Between 2016 and 2017, companies flocked to offering and selling cryptocurrencies (via “initial coin offerings” or “ICOs”) as a way to raise funds quickly. Since their inception, ICO issuers have raised more than $10B selling these coins. However, until recently, ICO issuers have done everything they could to circumvent existing securities laws; even when the underlying “coins” have all the characteristics of regulated securities.
By way of general background, anything that is being actively sold as a type of investment will most likely fall within the definition of a “security” under existing U.S. Securities laws. To attempt to avoid being viewed as securities, many issuers intentionally soft played their documentation. For example, a standard ICO sales contract often makes no mention of the word “investor” (opting instead for terms like “buyer” and “purchaser”) and/or affirmatively disclaims future returns, etc. from the selling company. In layman's terms, this means that the coins being sold have no intrinsic value according to the seller, and the seller can do whatever they want with the sale proceeds. This begs the question, why would anyone buy these coins?
Well, with all the hype surrounding the cryptocurrency industry, these coins were (and outside of the US, still are) marketed and sold to investors as investment vehicles. The seller prays on the hopes of unsuspecting and often unsophisticated investors that once purchased, the coins will naturally increase in value (i.e., like Bitcoin) and they will be able to resell them at a profit; often with no real plan as to how/why that would occur. It’s a truly deceptive way to raise funds.
The active circumvention of ICO issuers has left the cryptocurrency industry without any real regulatory structure. This is much to the detriment of ICO investors who resultantly have no clear course of remedy if (and in most cases, when) the investment goes south. To underline the extent of the problem, consider that more than 50% of ICOs issued in 2017 have already failed.
Luckily, at least for U.S. investors, the SEC has recently stepped in to help regulate the industry. As the SEC sees it today, the majority (if not all) of cryptocurrency sales qualify as sales of securities and thus must be done in compliance with applicable U.S. Securities laws. While many issuer companies hate the SEC’s involvement in the industry, it is necessary to provide the needed structure and investor protections, which will make cryptocurrency a genuinely viable investment vehicle.
For those that don’t know, an “STO” refers to a “Securities Token Offering.” In layman’s terms, it means a sale of cryptocurrency coins/tokens in a manner that complies with U.S. Securities laws.
The concept of an STO is similar to that of an ICO with two major differences. The first should be relatively obvious. STOs start with the premise that they are securities (unlike ICOs) and are therefore regulated by the SEC and existing securities laws. This brings STOs under the umbrella of decades of existing regulations and investor protections, which help provide structure to the industry. While there still isn’t clear regulatory guidance on many issues facing the cryptocurrency industry today, merely being treated as a security offers a much clearer blueprint for both issuers and investors (as opposed to the wild west of ICOs).
The second difference is a little more esoteric as it is related to the differences between cryptocurrency coins and tokens. For reference, “coins” typically refer to cryptocurrency that is purely transactional (i.e., act as a means of trade value between parties). A “token,” on the other hand, refers to a cryptocurrency asset which evidences one or more underlying interests/rights the holder is entitled to receive. By way of simple example, you can look at a “coin” as a chip in a casino whereas a “token” might be a ticket to spin a prize wheel in the same casino. The chip has a defined value and can be traded to a specified amount in the casino whereas the ticket’s value is dependent entirely on the result of the wheel spin.
Many ICO issuers specifically sold only coins (or simple tokens with very limited rights) in an attempt to avoid falling under securities laws. STOs on the other hand, since they are tokens and embrace the securities treatment, can be structured in a variety of ways to the benefit of both the investor and the issuer company. For example, one token may represent a fractional interest in the returns of a traditional investment fund, whereas another token may represent a fractional interest in the proceeds (if any) resulting from the mining of a literal gold mine. The options are quite endless.
Most importantly, STOs are digital assets, which, via the benefit of the blockchain technology they are built on, can be programmed with all of the relevant information so that investors will know what they are entitled to and/or own. As stated by Darren Marble, founder of CrowdfundX:
"STOs are a form of “programmable ownership” into which a company can program all of the material information into the software managing the securities. For example, when an investor acquires an STO representing an equity interest, the STO can be pre-programmed with the company’s cap table, as well as voting rights, dividend schedules, etc. of the subject STO. As a result, investors purchasing such STOs will know what their interest is in the company at any given time. No more vague contracts or lack of regulations.
STOs are an excellent option for companies looking to raise industry capital from individuals and institutional investors in a way that’s both fully compliant with securities laws and also allows for a highly tailored form of investment vehicle. For startups seeking capital, STOs are a viable and attractive option.
Regulation A (and now A+) which has been on the SEC books for over half a century now provides the preferred pathway for STOs. To fully understand the appeal and benefits of STOs, it’s necessary to understand Regulation A+. Updated in 2015, Regulation A+ (Reg A+) is an exemption from SEC registration which allows a company to issue and sell, to the general public, up to $50 million worth of securities in any given 12 month period. Given the high cap and well defined regulatory guidance, Reg A+ has opened the door for companies to issue securities outside of traditional IPOs and stock offerings, effectively making it a vehicle to bring freely tradable STOs to all investors. Plus, it’s better for companies hoping to attract quality investors who are serious about their portfolios.
In his article on INC.com, Darren Marble talks about the implications of STOs for startups, and how this new influx of institutional investors could impact growth and liquidity. He says, “Established companies are already beginning to tokenize equity in their business, and startups now have a new vehicle that may provide faster and easier access to capital.” In other words, STOs may be the next big opportunity for businesses to raise capital quickly, efficiently, and safely in a way that won’t scare off timid investors. Since STOs are qualified securities, there is little fear of speculation tanking the industry, as is sometimes the case with risky ICOs.
The facts are these. Cryptocurrency is going to be an important tool for companies to raise capital today and moving forward. But the way ICOs have been issued thus far has been negligent at best and fraudulent at worst. STOs open the door for serious, qualified investors to trade these assets in a way that’s regulated by the existing laws, guaranteeing protection for both investors and issuers.
To learn more about STOs and their implications for the cryptocurrency industry and markets in general, you can access our white paper here.
CERES is in the process of REG A+ (STO) to create a blockchain transaction network for the legal cannabis industry.