You might have heard of the terms - "IPOs" or "ICOs" or "STOs" in various crypto articles or even in the news. Don't know what it is? Don't worry. Let me simplify it for you so that next time to hear about it, you'll have a clear idea about what it is and how it operates. I recommend watching this excellent video by 99Bitcoins (I am not affiliated to this channel in any ways) where everything about IPO, ICO and STO are clearly explained.
Basics of Share Market - IPOs
In order to understand what a security token is, you'll need to know some basics about the share market. Let me give an over simplified analogy to understand it better.
Say a company X wants to expand it's reach to a much wider audience. For that, they will have to open up new offices in new locations and hire new employees to operate and maintain them. They will obviously need a lot of money to do all these activities but unfortunately when they calculated the estimated cost, they simply don't have that much money. They know for sure that there business model will generate profit given enough time but they just don't have the initial money to put up to cover the expansion costs till they become profitable. Now in this situation, how do a company find the expansion money or in other words raise capital to fund their expansion plans?
They can do either one of two things - one, they can reach out to some wealthy individuals (investors) or investment firms and ask them to put up the money but in return they will ask for a major chunk of the company. This is not appealing because usually such investors will simply ask for way too much of the company ownership such that the company will have to consult these investors before making any decisions. To avoid this situation, there's the second way - the company can ask the money from the general public by offering little portions of the company which when pooled together becomes the required capital. These little portions of the company is known as a share of the company and when it is offered to the public for the first time, it is called as - Initial Public Offering or IPO.
Example: Say this company X wants to raise $1 million dollars; they will release $1 million shares of the company X, where each share would be worth $1. If all the shares are sold, then they'd get their required capital to work on expanding their business.
When the public buy company X's shares, they have to buy in multiples of one share, i.e., they cannot buy half of a share or quarter of a share. Why does this matter? Well, say a person has got only $0.5 instead of $1. That person cannot buy a share of the company; they will have to come up with another $0.5 to buy 1 share. (This is important information which we will come back later; for now, just keep this in your mind.)
Now once the company gets enough money from the public, the company is expected to start their expanding operations and based on how profitable or trustworthy the company is, the company's share price will fluctuate. For example - if the company is doing well, their share price might go up to say $2; if the company is not performing as promised then the share price might fall to say $0.1. The share holders can sell their shares on various exchanges. Apps like Robinhood can be used to buy or sell such shares. Do note that a share are also refereed to as a 'security' (Now you know what the 'S' in 'SEC' or 'Securities & Exchange Commission' actually means).
Limitations of IPOs
This IPOs seem like a good option for the company. Instead of giving up major ownership of their profitable company to some random investor who may or may not interfere with their business operations, companies can get the money from public and work on making their profitable business expand and reach new heights. So what's the problem?
Well, share market is a highly regulated business. Companies needs to jump through a lot of hoops to get their company listed as a public company so that they can raise money via IPOs. This makes it difficult for a company who wants to just get the money and do their business. But at the same time, these regulations also keep the general public, the buyer of the shares, relatively safe from scams or fraudulent companies. Regulatory authorities make the company undergo strict evaluations to check whether there are any fraudulent activities that the people should be aware of. Though it slows things down, it is generally perceived as a "necessary evil" in the share market. Nobody likes it, but it is still essential.
ICO refers to Initial Coin Offering. This can be considered as a blockchain equivalent of IPOs to some extend; where it differs from an IPO is that ICOs are unregulated; this means any Tom, Dick or Harry can raise an ICO where they can release cryptographic tokens to the public which anyone can buy in order to raise funds for their company. These tokens are projected as to play an important role in the project, which if they could convince the public, then they can raise their required capital. Usually a token sale would only last for a limited time.
A good example of an ICO is the Ethereum ICO which happened in 2014 where Vitalik Buterin released ETH tokens to the public at $0.31 per ETH (1 ETH is now worth around $2000.). It was conducted between 20th of July, 2014 and 2nd of September, 2014, for a total of 42 days. Slowly the world got to know about ICOs and how it can be used to raise money and this led to an influx of ICOs. This ICO fever peaked during 2017, where an ICO was issued every other day. Unlike the share market, when one have to buy an entire share, in the ICO world one can buy tokens to the least decimal point to which it offers. That means, if a person only has $0.5, then that person can get $0.5 worth tokens. It's just like that fact you can buy a tiny portion of a bitcoin for $1 even though a bitcoin is worth over $30,000. Another good example is the ICO sale of Polkadot.
But what are these Tokens?
Well, these are cryptographic tokens which exists only digitally and can only be put into digital wallets. These cannot be printed a piece of paper; it doesn't exists in the physical world. That being said, any physical entity or asset or commodity can be tokenized and sold. We can generate two types of tokens - Utility tokens and Security Tokens.
Utility tokens are tokens that promise a future use of a product or service. A brilliant example of this can be - Amazon Gift Cards. They aren't meant to be an investment, but are to be used as a utility, i.e., using the gift card you can buy anything from Amazon for the specified amount. You can buy such cards and share them to your family & friends so that they can utilize it to buy whatever they want from Amazon for that specified amount..
