3 key things to know about Security Token Offerings (STOs) before you invest

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When Mastercoin announced the first Initial Coin Offering (ICO) in July 2013, it introduced an ingenious new way to invest in blockchain projects. Unlike traditional shares, crypto tokens could be purchased and traded instantly, anonymously, and often without fees.

Never before had it been so easy to invest or to raise capital. Soon, entrepreneurs and investors across the globe raced to join the ICO frenzy.

However, the simplicity of ICOs became its proverbial kryptonite.

More than half of them turned out to be scams and failed to develop projects after raising funds. With each failed ICO, the SEC began to pay closer attention to the industry.

At the end of 2018, the SEC finally stepped in to apply established securities law to all token offerings. And with that, the SEC put a stop to ICOs for good in the US and replaced them with the Security Token Offering (STO).

While this does not mean the end of capital raising for crypto projects, it does mean that the rules have changed.

For investors and entrepreneurs eager to capitalize on the rise of STOs, it’s critical to understand how STOs differ from ICOs and what is involved in launching one. Read on as I break down the 3 essential differences between the two forms of token offerings.

STOs require SEC registration

The simplest description of an STO is that it is an SEC-compliant ICO. This means that in order to launch an STO, you must register your token offering with the SEC like any other securities offering would be or be able to fit your offering within a registration exemption.

From experience, I can attest that proper registration with the SEC is very time consuming, expensive and difficult.

As an Issuer, you should expect to pay several hundreds of thousands of dollars or more to hire competent securities lawyers needed to ensure a compliant offering, including but not limited to filling out the necessary forms and ensuring that all marketing activities and announcements comply with the SEC’s requirements.

Then, if you elect to use a traditional broker-dealer to assist with the raise, you will have to stretch your budget even further. In order to pass broker-dealer due diligence, an Issuer needs to undergo a ridiculous amount of due diligence, including a full audit of the company’s financials. As accountants are just as overpriced as lawyers, you can imagine that this won’t come cheap— or quick. It can take you 4 to 6 weeks to pass broker-dealer due diligence even after you’ve provided all the necessary documents.

One shortcut around this is to fit your offering within an exemption. This involves restrictions on how much money can be raised, how many investors you have, and to whom the token offering is marketed, but can save a project a significant sum in compliance costs.

STOs offer investor protections

Even after going through all that to register with the SEC, your work as an Issuer is not done. After launching an STO, your company must continue to meet a number of compliance requirements. For example, you will be required to provide investors access to materials and information about all of the activities of the company.

As established by the SEC, investors must be informed of material facts, risks, and costs associated with their investment. (Which, let’s be honest, makes sense.) They also have the right to access company data, its financials, and whatever else is reasonably necessary for investors to make fully informed investment decisions.

That’s the key phrase here, ‘informed investment decisions’.

If you try to keep information quiet that comes out later, investors can take legal recourse against you for obstructing their ability to make an informed investment decision.

STOs are not anonymous

The third key difference between ICOs and STOs, is probably the most significant for the crypto community. While the first two differences mostly involve additional time and money, the third difference is where we find the greatest clash between regulators’ interests and the original principles of crypto decentralization.

Since ICO tokens can be traded anonymously peer to peer, they are ‘bearer securities’. A bearer security is one that is owned by whomever possesses it. Many years ago bearer shares and bearer bonds were commonplace in the US. As a kid you might have received a bearer bond from your grandparents for your sixteenth birthday. They could make the purchase and then give you the bond certificate to do with as you wanted. It was an easy, practical gift. There was no need to register the ‘transfer’, or any others thereafter. When the bond matured, whoever held the certificate could redeem it. Simple as that.

But what was convenient for investors, regulators saw as a threat.

They didn’t like the anonymous nature of these securities, and so over the years they gradually regulated them out of existence. We saw this with stocks and bonds and that’s what we’re seeing now in the shift from ICOs to STOs. (Fun fact: US dollar bills are the last remaining bearer instrument in the US. It’s more difficult, but regulators are even trying to push those out of existence as well.)

In summary, for a token offering to be in compliance with the SEC, Issuers are required to know who is the holder of each security at all times. This means that a ledger must be kept to track the tokens every time there is a transaction.

Beyond the ideological conflict this brings to the table, this also creates a need for new crypto exchange infrastructure to be introduced with the ability to track transactions. Though it’s taken time for exchanges to catch up, we are now seeing a number of projects enter the market to help projects accommodate these requirements, such as tZero, Polymath, Templum, and more.

What Does This Mean for Crypto Law Insiders?

Whether we like it or not, STOs are here to stay. So it’s important for Insiders to understand what this means for their projects and their investments. The game is not over, but the rules have changed.

The first thing to understand is that STOs are far more complex and costly to launch than ICOs. This higher barrier to entry will limit which projects can enter the market and unfortunately some good projects may never take off because they can’t get the funds together for a registered securities offering.

Equally important is to recognize that complete decentralization and anonymity is no longer an option with STOs. From now on, token ownership must be tracked. While this may help to reduce money laundering, as regulators claim it will, this is a major blow to the original Satoshi vision and the founding principles of blockchain.

In the face of these new hurdles, some projects will struggle to stay in the game, while others may choose to walk away. How about you, are you still game?

Dean Steinbeck

Dean Steinbeck

Dean Steinbeck, Managing Director of Crypto Law Insider, is the leading authority on legal issues related to cryptocurrency and blockchain technologies.