Reading: Alternative Going Public Strategies

The much hyped "blockchain" technology could give additional boost to digital financing platforms. After all, the purpose of the blockchain technology is to eliminate information asymmetry by providing a complete audit trail that is stored in a decentralized public ledger (the blockchain). Importantly, this technology has the potential to drastically reduces issuance, transaction, and coordination costs. 

The blockchain technology also opens new sources of financing to firms, namely digital assets known as "tokens" that firms can issue to finance projects. By conducting a so-called Initial Coin Offering (ICO), firms issue crypto tokens on a blockchain (usually Ethereum, possibly also on a separate blockchain) and distribute them to token buyers in exchange for a financial contribution to the project. In principle, the process of generating these tokens on an established blockchain is extremely simple and takes but a few steps that can be executed within a few minutes (to get an idea of the process, see here).

Tokens can represent any fungible tradeable good. Basically speaking, there are two main types of tokens, Utility Tokens and Security Tokens.

 

Utility Tokens

With a Utility Token a firm factually sells "digital coupons" for the products and services that it is developing. 

For example, a project named Filecoin raised $257 million in 2017 by selling Filecoin Tokens to public buyers. The purpose of the project is to operate a decentralized platform on which unused storage space in data centers and hard drives around the world can be put to work to fulfill storage requests. On that platform, Filecoin Tokens will be the relevant currency to trade storage space.

The buyers of these tokens therefore factually purchased digital vouchers that can later be used to purchase storage on the platform (once it comes into existence). They are not owners of the platform and have no claim on the platform or its assets!

This is a general defining characteristic of utility tokens: Utility tokens do not represent ownership in the underlying platform (or the firm). They are also not secured by any claims on the platform or its assets. 

In principle, utility tokens are therefore not designed to be an investment. In reality, however, many buyers of the tokens consider them as investments. These buyers do not intend to use the tokens for purchases of the platform's future services (storage, in the case of Filecoin). In contrast, they hope that the platform will be successful so that the coins will be in high demand and the original buyers can sell them at a higher price. 

At first sight, whether or not a token is considered an "investment contract" might not seem particularly exciting, but it turns out to be crucial from a regulatory point of view. The reason is very simple: If a token represents an investment contract, it generally qualifies as a security and consequently falls under securities law. The result is that there are much more pronounced registration, disclosure, and transparency requirements, including the requirement to issue a prospectus, and that the investing "public" is generally limited to qualified investors.

 

Security Token

If a token derives its value from an external, tradable asset, it is deemed a security token and, consequently, becomes subject to securities regulations.

From the point of view of financing, one of the most promising application are security tokens that represent ownership of company stock, so-called Equity Tokens. Instead of issuing shares directly, firms can write digital certificates on these shares in the form of security tokens and then sell these tokens to interested investors. The potential advantages of these tokenized shares are, among others:

• much lower issuance costs
• easier and immediate tradability through token exchanges
• Possibility of fractional share ownership (investors can trade tiny fractions of shares)
• Simplified corporate governance (e.g., electronic voting)

  

Security tokens can also represent a direct claim on the underlying platform, as in the case of the high profile offering by the digital trading platform tZERO. In August 2018, the firm offered tokens to qualified investors that are in accordance with U.S. and other countries securities laws. According to the offering terms, the tokens will receive 10% of the platform's adjusted gross revenue on a quarterly basis (subject to board approval). 

Not surprisingly, many observers believe that security tokens have the potential to become the mainstream vessel to trade assets in the future, as they can be extended to any underlying asset, including stocks, bonds, commodities, real estate, art, yachts, etc.

  

When is a Token a Security Token

The distinction between utility and security token is far from clear. This puts many of the recent coin offerings at great regulatory risk, as they were issued as utility tokens, without any formal listing prospectus, financial disclosure, etc. Moreover, they were issued to "non-qualified" investors, that is, investors who do not meet the minimum financial standards to be eligible for purchasing individual securities according to the market regulators. The consequence is that many of these coins might become non-compliant with securities laws, which can result in hefty fines, restitution, disgorgement, and even criminal charges.

There is no uniform way of determining when a token is a security, and different regulators apply different rules.

In the U.S., the SEC performs the so-called Howey Test to determine whether a certain transaction qualifies as an investment contract. The test goes back to a 1946 Supreme Court case SEC v. Howey, where the court had to decide whether a leaseback agreement was in fact an investment contract. Under the Howey Test, a transaction is an investment contract if it fulfills the following criteria:

1. It is an investment of money (or an asset other than money)
2. There is an expectation of profits from the investment
3. The investment is in a common enterprise
4. Any profit comes from the efforts of a promoter or third party.

  

The first news breaking case related to the ICO of DAO, a virtual organization that functioned lik an investment fund and raised more than $150 million from investors in a global crowdsale in 2016. Shortly thereafter, hackers exploited a vulnerability in the DAO code and siphoned off one third of the company's funds to separate accounts. This ended the DAO adventure before it could fund any projects.

The volume of the ICO and the subsequent hack also raised the attention of the SEC, which took a closer look at the ICO to determine whether the token in fact constitute securities. In July 2017, the SEC published a report, in which it determined that the DAO coins fulfill the criteria of the Howey Test and, therefore, were securities which stood in possible violation with the securities law.

 

Other countries take a similar regulatory approach to ICOs. In Swizerland, for example, the home of the "Crypto-valley Zug," the financial market authorities FINMA has ruled that utility tokens "do not qualify as securities only if their sole purpose is to confer digital access rights to an application or service and if the utility token can already be used in this way at the point of issue. If a utility token functions solely or partially as an investment in economic terms, FINMA will treat such tokens as securities (i.e. in the same way as asset tokens)."

The implication of this ruling is that most tokens will be treated as securities, as they constitute a pre-financing of the platform and cannot yet be used on the platform as functioning utility tokens.

 

Summary

Crypto Tokens and the associated public token offerings constitute a great financial innovation that makes a potentially significant contribution towards the democratization of investment. In principle, these tokens make it possible for any company to raise funds from any investor. It takes no crystal ball to predict that this technology will fundamentally change how financial markets and financial intermediaries operate.

Yet we are still far away from a well-functioning, transparent market. The hype around ICOs has attracted many scam companies that were in for a quick buck, without any reasonable business proposal to begin with. Combined with the great regulatory uncertainty discussed before, this has harmed the reputation of crypto assets and, as a consequence, deterred serious investors and serious companies from participating in this new technology.

However, there are good reasons to believe that once the regulatory framework becomes more robust and the scam-artists are pushed off the field, the crypto markets will pick up again.