Security Token has been the buzzword from the second half of 2018. Governments of many countries are supporting this trend and releasing guidance and related regulations. Here are some factors to consider.
Briefly, what is a Security Token?
Security (or Asset-backed) token is a digital representation of value that is subject to regulation under security laws.
The essence derived from this notion is the necessity to evaluate the underlying assets. And then to add other metrics related to the security wrapper and handling technology.
Do you, as an investor, have access to all information necessary to take a decision?
Jay Clayton, the SEC chairman emphases “ the two key principles the SEC has followed (1) embrace new technologies that cut costs and provide new investment opportunities while (2) continuing to require that our retail investors have access to the material information necessary to make an investment decision, including the key risks involved, and other fundamental protections.“
European regulators have echoed the calls for investor protection, stating in FCA consultation paper: "Our objectives as a regulator mean that we need to strike a balance between supporting innovation and ensuring consumers are adequately protected".
In most cases with ICOs, the information about the project was very limited and the investor was not able to understand if that is a stage of an idea or a prototype.
Do you understand the business logic and able to evaluate the project?
Another challenge is that the investor should have the expertise to access and evaluate a specific underlying technology or an asset.
One the advantage of DLT (Distributed Ledger Technology), the elimination of the middleman results in a lower cost of capital and widens access to investors. However, the removal of those financial intermediaries leads to additional responsibilities for both parties of the transaction. The intermediaries such as financial institutions have a very crucial role in formatting the market. The bunch of such functions as underwriting, background check, compliance regulation, security evaluation, preparation of marketing and certain educational materials, solicitation of investor interest will shift those functions and responsibilities to the investor and the issuer.
Smart contract features
Security token is a smart contract coded natively as software for the blockchain for the distribution, transfer, and store of value. A lot of conditions can be specified through the code, such as dividend payment, proxy voting, events triggered by hitting a milestone, lock up and holding periods and other financial conditions, and even asset pool segmentation. Thus, a smart contract brings automated compliance for the applicable cases. Some business cases require implementation of Smart Contracts Using Hybrid Architectures with On- and Off-Blockchain Components. Although hybrid architectures are largely unexplored.
In both case, it worth to question : "Is anyone using the smart contract in production?" And if the answer is no you may not be wanting to get involve and to take such risks.
Underlying security evaluation
Because the security tokens are deemed security, the underlying asset is a subject of evaluation. Not all security token are the same.
For simplicity, it's worth to breakdown security tokens by the categories:
1. Tokenized security as a token wrapper around familiar security, with a view to enhancing accessibility and liquidity. It's not a new product but rather a new distribution channel. As it's already approved by the regulator, all the necessary information for the investor valuation is available.
2. Security token as a new product.
2a) Equity tokens. Tokens which function as same as shares of stock. They represent the percentage of ownership of some third-party asset. Equity value = # of shares x share price
The equity value (or net asset value) is the value that remains for the shareholders after any debts have been paid off. You can apply leverage free cash flow of the DCF model to get the equity value. The value of those tokens can be affected by payable dividends and they provide with rights associated with shares. Dividends, voting features are programmable into a smart contract. The token holder rights are protected.
2b) Revenue share tokens, which are not linked to equity. Revenue sharing model works well when the capital belongs to the sleeping partner, for example, state, and the active partner exploits it commercially. So the capital owner has a guaranteed revenue. Here is the opposite situation. All the risk are on token holders. Their liability is limited to the amount invested, the profit is not guaranteed. ICO analysis framework is applicable to this category.
It's important to mention that in 2019, most of STOs are rebranded ICOs with an idea, or in some cases a prototype in place without any revenue, business or financial model. They are targeting institutional investor class without proposing investor presentation, audit and legal opinion in place.
Let's take an example.
1. Tokenization of the Renewable Energy Fund. It's an European infrastructure fund established as a Common Limited Partnership dedicated exclusively to investments in renewable energy infrastructure Investment funds with such profile are targeted mainly at high net worth individuals and institutional investors, such as pension funds and insurance companies. This targeting strategy is often achieved by imposing a high minimum investment threshold. Furthermore, such funds are often distributed via private placements and thus not promoted to non-qualified investors.
