Understanding STOs (Security Token Offerings)

The buzz created by ICOs for past 2 years have caught the attention of almost every entrepreneur. Especially since in 2017 when it outperformed venture capital funding and became the number one method of funding blockchain organizations. The rapid growth in this particular sector has attracted a few fraudsters to come up with fake campaigns to loot the money out of ICO investor’s pockets. To put an end to fraud ICOs, SEC (Securities and Exchange Commission) of the United States have defined a set of rules and regulations to protect the investor interests.

Token offerings can be broadly classified into two based on the type of token which is issued. The two type of tokens is utility tokens and security tokens. Utility tokens allow individuals to utilize a product or a service provided by the token issuing company. For an example, a utility token can be used in a chat platform to purchase new emojis or stickers in the chat. The utility tokens are not designed for investment; however, many people contribute to utility token ICOs with the hope that one day the value of the token may increase with the demand for the company’s product and service. But when it comes to security tokens, its all about profit. Security tokens act as an investment contract. They basically are similar to the traditional IPOs. Here, the token is backed by external, tradable assets. One of the main applications of security tokens is that they grant companies with the ability to issue tokens that represent shares of a company’s stock.

The success of an ICO is determined by how effectively it can attract the ICO investors and they are easily attracted if the token offers a considerable profit in a short duration. This has led most of the ICOs to offer profitable tokens to the investors without complying with the regulations set by SEC. In this scenario, token issuances are gradually moving towards the STOs (security token offerings) from ICOs. Let’s understand what an STO is and how to identify one.

What is a Security Token Offering?

STOs or security token offerings are being introduced in the crypto community to provide legal protections for investors. It is the same as ICOs but the difference is that STO provide security tokens in the place of utility tokens as seen in ICO. We can expect an increased number of STOs in the latter half of 2018. A legit STO will go through a set of processes as defined by SEC to register and establish itself as a trustable security offering. One can distinguish security token from other tokens using the Howey Test. This test confirms whether or not a transaction qualifies as an ‘investment contract’. If the criteria in the Howey test are met, the token is considered to be a security and it will be subjected to additional disclosure and regulation requirements. The token must meet the following conditions to be classified as a security token,

• The user is investing money
• The user expects to profit from the investment
• The investment is in a ‘common enterprise’ (this term has not been precisely defined. Many courts have used different interpretations)
• Any profit comes from the efforts of a third-party or promoter

Moreover, in an STO, only accredited investors are allowed to participate. Investors should meet one of the following requirements to fulfill this requirement;

• An annual income of over $200,000 individually, or $300,000 with a spouse, maintained over the previous two years and with the same expectation for the current year.
• Net assets worth upwards of $1 million, excluding the primary residence (unless more is owed on the mortgage than the residence is worth).
• An institution with over $5 million in assets — e.g. a venture fund or trust.
• An entity made up entirely of accredited investors.

Security tokens can reduce legal risk and provide protection for both the founders and the investors. Founders who are not able to comply with these regulations will be classified as unregistered securities offerings. In an STO, only accredited investors can invest in private securities offerings. However, many of the founders launching ICOs tries their best effort to avoid having their tokens classed as securities. This is because the token classed as security places regulations and restrictions on who can invest in and exchange the tokens. Even Though this can limit the founder’s ability to reach a wider investor community, the perspective of ‘profit’ labeled to the token can attract bigger fishes to the campaign.