As an alternative to selling to the masses, US companies can issue security tokens to attract investors. Whereas 2017 was the year of the utility token, 2018 is for building new and better ecosystems, showing the maturation of the crypto world.

Defining utility and security tokens

Tokens can provide value for companies offering services. A security token is a type of investment instrument that may be issued by companies and purchased by institutional investors, accredited investors, and qualified purchasers. For contrast, utility tokens can be purchased by anyone, as currency in an ecosystem.

Previously, many companies issued utility tokens as a way to offer future access to something still under development, like a pre-purchase of future software, access to services, or a  product in development. Josiah Wilmoth in a Strategic Coin interview mentioned that Filecoin raised $257M this way by selling tokens that would grant access to a decentralized cloud storage platform once it was ready.

On the other hand, a security token is issued under the federal securities laws, designed to protect both issuers and purchasers alike. These laws are well known to the broader investment community, thus security tokens offer more familiarity for investors. Security tokens are similar to other cryptocurrencies given that they are also generated as a digital, cryptographic smart contract representing investment rights such as dividends, equity, debt, and/or profit sharing. Since the shares are in form of tokens, they can also be traded. As the market develops, security tokens have the ability to become highly liquid investments.

Companies issuing securities tokens must comply with the federal securities laws as well as the laws of the countries in which their purchasers are solicited. Additionally, security token purchasers must comply with their relevant, local securities laws. Security token offerings structured in accordance with federal securities laws and various SEC regulations, can be appealing not only to crypto investors but also to institutional investors.

Various fundraising options

There are three types of fundraising options currently available for companies:

• Traditional equity/debt investments
• Utility tokens
• Security tokens

Purchases of either equity or debt in a company is the traditional way investors make investments. For example, a company could offer ten percent of the outstanding shares in a company in exchange for an amount of money analog to the existing valuation of the company. The investors would have rights to profit sharing, dividends and potentially the ability to influence the management team. This can be desirable for for the investor, but can restrict management in making key business decisions.

As amazing as utility tokens can be for in-game purchases or as currency in an ecosystem, they are rather unappealing for companies and investors, given that they are issued outside of the protections of the federal securities laws, which rise to significant legal risk. Purchasing utility tokens is a gamble without any guarantees. While traditional investments can pose challenges for companies, utility tokens do not appeal to the institutional investment community .

The third option is a security token. In Tatiana Koffman’s “Official Guide to the Security Token Ecosystem” she writes about the process of issuing a security token, which can take up to six months to set up.

First, the company structures its offering and creates marketing materials. That is followed by the legal process of registration under federal securities laws and afterwards the selling of security tokens. The company should also make a determination about the suitability of issuance platforms.

A security token offering (STO) can give a company access to capital for expansions, follow-on token offerings, and establishing the crypto platform. It can also potentially dilute the ownership of the company. Investors participating in a security token offering might expect dividends, voting rights, and possibly future utility tokens necessary to access the company’s ecosystem. Purchasers must be accredited investors or an otherwise qualified purchaser under federal securities laws. Shortcuts are not permitted and a regular legal process must be followed.

It is also possible to run a hybrid campaign, airdropping utility tokens later. The company might begin with STO as a fundraising mechanism, helping to finance the company and to build an ecosystem around it. Afterwards, the utility tokens can be issued to investors and the developer community to be spent in the new ecosystem, thus driving engagement. While voting rights and dividends are not typically given to purchasers of utility tokens, when the platform is live, the tokens can be used and peers may be able to exchange tokens just like any other asset.

Below are five examples of companies that are already engaged in selling security tokens:

1. BlockchainCapital  – Tokenized Funds by Security tokens.
2. SpiceVC – Tokenized VC fund model.
3. Kairos.com – Dual Utility and Security token model
4. Lottery.com – Revenue based tokens
5. Monetizr.io* –  Building tokenized ecosystem for gamers and developers through STO

Elephant in the room – Issues with the SEC

When properly structured under an exemption from registration, security tokens can be compliant and legal. There are several additional benefits of an STO:

For investors:

• The new security token model works for more traditional investors, not only crypto investors as was the case previously.
• Selling a security token now, still allows for the selling of utility tokens later to bring in a significant amount of money without further dilution.

For token creators:

• Gaining valuable advisors in form of investors who want the company to succeed, not just flipping the token for a quick profit.
• STOs support growth by enabling future fundraising with utility tokens without the need for a nonprofit issuance vehicle (a topic to be covered in a later blog – so check back with us!).

Tokens are a very viable course of action to raise funds for a startup, but you need to invest the time and do it right the first time around, paying careful attention to SEC regulations. For those that do, it can be a great way grow your company.

Got something you want to talk to us about here at 500 Startups?  We have a fall program and happy to work with folks working in this space. Feel free to contact me by email Rob@500.co or on Telegram @NoOneofSignificance

Special thanks to Michael Pierson from Fisher Broyles  for providing legal  perspective in writing this article.

*DISCLOSURE: FISHERBROYLES REPRESENTS MONETIZR

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