Security Token Offerings: the differences from other fundraising methods
In the past, the process of fundraising was a very long, tiresome and costly procedure for any company. In order to conduct an IPO (Initial Public Offering), a business owner had to submit dozens of documents to different governmental organizations, wait a lifetime for them to be checked and approved, pay astronomic sums of money at each step, and pass through who knows how many levels of hell to prepare the stock issuance and placement on an exchange.
There’s no wonder that such a way of fundraising was only available for really huge companies with solid reserves under their belts. As for investors, only the wealthy were allowed to get in as the entry barriers were very high. “The rich get richer, and the poor get poorer,” so the saying goes. Unfortunately, this is the reality in this cruel and often unfair world.
New technologies expand the horizons
The new method of fundraising via ICO (Initial Coin Offering) was first tested in 2013 by the project MasterCoin and then by Ethereum in 2014.
The introduction of blockchain technology in conjunction with smart contracts that eliminate the need for a third-party to govern the deal has significantly expanded possibilities. It turns out that there’s no longer a need to bury yourself under a heap of paperwork and you aren’t restricted by budget limitations as ICOs allow you to make investments:
- of any size
- in a fully transparent way
The craze began in 2017 when dozens of IT startups eventually grasped the benefits of the new technologies and rushed to launch their own ICOs. The number of crypto-projects grew exponentially every month along with the amount of raised funds, totaling 6.5 billion USD over that period.
Happy investors were bringing their hard-earned money to the table, and some were even lucky enough to make significant profits when tokens got listed on exchanges. The solution to overcoming the greatest obstacle for the little guy had finally been uncovered and brought equality to this unfair world of investing; individuals with little money and small companies could now make a profit as well as the big guy on the block!
Turning towards securities
However, such a rally couldn’t last forever. Eventually, authorities turned their attention towards the enormous sums of money flowing outside of their purview and tightened their grasp on regulators. This move was especially relevant in the light of the study by Satis Group which revealed that 80% of all ICOs were a scam.
With the introduction of new legislation, the model of an ICO transformed into an STO or a Security Token Offering. The new approach now referred to tokens as securities and thus made it possible to apply the corresponding legislation to them.
ICOs can be compared to STOs by the following characteristics:
What are security tokens
In traditional markets, a security is a tradeable asset that represents a share of the company’s property and grants its holder with corresponding rights, such as a chance to get the revenue share. In the new reality of blockchain-oriented startups, securities take on a new form as security tokens.
A security token is the digitized form of this asset that provides its holders with certain ownership rights in an issuing company. Stricter regulations provide some sort of protection to investors.
Tokenization of securities is advantageous to both entrepreneurs and investors for the following reasons:
- Lower costs: It is much cheaper to issue security tokens on the blockchain than to organize an IPO.
- Speed up the deals: With security tokens, you can buy and sell your share in an instant since there are no middlemen to govern the deal.
- No geographical limitations: A company can sell its tokens all around the world unless restricted by local laws.
- Higher liquidity: You can sell your tokens hassle-free on any exchange where they are available for trading.
- Trading 24/7: Traditional stock exchanges are limited by a set number of working hours while online exchanges work without any breaks or holidays.
Now that we know the definition and the characteristics of security tokens, let’s see how they are different from ICOs and IPOs and what is needed to launch the whole enterprise in each of these cases.
3 ways to raise funds
Here’s what the initial funding process looks like for all three models of fundraising.
Launching an IPO
- An entrepreneur receives some funding from the first investor (called “an angel”).
- The prototype of the product is developed.
- Additional funds from other venture capital companies are received. With every new funding, the company grows in its valuation.
- The company eventually gets to launch its IPO on the stock market and collects funds from a much broader variety of smaller investors.
Launching an ICO
- The project raises some funds from early investors.
- The tokens are issued on the blockchain.
- The pre-sale for huge investors with high entry-barriers begins and goes on for several rounds.
- Then comes the crowd-sale for smaller investors with lower barriers and higher token prices.
The difference between an ICO and an IPO is that a project raising funds via the blockchain does not always have a prototype of the upcoming product. The prototype can be developed at any moment (if developed at all). In most cases, it is a small startup at its earliest stage which comes with much higher risks.
Launching an STO
Why is an STO so appealing and interesting to investors? Well, an STO provides entrepreneurs with all the conveniences of raising funds on the blockchain while at the same time providing investors with a higher level of protection. The process is very similar to an ICO with the only difference being that investors get the real share of a company whose tokens they purchase. Here are some calculations to put it all in perspective:
- Initial funding to launch the whole process is required like other offerings. Let’s say you’ve granted 10% of your company in exchange for 100,000 USD from your angel. Now the price of your company equals to 100,000 USD / 10% = 1 million USD.
- With the first funding from early investors, you create a business plan, hire specialists, and develop a prototype. And don’t forget about the lawyers; you’re going to need lots of them to fit into the regulatory framework.
- Issue security tokens and grant some of them to your early investors as proof of their ownership rights in your company. Let’s say you issue 1,000 tokens in total. Early investors that possess 10% of your company get 100 of them at the price of 1,000 USD per token.
- Then you distribute 100 tokens more at a higher price of 10,000 USD per token and give away 10% of your company to the next pool of investors. Thus, you raise 1 million USD. The valuation of your company now equals 1 million USD / 10% + 1 million USD from the first round = 11 million USD.
- Eventually, you conduct a public sale to distribute some portion of the remaining 800 tokens. The cost per token at this stage is defined by the market demand. And since everything on the blockchain is visible to everyone, the price of your tokens soars and so does the valuation of your company.
There’s no magic, just pure numbers.
Note that although security tokens provide their holders with a higher level of security, at least from the legal point of view, they still aren’t protected from crypto market fluctuations and the case where a company goes bankrupt.
The new way of fundraising on the blockchain has opened new possibilities both for companies and investors. While only a small number of large companies had enough capital to gain access to accredited investors via IPOs in the past, now small startups and small investors have a chance to make money as well.
ICOs, as we knew them in 2017, are now most likely dead due to the high percentage of exit scams and money losses. But the approach itself, when applied to traditional securities, is still viable. The list of ongoing STOs is available on ICORating and many other ICO listing websites, so if you are still inclined to test your luck with blockchain investments, you can now take the plunge with much lower risk.
Originally published at cryptoheroes.ch on February 17, 2019.