Create Value & Secure Funding With Tokenized Equities
The issuance of tokenized equities has been growing in popularity since the initial coin offering (ICO) boom in 2017. As adoption of cryptocurrencies and blockchain-based projects became widespread, both Wall Street and Silicon Valley began developing novel use cases and digital tokens applications.
Attempting to correct the regulatory concerns born out of the SEC’s action against DAO, the Security Token Offering (STO) came to challenge the security and equity market’s traditional methods. While the STO continues to gain popularity among private companies looking to secure funding, other companies are turning to Decentralized Finance (De-Fi) tokens to acquire capital through a hybrid crowdfunding/ICO model.
In many ways, the resurgence of decentralized blockchain systems’ popularity is reminiscent of the ICO’s growth back in 2017. As decentralized blockchain technology continues to create new and innovative funding opportunities, tokenization has become a more affordable way to create, issue, and transfer equity.
Benefits of Using Tokenized Equities
By tokenizing assets, especially private securities or typically illiquid assets such as fine art, these tokens can then be traded on a secondary market of the issuer’s choice. This access to a broader base of traders increases the liquidity, benefiting investors who consequently have more freedom and sellers because the tokens benefit from the liquidity premium, thereby capturing greater value from the underlying asset.
Faster and Cheaper Transactions
Because the transaction of tokens is completed with smart contracts, certain parts of the exchange process are automated. This automation can reduce the administrative costs associated with buying and selling, reduce the number of intermediaries, and create an overall more efficient transaction process. This leads not only to faster deal execution, but also lower transaction fees and less legal jargon.
A security token is capable of having the token-holder’s rights and legal responsibilities embedded directly onto the token, along with an immutable record of ownership. With the rights and responsibilities embedded, you to know with whom you are dealing, what your and their rights are, and who has previously owned this token. This increased transparency further reduces administrative costs by having an easily accessible record that can expedite your ability to fulfill any legal or regulatory compliance measures.
Easy and Reliable Accessibility
Importantly, tokenization could open up investment in assets to a much wider audience thanks to reduced minimum investment amounts and periods. Tokens are highly divisible, meaning investors can purchase tokens that represent incredibly small percentages of the underlying assets. If each order is cheaper and easier to process, it will open the way for a significant reduction of minimum investment amounts.
Higher liquidity of security tokens can reduce minimum investment periods since investors can exchange their tokens on the secondary markets. Platforms like Uniswap allow easy and convenient access to secondary markets. Because of the global nature of the secondary markets, your security token can be accessed at any time of the day and by investors on an international level.
Things to Consider Before Creating a Tokenized Equity
Evaluating your business goals is important when considering whether tokenized equities is the right solution for you. Depending on your market, target audience, and other motivating factors for your funding, some startups may elect to go with the traditional finance methods. Those who choose tokenized equity are looking to improve their liquidity, gain a larger audience for funding, or perhaps even use the offering as a marketing tactic.
Additionally, a startup would also want to look at how the business goals are reflected in the tokenized asset. Among the questions you should be asking, it is important to consider:
- Does access to the tokenized equity include voting rights or a profit-sharing agreement?
- What rights do you want to grant to your investors?
- Who is your target investor? Institutional? Retail investors?
When founders form a corporation, LLC, or other legal entity, the sale of tokenized equities or interest to the founders and investors will be subject to federal and state securities laws. Such laws typically require compliance with certain disclosure, filing, and form requirements unless the sales are exempt.
Sanctions from the SEC, CFPB, and FTC for noncompliance with securities laws can be significant, including civil and criminal penalties. Just a couple of weeks ago, crypto exchange BitMEX faced joint charges by the DOJ and CFTC for failure to comply with security and currency regulations. Digital assets don’t precisely fit the traditional definition of an investment. The SEC frequently relies on the “Howey Test” to determine whether a digital asset is an “investment contract” that requires security law compliance. Under the Howey Test:
“An investment contract means a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
SECURITIES AND EXCHANGE COMMISSION v. W. J. HOWEY CO.(1946)
While a tokenized equity would undoubtedly be an investment contract under the Howey Test, De-Fi tokenization for crowdfunding is more of a grey area. Recently, the US Treasury Department released updated guidance on the handling of cryptocurrencies and tokenized assets. Hopefully, the legal and regulatory status will be further clarified in the future.
Tokenized equity has already proven to be successful among early adopters. As new entrants continue to build upon preexisting infrastructure, the traditional market and government regulators have also shown signs that tokenized equity and other tokenized assets are moving toward mainstream adoption. While regulatory obstacles still stand in the way of its full acceptance, tokenization is rapidly moving toward creating a more efficient, reliable, and transparent financial system. Tokenization is also reducing the costs of raising capital and giving investors access to investments that were formerly out of reach.
Originally published at https://law4startups.com on October 25, 2020.