What is a Security Token Offering (STO)?
Among the acronym soup of digital currency phrases, one term is being heard more often: security token offering (STO). The STO is emerging as a powerful and valuable alternative to private equity and venture capital financing for companies globally. It is such a powerful alternative that Polymathestimates will grow to a $10 trillion opportunity over the next two years.
For companies seeking to raise capital, an STO is worth a closer look for a few good reasons I’ll share shortly. If your specific goal is to raise a large amount of capital and your company matches three or more of the profile points below, keep reading.
It is worth considering an STO if your firm is:
- Generating in excess of $10 million in annual revenue
- A high growth company
- Operating a global business
- Preferring to issue a transferable asset
- Interested in a funding method that connects with your customer base
- Desiring greater liquidity for stakeholders
Before diving into why STOs are becoming more compelling for investors and companies raising capital alike, let’s step back to recap what security tokens are and how they function.
In simple terms, a security is a financial instrument representing a real asset. Stocks, bonds and managed real estate trusts are examples of securities. Historically, when a security is purchased, the transaction is signed on paper. A security token performs the same function, except it confirms ownership through blockchain transactions. Security tokens can offer many financial rights to investors including equity, dividends, revenue shares, profit shares, voting rights and other financial instruments.
What makes an STO so compelling for business owners?
1. Access to global capital
Historically, accessing foreign investors has largely been the domain for established companies who could afford the associated costs and risks. However, security token offerings are not limited by geographic borders. This means companies, large and small, can present themselves to more investors over the internet. We saw the impact of this phenomenon in the recent ICO boom. Many service providers have since emerged to help companies market their offerings in foreign markets and different languages. This flexibility gives start-ups and growth businesses entry to deeper funding pools and broader brand awareness. The global nature of tokens also means a wider marketplace of buyers and sellers can interact post-STO, which can translate into greater market liquidity.
2. New ways to market your offering
Traditionally, fundraising in a global environment included an almost limitless price tag and mind-bending complexity. Some challenges have included facing localized securities laws and the need for language translations. The advent of the ICO brought about services and tools to support global token offerings. Advertising to the corners of the earth in multiple languages has become easier, and new techniques such as bounty programs enable companies to offer rewards to people globally in exchange for performing certain tasks, such as being active about a brand on social media. Translating content into foreign languages and posting to communities on Telegram, WeChat, and KakaoTalk is also becoming a successful marketing strategy for raising capital. Experienced agencies with specific skills to support global token offerings are emerging, and investor onboarding programs such as the services offered by groups like Lexico can enable an easy conversion funnel.
3. Better terms
STOs offer enhanced terms when compared to raising capital from VCs. Firstly, companies do not have to give up control of their company or a board seat. This puts management teams in a stronger position to make business decisions, and it reduces the risk of being removed from their own company. Next, for equity STOs, companies can sell common stock instead of preferred stock. This effectively lets management and other common stockholders retain a higher percentage ownership in their company, especially in downside scenarios. While dividend rights will be granted to common stock security token holders, STOs can be accomplished without offering voting rights to these investors. Again, this is another advantage that gives management teams more control over their company. Finally, STOs generally raise at higher valuations.
4. Low cost of entry
A security token offering can be used to tokenize many assets, commodities and financial instruments. That means smaller companies have the opportunity to raise large amounts of capital from a global investor pool quickly without necessarily having to absorb large costs, particularly in legal fees. Imagine, for a moment, raising capital from a global investor pool using traditional means. You’d be required to engage a new lawyer in every country where an investor wanted to buy into your offering. Security tokens remove that requirement because compliance is integrated into the token itself. In the US, frameworks such as Reg D and Reg A+ are used by companies seeking to raise capital, and compliance with their requirements can be guaranteed without the use of lawyers.
5. Uses beyond a traditional security
By incorporating utility token-like features into security tokens, additional value can be created. For example, if Hotel Crypto released a security token, customers of the hotel who purchased tokens could be entitled to a 10% discount on their room rate or free access to VIP areas. With tokenized offerings, companies have the opportunity to use their imagination to offer new benefits to their customers. In another example, companies could offer benefits with financial value to customers who hold their tokens for more than three years, for example, discounted meals, spa treatments, in-room entertainment or reduced room rates. Essentially, companies offering security tokens have an option to reward customers for buying and holding their securities over time. These rewards go beyond an appreciation of the value of the underlying security.
So what’s the catch?
While there are many benefits of STOs, its true this style of raising capital is not suitable for everyone. To begin, this is a nascent market. With the first STOs being completed less than two years ago, we do not yet have extensive precedent (legal or otherwise) to reference. Second, without the benefit of time, insights around how STOs will perform over the long term are still being formed.
Third, regulators could weigh in at any time and influence the market with compliance rulings. As it stands, the closer scrutiny given to security tokens can make compliance more burdensome. Fourth, there is still uncertainty around when a token should be treated as a security, although the SEC is attempting to address this. Finally, running an STO demands that businesses create and manage tokens. Security tokens are not immune to the threats of hackers. Having access to the right cybersecurity skills and technology is critical for success.
Want to know if an STO is right for you?
There’s no doubt the STO funding avenue offers a persuasive alternative to private equity and venture capital funding. While there are many advantages to an STO, it is important that this strategy makes sense for your business.
I have found that many executives looking into STO financing originally say something like: “Hey, companies are raising crazy amounts of money this way – it must be easy.” The truth is that outsiders only see the tip of the iceberg, and there is much that happens behind the scenes which many don’t understand. Knowing what happens behind the scenes and the partners to bring into an offering are critical insights that an advisor can provide to make the difference in an STO’s success.