What type of token it is?
The issued token will be an equity token of the category 1 as the fund is already established, regulated, and has all necessary audit, technology, legal expert conclusions and opinions.
Are the token investors protected?
In this case, the token is linked to 1 share of the “Fund”of B Class of Interest subscribed, thus token holders are ultimately become equal to shareholders (limited partners). Dividends, buy-back rights are written into a smart contract, and the token are to be traded on the regulated exchange for a security token.
What are the investor rights?
As a holder of B Class shares the token holder benefit from annual x % yield since the fund acquired royalty interest in WTE project.
What are the token investor risks?
The same as for the underlying security. The issuer state that the product has no development, no technological, no financial risks. The tokenized security is a security compliant with the regulation of the European country.
What are the advantages for the investor?
Accessibility and additional liquidity. The main advantage of security token is fractionalization of larger assets. Lower investment minimum. While minimum investment for specialized investment funds is over 100 K Euros, there is a barrier to entry to majority of people. If the funds is offering an attractive yield and have a high credit quality, it's a target of institutional investors, family offices, pensioned funds.
But it's important to mention, that tokenizing doesn't change directly the quality and risk profile of the investment.
What is driving factor for the Security Token issuer? Why tokenize the fund/asset?
This is the key question to start with a due diligence process. It's important to understand the issuer strategy and motivations. Is it a necessity for additional liquidity? Or my it's a wiliness to be a pioneer? Who covers the cost of tokenizing?
What are the real case studies currently present on the market?
Currently, most of STOs are either rebranded ICOs of the last year or those with the private placement's model. Here are some real case studies of the beginning 2019.
Case 1: Convexity Properties doing tokenization of luxury student residence, with aim to be raise 20 mln USD from accredited investors.
Case 2: Aspen Digital Inc., to tokenize St. Regis Aspen Resort.
It’s token will be backed by shares in a corporation which in turn owns the a trophy real estate asset. It’s also digital Reg D 506c security offering dedicated to accredited investors. Those group investors are qualified to understand the business model, value the assets, and such calculate such important indicators of profitability valuation for the luxury real estate deals as ROE, and especially ROIC (return on invested capital).
Another point to consider: in case of a structure of single REIT, the goal is to pass through income without paying extra tax on it, to non-US investors. They are, either a foreign corporation or nonresident alien individual, the subject to withholding a 30% tax on the gross amount of US source income under FIRPTA. More than that, the "single asset" deal is a subject to various shareholders restriction.
Case 3. VC firm Blockchain capital Fund focusing on blockchain technology sector.
Case 4 Technology IPwe, the patent transaction platform to bringing liquidity to the patent asset class.
The risk factors can also be divided for 2 major categories:
1. The risks in relation to crypto-assets lifecycle : the issuance , distribution, trading and provider of custodian services. For STO, most of the infrastructure are the subject to regulation.
2. Another risks are related to specific underlying technology, the regulatory framework and investor protection. Cyril Demaria, partner of Wellershoff & Partners from Switzerland has noted: “There is not equivalent of a shareholder agreement; neither any governance framework with a legal Board, representation of the token holders, voting and decision rules, not other usual rights negotiated by shareholders.”
Exit strategy factor.
Where it will be traded? Currently there are few platforms, with low volume. Liquidity is a major factor. Such ICO scenarios with low liquidity when investors had a limited possibility of liquidation their investment should be avoided.
The tokenizing security is an upward trend for tokenized securities, and they could significantly replace traditional stock exchanges and OTC market in next decade due to fractional accessibility, increased liquidity, lower issuance fees, deeper penetration to the target audience and greater market efficiency. 2019 will bring us more cases, developed infrastructure, and developed legal framework.
If you’re interested in #SecurityTokens Offerings and would like to learn more about them, try some of Tatiana's talks and articles on Security Tokens and blockchain:
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