Lately, there has been an increased interest in security token offerings or “STOs” for blockchain startups looking to raise capital. STOs are a response to initial coin offerings or “ICOs” that were popular last year.
ICOs Were the Precursors to STOs
What is an ICO?
In an ICO, blockchain startups raised money by issuing and selling “utility tokens.” These tokens were meant to be used to purchase the issuing company’s goods or services. Some of these tokens were highly liquid and could be sold for other cryptocurrencies and even converted into fiat currency.
Due to its liquidity, some blockchain startups marketed their tokens by emphasizing the possible increase in value that a purchaser could receive in return for purchasing their tokens. A common belief amongst such startups was that utility tokens were not securities and thus exempt from regulation under U.S. securities laws.
However, the SEC has made clear that whether a security exists is based on the facts and circumstances surrounding the offer and sale of a token and not the name that you give it.
When are the Sale of Utility Tokens the Sale of Securities?
Depending on the attributes of the token and how the token was sold, utility tokens can be securities. The SEC illustrated this point when it stopped a company from selling self-proclaimed utility tokens in violation of U.S. securities laws.
Applying the “Howey test,” the SEC found that the company were selling securities in violation of the securities laws because they sold securities without registering their offering or selling the tokens under an exemption to registration.
When is a Blockchain Token a Security?
What is the Howey Test?
The Howey test is the test that determines whether an investment contract and thus, a security exists. Under the Howey test, an investment contract exists when a buyer invests money in a common enterprise and expects profits from that investment from the efforts of a third party.
In other words, if a buyer gives your company money for a token and expects you to make him/her a profit in exchange for that money, then you are likely selling a security.
In the case that gave rise to the Howey test, a creative entrepreneur named William J. Howey, devised a scheme to raise money for his orange grove venture in Florida. He decided to sell ownership interests in his orange groves to guests that stayed at his Florida resort. He told them that he would sell them a piece of his orange groves, tend to the land, market the oranges, and share any profits obtained from his orange grove enterprise with the buyers.
The SEC sued Howey for selling securities in violation of the securities laws. Howey argued that he was simply selling orange groves. The SEC disagreed and the Supreme Court developed to Howey test to determine whether an investment contract exists.
How does the Howey Test Help You Determine Whether Your Tokens are Securities?
Under the Howey test, an investment contract exists where a buyer invests money in a common enterprise and expects profits from that investment from the efforts of a third party. Fast forward to 2017, the SEC applied the Howey test in enforcement actions against blockchain companies illegally selling securities.
The SEC stated that whether a security exists is based on the facts and circumstances surrounding the offer and sale of your token and not dependent on what you call it.
For example, the SEC found that a token which was meant to be used to purchase food and advertising from the issuer’s website is a security because the company marketed to people who participated in ICOs for investment purposes and told potential buyers that they would create a market for the tokens and use various efforts to increase their value.
What Does the SEC think about Utility Tokens or ICOs?
Given the popularity of ICOs and risks to investors, the SEC created a task force to go after companies selling blockchain tokens in violation of securities laws and subpoenaed 80 companies this year that were involved with ICOs.
The chairman of the SEC, Jay Clayton, stated that he has not seen a single ICO that is not an offer of a security. However, he recently stated that cryptocurrency such as bitcoin are not securities.
In addition, William Hinman of the SEC stated that tokens such as ether were not securities. However, any token can be packaged and sold in a way that would make it a security even if the token itself does not have any features of security.
What is a STO?
As a response to the SEC’s enforcement efforts, the STO was born. An STO is short-hand for the offer and sale of tokens that are securities.
How Does a STO Differ From a ICO?
Strictly speaking, an ICO can be a STO. As mentioned earlier, the sale of any token can be structured so that it is the sale of a security. However, the industry has developed practices to differentiate ICOs from STOs.
Unlike the utility tokens offered in an ICO, tokens offered in an STO aren’t meant solely to provide a purchaser access to their goods or services. Rather, they are backed by real world assets and are meant to give buyers a return on their investment.
For example, a security token can represent ownership interest in a company and entitle to holder to dividends, voting in the company’s affairs, and other rights. It can also represent ownership of a real asset, such as real estate or art.
How Do I Structure an STO?
An STO is an offering of a security, so there is no question that securities laws apply. That means, before offering your tokens, you have to either register your offering or find an exemption to registration.
I’ve talked to companies that find an exemption first and then back into an offering. A strategy that would help give better results is to first think about how you plan to raise money and structure your offering around that plan. For example:
How much money do you want to raise?
What kind of investors do you want? Do you want accredited investors only or do you also want to allow non-accredited investors the opportunity to invest? Do you want both types of investors?
Where do your investors live?
Your answers to these questions will determine which exemption or exemptions are appropriate for you.