With the financial sector constantly evolving, it is important to stay abreast of new investment vehicles.
Even if you’re not yet ready to embrace these offerings, your clients will likely have questions as these offerings gain popularity. Among the newest type of offerings that we anticipate gaining market traction in the long term are Security Token Offerings (“STOs”).
Whether you wish to add STOs to your client portfolios or just looking to stay knowledgeable as to new offerings in the marketplace, it is important to understand STOs so that you will be better equipped to guide your clients through this exciting and evolving sector.
What is a security token?
Security Tokens typically represent a stake in an asset or external enterprise. Technically, a token is categorized as a security token when subject to rules and regulations under federal or state securities laws and regulations as a result of deriving its value from external tradable assets or enterprises.
Governments or businesses can issue security tokens. As such, these tokens serve similar purposes as stocks or bonds. Security tokens are different from utility tokens, for example, because they represent the right of ownership to an asset.
Simply put, they are liquid contracts in digital format that represent shares in valuable assets like corporate stock, real estate, or another investment vehicle. By using security tokens, ownership stakes are preserved on a public ledger (blockchain).
This structure allows for:
- Transparency: Every transaction is recorded on the blockchain and accessible for review, ensuring accountability.
- Inclusivity: Fractional ownership allows smaller investors to participate in high-value assets, democratizing access.
- 24/7 Access: Digital assets are traded around the clock; no more waiting for market hours.
- Speed: Ownership transfers are near-instantaneous, enabling quicker liquidity.
By tokenizing securities, startups launching initial coin offerings (ICOs) and initial exchange offerings (IEOs) can improve their asset liquidity and attract more investors. There are other benefits, too, like lower issuance fees, high market efficiency, fractional ownership and improved access to real-world assets that are digitized. Notably, startups and companies wishing to distribute shares to their investors can now do so in the form of security tokens.
Holders of Security Tokens can be entitled to a variety of different things depending on how the token is structured and what its underlying asset is. Examples include:
- Direct Equity / Conversion to Equity
- Liquidation Preferences
- Dividends
- Profit Sharing
- Voting / Vetos
- Buyback / Redemption Rights
- Options to Purchase
By virtue of their issuance via blockchain, Security Tokens are also transparent, divisible, and quick to settle; typically with little to no downtime.
Transparency
Security Tokens can provide public ledgers allowing for transparency of transactions despite permitting participant / holder anonymity. Consequently, all information relating to the Security Token can be accessed on the public ledger and audited at any time. Smart contracts that manage tokens, as well as holdings and issuances, can be viewed by anyone.
Divisibility
Extremely valuable assets (e.g., art, real estate, commodities) can be offered to investors who find fractionalized ownership / participation more appealing and affordable. By way of example, a painting worth $10 million can be tokenized into 10,000 units sold at a price of $1,000 each; the same painting can be carved up / fractionalized up or down to affect the offering price higher or lower as well. Tokenizing assets increases accessibility by making them divisible. As a result, STOs can open up access to entire classes of assets that have historically been unavailable or unaffordable to many would be investors.
Quick to Settle
Settlement and clearing of transactions can take a long time when transferring assets traditionally. On a blockchain, however, processes are largely if not fully automated, meaning that actual transfer of ownership can be accomplished near-instantaneously.
Types of Security Tokens
Security Tokens can take almost any form and are typically structured similar to other non-digital assets / investments. Examples include:
- Equity (Common / Preferred / Founder)
- Debt (Notes / Debentures)
- Convertible Instruments (SAFEs / Convertible Notes)
- Asset-Backed Tokens
- Utility tokens
Equity tokens
An equity token represents ownership of an underlying asset such as company stock. An equity token holder may be entitled to dividends, voting rights, or both. Similar to shares, a contract dictates the applicable terms and conditions of such.
Debt Tokens
Debt tokens are tokens mimicking other debt instruments like promissory notes and other loans. Such tokens represent debt owed by the token issuer to the holders of such tokens; they are essentially the equivalent of a loan made to the issuer. Debt tokens inherently accrue interest.
Debt tokens can be structured in a variety of ways (much the same way that loan or debt transactions can). Variables can include: maturity, interest rates, interest types (fixed / variable), and conversion to equity or other securities.
Asset-Backed Tokens
Tokens built on the blockchain and considered real-world assets are called asset-backed tokens. These assets can be anything from real estate to company shares, commodities, or even diamonds. They give users ownership rights over valuable tangible or intangible objects, and in digital form.
Utility Tokens
A utility token helps companies, startups and project development groups raise funds and capital to develop blockchain projects. These tokens can be used later on to purchase goods or services from the cryptocurrency’s issuer.
Regulatory Requirements for Managing Portfolios with STOs
STOs are classified as securities and, as such, are subject to the same regulatory requirements as traditional stocks and bonds. STO’s share the same risks as their non-digital counterparts (e.g. private placements, IPO’s, restricted stock, etc.) and should be evaluated on both their underlying investment merits together with their technical / technological merits.
STOs must comply with the Securities Act of 1933, which mandates that public offerings be registered with the SEC unless exempt. This ensures transparency and investor access to critical information. Private Fund Advisers must confirm the correct categorization of the STO and determine if registration is necessary.
Advisers managing STO portfolios should also be aware of disclosure obligations, AML requirements, and state-specific Blue Sky laws.
It is crucial for Private Fund Advisers who manage portfolios with STOs to perform a comprehensive review to avoid violating compliance regulations.
As the regulatory and technology landscape evolves, with STO regulations subject to change, Private Fund Advisers should regularly review new rules or amendments and ensure full implementation of all applicable mandates.
Jacko Law Group helps fund managers understand and meet their compliance requirements and adhere to the stringent regulatory rules in the private funds sector. For legal and regulatory compliance counsel regarding private fund management, or other compliance or corporate matters, please call 619.298.2880 or email [email protected].
JLG works extensively with Private fund advisers, investment advisers, broker-dealers, investment companies, private equity and hedge funds, banks and corporate clients on securities and corporate counsel matters. For more information, please visit https://www.jackolg.com/.
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