What Are Security Token Offerings (STOs)?

Dec 14, 2021 05:26 PM ET
What Are Security Token Offerings (STOs)?

In 1946, the Supreme Court set a precedent as to what qualifies as a security. The definition became known as the Howey Test, which is a transaction that involves:

  1. An investment of capital.
  2. An expectation of monetary gain.
  3. An investment in a common enterprise.
  4. Profits come from the efforts of a third party, as opposed to the investor.

A security token, on the other hand, represents a stake in a valuable asset, such as shares in a company, a piece of real estate, a work of art, or even a vehicle. When one purchases a security token, their ownership rights are stored on a blockchain. It differs from a utility token by conferring these rights of ownership rather than just giving access to specific services.  

Advantages of security tokens

Security tokens can be utilized by startups and companies looking to crowdsource funds by distributing their shares to investors. Since tokens are stored on a blockchain, they enjoy the following perks.

  • They are transparent as all transactions can be viewed and audited at any time on the blockchain. However, the identity of investors is kept anonymous. 

  • They help divide valuable assets such as art and real estate, making them far more affordable to the common investor.

  • Changing the ownership of assets has traditionally been a lengthy process. By employing a blockchain, one cuts down on this time of transference to a few minutes.

  • Digital asset markets are open 24/7, every day of the week. This means there is no downtime to trading and issuing security tokens.

Types of security tokens

1. Equity tokens

This is a token that grants the holder an ownership stake to a valuable asset, just like shares to a company. Such a token may carry voting rights, dividends, or both. Such terms and conditions are stipulated in a contract. 

2. Debt tokens

This token represents a debt owed by the holder, which accrues interest over time. To that end, they manifest in two types: stable debt tokens whose interest is at a fixed rate and variable tokens whose interest varies.

3. Asset-backed tokens

These give their holder an ownership stake in a tangible or intangible asset in the real world. 

4. Utility tokens

These are used to obtain funding to develop a blockchain project. In return, the holders can use them to purchase items on the blockchain. 

Security token offering (STO)

An STO is a public offering on which valuable assets are sold in a digitized format. Further, all these transactions are stored and validated on a blockchain, which is essentially a public ledger. The marketplace on which this happens is called a security token exchange. Since they are classified as securities and thus subject to regulation, STOs are a much more secure way of investing than initial coin offerings (ICOs).

How STOs work

In essence, STOs help startups and project development teams raise capital for building blockchain projects. Traditionally, they had to approach venture capitalists to secure said funds, which presented a whole set of hurdles. Being subject to laws and regulations, STOs provided a safe alternative for companies to acquire these much-needed funds. 

Security tokens also enable the division of real-world assets. For instance, a painting worth $2 million can be represented by 1,000 tokens, each of which will cost $2,000 to purchase. This way, such a painting becomes easier to trade.  

Security tokens can be used to represent real estate, company shares, commodities like artwork, or even equity funds. For the latter, security tokens can earn the holder a percentage of the equity fund’s profits. 

Please note that tokenization does not in any way change the nature of the underlying security. It is still the same security, be it company shares or a commodity. 

Factors to consider when launching an STO

1. The asset being tokenized

Depending on the asset you’re selling as security tokens, you may be subjected to different laws and regulations. Further, different assets may pique different levels of interest among investors. 

2. The jurisdiction you fall under

Depending on the location of you launching the tokens, different laws may apply to your case. Further, you may need to tweak your marketing techniques to suit that specific area. You may also be subjected to different tax obligations depending on the jurisdiction you launch your STO in. The number and nature of token holders may also be limited by law, such as limiting them to citizens only. 

3. AML, KYC

This stands for Anti-Money Laundering and Know Your Customer. Most countries have AML and KYC requirements so as to ensure that your investors’ capital was acquired by legal means. 

4. Tokenization platform

There are several platforms on which you can tokenize your assets, such as Tokensoft, Securitize, Token IQ, etc. Your choice of platform will determine the price you pay for partnering with them and the commission you’ll pay on the funds you raise. You should also ensure the platform has provisions for running KYC and AML checks, as well as a good track record of launching tokens successfully.

Drawbacks of STOs

The regulations which make STOs safe and secure investment vehicles are also their Achilles’ heel. These regulations may make administrative processes more difficult. What’s more, STO platforms have to constantly keep up with changing AML and KYC requirements and other laws. These regulations may also limit who can invest in these tokens. In the US, for example, the limit is 99 investors residing in the country. 

Conclusion

Security tokens offer a safe and secure way of investing, where investors are granted an ownership stake in the company or underlying asset. Such tokens may carry with them voting rights and/or dividends. Before offering tokens for sale to the public through an STO, you should consider the asset they represent, the jurisdiction you fall under, AML and KYC requirements, and the platform you launch them on.

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