Security tokens on the other hand are tokens that represent tradable financial assets. Example of a security token is a share or a bond of a company. It is meant as an investment because it can be used to pay dividends, share company profits with the share holders, pay interest as a way that promises future profit, etc.
ICOs issue security tokens and this is supposed to represent as shares of the company which issues it. But to circumvent regulations, many ICOs when get caught would claim that they had actually issued utility tokens instead of security tokens.
Limitations of ICOs
As mentioned before, ICOs are unregulated and therefore it is easy for scammers to use ICOs to raise funding for their fraudulent companies. It came to an extend where ICOs became a de-facto method for such security related scams. Anyone with some basic computer and blockchain knowledge, especially Ethereum knowledge, can issue ICOs. It's that simple.
During the ICO boom, the news reports were filled with ICO scams on a daily basis. When an ICO is raised, it doesn't cost much to the founders of the company. The company is not giving away anything to the public in return for their money. It is up to the general public to separate the wheat from the chaff, to find out whether the company is good or bad. But when money comes easy, there are less incentives for a company to actually deliver what they had promised. Many of them would just raise an ICO, pump the coin price to the maximum, dump all of it raking in huge profits and then become absconding. This scenario became the new normal. People started to lose their trust in ICOs. It also started to cast a shadow on blockchain technology and cryptocurrencies as well where people got panicked and started to believe that even those are scams as well.
In the US, regulators use something called as a Howey test to determine whether what someone is selling should be considered as a security. Why does this matter? This matters because if a person or company is proven to be selling securities as an ICO, for example, then they can be prosecuted to take legal actions since securities can only be raised via the regulated IPOs.
It can be simplified and broken down into 4 questions:
- Was there an investment?
- Was this investment done in a common enterprise?
- Was there an expectation of profit?
- Are the profits a result of third party efforts who are not an investor?
If the answer to these questions are yes, then that means whatever was sold can be considered as a security. When the regulators came knocking, most of these companies which raised these ICOs claimed that they were actually issuing utility tokens and not security tokens. But when reviewed, it was found that they actually issued security tokens (using the Howey test) and therefore the regulatory authorities were able to prosecute them and even legal actions were taken against them including hefty fines and jail time.
Presenting to you - STO
STOs stands for Security Token Offering. An STO is a regulated offering of tokenized financial assets to the public. STOs can be considered as a regulated version of ICO with the oversight of an IPO. It brings forward the best of both the worlds. STOs can be used to sell security tokens to the public without raising an IPO. All tokens are securities tokens and all participants are considered as an investor. STOs are also AML (Anti Money Laundering) complaint. But you may be wondering - how is this possible?! It is possible via exceptions.
You see, in the US, the SEC (Securities & Exchange Commission) allows companies to raise money without an IPO if they fall under any of these three regulations:
- Reg D: where all the investors are accredited investors, i.e. investors with more than $ 1 million in hand or having an annual income of more than $ 200,000. The capital that can be raised has no cap means there's no limit to how much amount that can be raised. The only catch is - the investors have a lock in period of 1 year before they can sell off their securities (this is done to prevent "pump & dump" schemes)
- Reg CF (Crowd Funding): where any type of investor regardless of how much money they have can participate but there is a cap on the total investment that can be raised which is $1.07 million. This investment also comes with a 1 year lock-in period.
- Reg A+: where the company undergoes SEC qualification process. All types of investors can participate in this investment. A maximum of $50 million can be raised. There is no lock-in period in this investment unlike the previous ones.
Thus, these exemptions allow companies to raise capital via STOs. This also gives the buyer regulatory protection on their investment. Here, everybody wins.
Pros and Cons of an STO
An STO offers many benefits over an IPO and an ICO. Regulations on STOs will reduce the chances of one being a scam unlike in an ICO. Again, unlike an ICO, STOs are traded on verified exchanges. Even a portion of the security tokens can be bought and the buyer need not buy an entire token to get involved, unlike the share market. STOs open up the market to potential investors who are not multi millionaires (STOs raised under Reg CF and Reg A+). STOs enable easy access to investors as the trade happens on a global scale unlike an IPO which opens the business to local market only.
There are some cons as well though. If the STO was raised under Reg D, then the securities are open to accredited investors only, meaning only millionaires are allowed to participate. Another down side is the lock in period which may prevent various investors from investing as they are unable to make quick gains. Only long term investors would be interested in buying such STOs.
So there you have it. That's all you need to know about STOs or security tokens. I hope this helped in expanding your current knowledge about this subject. Have a great day ahead.
Couple of other articles which you might be interested in:
- Is Solana (SOL) the real 'Ethereum Killer'?
- All you need to know about Stablecoins
- All you need to know about Liquidity Pools
- All you need to know about Hardware wallets
- All you need to know about Hyperledger
- All you need to know about Aave
- All you need to know about NFTs
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