Security Token Offerings (STOs) are touted as the future of fundraising. A trillion-dollar market in the making.
But how does an STO actually work? In general, we can divide the process into five steps:
Step 1: Plan the issuance
Assuming you have done your homework and have decided an STO is the way to go, the first step is to put together your game plan. Failing to plan is planning to fail. It sounds corny, but it’s true.
The main aspects you have to think about are:
- What are your business goals?
- What legal aspects do you have to consider?
- What do you have to do on the tech side?
Clarify your business goals. Most companies aim at fundraising, but that’s not always the case. Some businesses might want to tokenize certain assets to improve their liquidity, or simply use an STO as a marketing stunt.
If you are tokenizing equity, do you include voting rights or only a profit share agreement? What other rights do you want to grant your investors? And what kind of investor do you want to get on-board, institutional or retail investors?
Legal aspects can vary greatly depending on the jurisdiction. That’s why the first question is: WHERE do you want to launch your STO? While some jurisdictions like Liechtenstein have clear guidelines for STOs in place, others might leave the space completely unregulated – which increases your legal risk.
Keep in mind, that you are issuing a security token – a financial security. Thus, all relevant securities laws apply. In the EU and in Liechtenstein, those are covered by pan-European MiFID regulations.
If your STO is exceeding a certain amount – in Liechtenstein that is currently CHF 5 million – prospectus laws apply. In this case, you will have to issue a detailed prospectus which the Financial Markets Authority will have to approve. Thus, the required paperwork will become a lot heavier.
Once you know what you want to do, the next question is, how can you do it? Keep in mind that there will be a life after the issuance. Thus, besides the questions what technology you will use to tokenize the asset and distribute the tokens, you need to think further.
How will you enable secondary trading and how will you enforce trading restrictions? Also, how will you pay dividends or interest to your investors? Will you pay in fiat or cryptocurrency? Mostly, these issues are governed by smart contracts.
Another issue that often pops up is, what happens if an investor loses his/her private key? Can inaccessible shares be reissued?
Step 2: Build up your team
You don’t know everything yourself, and it’s way too much work for one person anyway. Thus, you will need experts from all three fields: business, legal and tech. Preferably, they will already have had STO experiences. But considering how young the industry is, people with STO experience are a rare breed.
No big deal, it’s not rocket science. You need people who understand the fundamentals. For the details, you can work with external service providers that are specialized in STOs.
Step 3: Select external service providers
One of the main advantages of STOs compared to IPOs is that you don’t need an investment bank. Everyone who has ever worked with an investment bank knows about their exorbitant fees. Service providers involved in STOs are not Father Christmas either, but they will be significantly cheaper.
Unless you can get experienced people to work for you in-house, you will need an STO advisor who has been through the process before. That should be someone with a proven track record. In Liechtenstein, there are several STO advisors, for example Bank Frick. Just shop around and see who you feel comfortable with.
Lawyer and compliance provider
While a lawyer will assist you with the general legalities, such as setting up a legal entity, register with the FMA, and formulating contracts, the compliance provider will be your partner on the tech side.
A compliance provider is essentially a platform that investors can log into and access information relevant to the offering. Investors then go through a compliance process that guides them through the entire process from investor onboarding and payment of funds, to receiving their tokens. The compliance provider hereby ensures that relevant laws, for example KYC and AML rules, are being followed.
Always ask for a tech demo before you sign up with a compliance provider and discuss it with your lawyer.
You should be able to manage the entire lifecycle via this compliance provider; not only the issuance but also everything that comes afterward.
Although you can work with the same compliance provider from start until the end, you want to be able to change your compliance provider – just in case things don’t work out as planned. Thus, if your token won’t work anymore after changing the provider, don’t choose this provider. Flexibility is key in a young market.
The compliance provider also needs to support the blockchain of your choice. Currently, Ethereum and Stellar are the two most popular blockchains for asset tokenization. When selecting a blockchain, the main considerations are the issuance costs and how easy it is to issue the token.
Brokers can help you to find investors. You may not necessarily have to work with a broker if your network is strong enough to find investors by yourself. Brokers usually charge a percentage of the raised amount as brokerage fees. In most markets, brokers need to be licensed. That’s no different in Liechtenstein.
Step 4: Structure the offering
At this point, you are putting the business, legal and tech considerations outlined in step one into a concrete offering. Your offering needs to make business sense, be legally compliant, technically feasible, and also make sense to potential investors.
The structuring process can quite simple or incredibly complex. It mostly depends on the asset that you want to tokenize. If the underlying asset is startup equity, say in form of non-voting common stock, this can be relatively straightforward. If you are tokenizing assets with complex future cashflows, it could become a lot more complicated.
Step 5: Select a Security Token Exchange
You don’t have to list your token on an exchange. But listing it can provide liquidity. It will also make your token more attractive for investors.
Keep in mind, that an exchange needs to be licensed to list security tokens. Casual “crypto exchanges” won’t do the job, the exchange needs to support a security token standard.
The Liechtenstein Crypto Exchange LCX is licensed to trade payment and utility tokens, but not yet security tokens. However, LCX plans to launch “LCX Exchange,” a trading platform for security tokens and other crypto assets. In order to fulfill the requirements of the FMA to be able to trade security tokens, LCX has increased its nominal capital from 100,000 CHF to 1,000,000 CHF. Thus, it’s likely you can soon list security tokens in Liechtenstein.
Most exchanges have their own listing standards and are selective which tokens they list. Also, the due diligence process can take a long time. Therefore, it’s important to engage with exchanges early in the process. You don’t want to go through steps one to four, just to discover later on that your token offering does not meet any platform’s listing requirements.
There is a lot more to know about STOs, but roughly, this is the process you will follow. STOs are still young, and many aspects are not yet clear. Liechtenstein’s upcoming Blockchain Act will provide guidance and legal security, making the country an ideal location for STOs.