render cross-border transactions more feasible and more efficient. This wave of security tokens started in 2018.

The third wave of security tokens: This wave of security tokens is pillared on the reduction of regulatory risks, and seeking more innovative financial opportunities. These security tokens will focus on improving liquidity, boosting cross-border trading liquidity premiums, promoting compliance with AML and KYC regulations, and reducing settlement times. The third wave has the potential to properly tokenize existing assets, and automate the management of dividends, as well as STO team token lock-ups (vesting). In 2018, security token trading emerged, yet this required security token trading organizations such as Security Token Alternative Trading Systems (ATS), which represent hybrid platforms that can be used for both the issuance and trading of security tokens.

Observers of the cryptocurrency market can mark the occurrence of three waves of security tokens:

 

The first wave of security tokens: Security tokens exempted from the US SEC regulations. Security tokens from this category utilize regulatory exemptions for reputable, wealthy investors. These tokens have been used by cross-border investors. This wave of security tokens began in 2017.

The second wave of security tokens: Security tokens that will revolutionize identity management to yield a wave of security tokens that are compliant with US SEC regulations. Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations are automated via a new technology that sits on top of the blockchain layer of smart contracts. Hashing of AML and KYC regulations on a country-by-country basis can render cross-border transactions more feasible and more efficient. This wave of security tokens started in 2018.

The third wave of security tokens: This wave of security tokens is pillared on the reduction of regulatory risks, and seeking more innovative financial opportunities. These security tokens will focus on improving liquidity, boosting cross-border trading liquidity premiums, promoting compliance with AML and KYC regulations, and reducing settlement times. The third wave has the potential to properly tokenize existing assets, and automate the management of dividends, as well as STO team token lock-ups (vesting). In 2018, security token trading emerged, yet this required security token trading organizations such as Security Token Alternative Trading Systems (ATS), which represent hybrid platforms that can be used for both the issuance and trading of security tokens.

Security token offering process

Let us take you through the process of setting up a security token offering (STO).


Understanding regulations and legal compliance

Before launching a security token offering (STO), you have to understand the federal security regulations, especially if you are looking to accept investors from the USA. In the US, security tokens have to be compliant with one of the following regulations:

- Regulation D
- Regulation A+
- Regulation S


Regulation D

Regulation D will allow an STO to avoid registration with the SEC, provided that the issuers of the tokens have filled "Form D", after the security tokens have been sold. The party who is offering the security tokens can solicit offerings from investors in compliance with Section 506C.

Section 506C requires a verification implying that investors are provably accredited and that the information provided throughout solicitations is "free from misleading or false statements".


Regulation A+

This exemption will enable the creator of the STO to offer an SEC-approved security token to non-accredited investors via a general solicitation for an investment totaling up to $50 million.

For the requirement to successfully register a security token, the issuance of Regulation A+ can consume more time when compared to other options. For the same reason, issuance of Regulation A+ is considerably more expensive compared to other options.


Regulation S

This occurs when an STO is launched in a country other than the US, and is thus, not subjected to the registration requirements of section 5 of the 1993 Act. The creators of the STO still have to comply with the security regulations of the country where the STO is supposed to be launched.


When to launch an STO?

We recommend launching an STO to raise capital for a company or start-up which meets 2 or more of the following criteria. As such, consider launching an STO if your company is:


- Expected to generate at least $10m of revenue annually
- Planned to be a high growth start-up
- Conducting cross-border business
- Designed to issue transferable shares of an asset
- Interested in means of funding that connect with the company's customer base
- Looking for higher levels of liquidity for holders of shares of the company


Identifying your target customer base

Creators of STOs can look for full registration with the SEC, which is a legal, financial, and logistical dilemma. To skip this step, the company has to go for an "SEC exemption". To accomplish this, you have to go for Regulation D exemption, which prohibits sales to non-accredited investors from the US.

On the other hand, you can go for Regulation A exemption. Securities group Tripoint Global is on its way to become the first ever regulated company to offer sales of security tokens under SEC's Regulation A, i.e. it can sell security tokens to non-accredited investors from the US.

However, currently, you can only sell security tokens to accredited and non-US investors. Accredited investors refer to either individuals or institutions with a net worth of at least $1 million. You should only target these two groups in your STO marketing.

Issuance of your security token

One of the biggest problems associated with security tokens is liquidity. Prior to advent of the blockchain, trading fractional ownership of assets with low liquidity levels, such as private equity funds, or real estate investments, was almost impossible. With blockchain-based asset tokenization, the problem is much less prominent.

However, there are a few catches. Tokens have to remain legally compliant as they change hands, which mandates ongoing implementation of KYC/AML regulations all through the lifecycle of the token. Security token buyers must have a legally compliant platform to find one another: a security token exchange. The SEC has decreed that all crypto exchanges which list security tokens should register themselves as securities brokers.

Consequently, you have to pick one of the registered security issuance platforms to launch your STO. These include one of the security token platforms that we mentioned earlier such as Polymath, Harbor, Securitize, and others. 

(To be upgraded continuously)