By: Dan Artaev and José Padilla
A security token offering (or “STO”) is a 21st century blockchain-based alternative to a traditional issuance of equity to raise company funds. Instead of selling shares of stock in a corporation represented by a stock certificate or uncertificated shares in a company’s stock ledger, a security token is a one-of-a-kind digital representation of such share of stock. In fact, a security token can represent many kinds of traditional financial securities, such as promissory notes, bonds, options, as well as stocks and other similar assets. For a startup company looking for venture capital, this article focuses on the use of security tokens to issue equity.
The main difference between issuing a security token and a traditional issuance of stock is that, while traditional stock is kept track by the issuing company on a ledger, a security token uses blockchain technology to authenticate the identity of owners separate and apart from a company’s ledger. Possession of a security token and its distributed ledger grants the rights to fractional ownership, and not the records kept by the company. In essence, token holders do not have to rely on central company management to keep track of their investment – their possession of the token is actual ownership.
Thus, a security token has certain benefits over a sale of traditional securities for startup founders:
- Unlike traditional securities, the STO eliminates third parties and middlemen inherent in a traditional securities offering, leading to greater efficiencies, lower costs, and a faster issuance process.
- Blockchain technologies are inherently transparent, as the digital ledger is public. This makes the offering inherently more secure.
- Security tokens are considered more liquid because tokens can be bought, sold, and traded around the clock. Clearance and settlement of any transfer of ownership can be instant and the process is automated.
- The digital nature of the tokens makes corporate governance and voting easier and more transparent.
- Launching a security token does not require surrendering voting rights to investors. The security token can be a share of profit or simple dividend.
STOs should not be confused with initial coin offerings (“ICOs”). ICOs boomed in 2017, as some companies turned to unregistered token sales to raise funds outside of the traditional securities disclosure, registration, and other legal requirements. ICOs also are associated with several high-profile “exit scams,” where cryptocurrency promoters claimed big plans for a new crypto project, collected funds from investors, and then simply disappeared with the funds.
By contrast, STOs are overtly the sale of securities and subject to the same SEC regulations that regulate the sale of preferred stock, such as Regulation D. Because of this, STOs may not be as revolutionary as other uses of blockchain technology, but at the same time, these regulations protect investors from the scams associated with ICOs. While the regulatory environment around digital assets is subject to change, as the White House’s recent executive order shows, STOs benefit from already being subject to well-known regulations.
For those wanting to wait on issuing security tokens, instead of using a SAFE (simple agreement for future equity), companies can offer investors a SAFT (simple agreement for future tokens).As cryptocurrency, NFTs, and tokens become more mainstream, it is important to recognize that the STO is a new way for innovative companies to raise funds. While these are still securities offerings that must comply with applicable regulations, the flexibility, transparency, and efficiency that these digital instruments offer are certainly attractive. At the same time, this sort of offering is new and rife with pitfalls for the unwary – and if you are considering raising funds using an STO, you should choose the right security token platform and legal experts, such as the experienced corporate lawyers at Padilla Law PLLC.