Is an STO a good Capital Raise Option? | by Frederik Bussler | The Capital | Aug, 2020

TLDR: Yes if the alternative is an ICO. Maybe if the alternative is a private placement. Not yet if the alternative is an IPO.

Photo by Blake Wisz on Unsplash

After payment methods, the greatest disruption blockchain brought to the financial industry was in capital formation. The concept of the ICO exploded in 2017 as a way to reach a large market of investors through crowdfunding “smart contracts” on the Ethereum blockchain. In 2017 alone, ICOs raised roughly $7 billion.

However, people started realizing that you can’t sell “tokens” to anyone you want. More often than not, “utility tokens” are actually deemed securities, meaning they must comply with existing securities regulations, including KYC/AML and accredited investor laws. It’s much easier for a crypto exchange to handle KYC/AML than it is for every single project out there to do it on their ICO landing page.

This, in conjunction with the powerful marketing reach crypto exchanges have, led to the birth of the IEO. Essentially, an IEO is simply an ICO done by an exchange. In other words, it’s very much an ICO re-branded and does not solve any of the securities compliance issues.

While there have been literally thousands of ICOs, we’ve only seen a fraction as many IEOs. After and in parallel with the IEO we’re now seeing the STO — the Security Token Offering, as a way to conduct a compliant blockchain-based capital raise.

Essentially, there are two ways to look at Security Tokens: through the lens of crypto or through the lens of securities. Personally, I see Security Tokens as an evolution of securities and a means to improve operational efficiency for securities, among other benefits.

In any case, one of the major problems Security Tokens aim to solve relates to the Howey Test. The Howey Test means that any asset with an expectation of profit, based on the work of others, is deemed a security. This is problematic for the crypto industry because virtually every token out there gives investors an expectation of profit.

Let’s say you have an ERC-20 utility token. The two biggest problems are this: First off, ERC-20 tokens don’t have transfer restrictions built-in, meaning that you can send any ERC-20 token to anyone, such as a minor, an ex-convict, an unaccredited investor, or any other number of individuals where it wouldn’t be compliant to send it to them.

The second problem is sort of a catch-22. If it’s a utility token, there can’t be any expectation of profit. So if there’s no expectation of profit, why would you list it on an exchange, where it’s trade-able for real assets? Logically, virtually every exchange-listed token is a security (Ether is one exception).

So if you’re in the crypto space trying to raise money, an STO is a no-brainer compared to an ICO or IEO. ICOs and IEOs are, at best, in a legal grey area. You’re putting yourself in unnecessary legal risk by selling non-restricted securities.

If you’re not in the crypto or blockchain space at all, then the comparison isn’t STO vs ICO or IEO, it’s more like STO vs private placement.

In this case, it comes down to a number of trade-offs. The biggest one is simply your budget. A digital securities offering is, by a very conservative estimate, around 40% cheaper than a private placement deal. You might think that STOs are a lot more difficult because it’s a new field, but private placements don’t come without significant legal and practical hurdles.

Alongside budget, an important factor to ask if what sort of asset you’re offering to the market. A token doesn’t increase or decrease the value of the underlying asset, it simply opens it up to a greater pool of investors, more easily. Security Tokens are designed to retain some underlying value of an asset, such as debt, equity, or shares of revenue.

Finally, decide if you need liquidity in the asset now. Currently, the Security Token market has virtually no liquidity. If you sell Security Tokens, your investors won’t be able to trade them for likely several more years. If this is a major concern for you, re-consider an STO.

So if you’re considering a private placement deal, an STO is a cheaper and easier alternative, but not the right one for now if you need liquidity.

Finally, let’s consider the options for late-stage companies: STO vs IPO. An IPO typically costs around $4.2 million plus a 4–7% fee and can take around two years to do. Clearly, an IPO is an incredibly difficult, expensive, and time-consuming process. However, there’s a good reason for it: The average IPO deal size is massive (over $100 million USD), so to cross all your T’s and dot your I’s will take time.

With an average deal size so large, STOs are undoubtedly in too nascent of a stage to be considered as an IPO alternative.

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