What do we call assets, debt and revenue share utilizing blockchain?
This is an interesting question as the market is changing so rapidly, so do the buzz words - the following terms are generally interchangeable: Tokenization, Digital Securities Offerings (DSO), Security Token Offering (STO), Digital/Digitized Securities, finally Digital Assets, which is the US SEC’s terminology, so clear as mud!
Sharkaroo uses STO as a description for clarity.
What is a Security Token Offering?
A security token offering (STO) is tokenized equity, an asset, debt or complex financial instrument placed on a blockchain environment and is a novel means to utilize existing equity, either to take money off the table, or to pursue new opportunities. All while being able to place the offering with a new investor class that is not normally eligible to participate in these types of offerings. In return the investor has almost instant liquidity (once restricted trading ends) and ideally trades on a national exchange or Alternative Trading System (ATS). No longer is an investor required to hold an illiquid asset for five to ten years prior to a liquidity event occurring. STO’s are fully regulated by the jurisdictions that their offering is being placed.
Bespoke STO’s are best suited for well established companies with a strong track record and considering an offering starting at $25M USD and up.
Turn-Key Digital Assets may be appropriate for a late-stage startup that is enjoying considerable traction, with a veteran founding team, seeking to raise $3M USD and up.
How much does an STO actually cost?
Typical all-in costs range between 2.5% & 12% cost of capital depending upon the specifics of your project, jurisdictions the offering is placed in and caliber of the vendors involved. There are typically significant up-front fees and retainers prior to an issuance, that are a sunk cost if the offering fails to raise it’s minimums.
Why an STO vs. Traditional Funding?
Access to a larger investor pool
Liquidity, immediate or after lock-up period via secondary exchange
Tokenizing Fractional Ownership
Programatically-Coded Compliance and Contract Terms
What are the risks I’m exposed to (worst case scenario?)
Failure to raise minimum - if your offering fails to raise it’s minimum and you have exhausted marketing funds then all funds to date are sunk costs and will have to be written off. This risk can be mitigated to some degree in the US by running a testing the waters campaign prior to your offering to judge investor interest.
End of the world, if you attempt to skip steps or save money, by not using a proven professional team of vendors, comprised of industry professionals whose companies are dedicated towards Security Token Offerings there are many potential outcomes. The absolute worst case scenario would be to be charged by one or more Security Exchange Commission’s or Monetary Authorities for selling unlicensed securities. If found guilty, beyond having to refund every single cent raised in your offering, there are significant penalties that can be enforced, both civil and criminal.
We are a startup and are BOOTSTRAPPING - is a STO even an option?
At present the cost of capital on raising under $5M is better served with traditional financing sources, as there are many STO vendors whose price does not effectively scale. As an example, it takes a broker-dealer the same amount of work to list a $1M offering as it does for a $100M offering, auditing, legal and security are much the same, the workload is consistent, regardless of the amount of the offer.
What if my company fails due DILIGENCE - now what?
Sharkaroo is currently exploring equity-based small cap options for the United States, we are not quite there yet, but may have a fully compliant option by the end of the year for offers under $5M that do not carry an excessive cost of capital. As the STO market matures, and global standards are created for repeatable workflow, costs across the board should fall.
What are the steps involved in running an STO issuance?
Please see our STO Checklist for a high-level step by step overview.
Can I sell my token to Anyone?
In most countries—but not all—security tokens sales are limited to accredited or professional investors. Beyond that secondary trading is typically restricted from one accredited investor to another accredited investor. Main street investors are currently locked out of the STO market for the foreseeable future.
In the instance where you may be able to sell to both types of investors, it may be beneficial to offer two separate tokens to keep potential regulatory compliance chaos at bay. You will want your securities attorney on speed-dial in this instance.
Best practice is to only sell your tokens via a broker-dealer on a licensed exchange, Alternative Trading System (ATC) or OTC equivalent where relevant. KYC/AML, validation of accredited status checks must be run on all potential investors and updated at least annually.
Should I CONSIDER registering my token in the US?
If you plan on selling securities to US residents, then definitely. Nearly 80% of global stock market transactions flow through New York, so it’s a massive market to be missing out on.
The US is known for stringent—if not an overarching—regulatory climate, however, if you achieve compliance with a US offering, listing anywhere else in the world should be a straightforward process.
Is there a global standard for Security Token Offerings?
Not yet, as the STO market is nascent and most of the major players are in a race to create their own standard. However there are three international working groups, including the Security Token Alliance (Sharkaroo is a member) all seeking to solve for an international standard. There are numerous subgroups including self-sovereign identity management, multi-framework token issuance, asset custody and transference, database to oracle to blockchain queries and finally AI analysis of both KYC, funds transfer activity and governance. Digital securities are a new and emerging market, with a great deal of brain power dedicated towards solving key problems. Also see: Security Token Standard, International Token Standard Association, Global Digital Finance.
There is no single standard or best practice today, 18-months from now this will likely be a different story.
If I do not have a good relationship with my issuance provider—can I change to another?
Sharkaroo’s clients are urged to thoroughly interview the issuance provider and make sure that they have a good relationship prior to moving forward. Changing providers after tokens have been issued and the smart contracts are live is a potential land mine. The reason is not technical, tokens and smart contracts while complex are normally based around open source code, which any competent blockchain developer can recreate, rather they pertain to IP rights and the suite of products deployed by the primary issuance provider. In all development contracts that we are aware of, the developer is granting the client a unlimited, global use-license with a no reverse engineer clause. So while you could take your existing token and smart contract and have it recreated by another developer, you would likely be breaking your contract terms leaving yourself open to breach of contract.
If worse comes to worse, another issuance platform can recreate your token and smart contract by deploying a Chinese Wall. It is a messy and expensive solution, but the best and possibly only choice until international token standards are formalized.
If my smart contract launches with an error, what happens next?
This is an area of smart contract and issuance protocols that is currently in development by multiple vendors, in effect how to modify a contract that is suppose to prove immutable proof and inarguable terms and conditions.
The best course of action is of course to avoid this in the first place, test, test and test some more. At Sharkaroo we use two third parties to audit our smart contracts…as it is critical to get these right the first time, forever.
Mistakes happen, and currently the best means of dealing with a smart contract error is to burn all existing tokens and reissue tokens with the new smart contract implemented. This is not for the faint of heart, especially if your tokens are now trading on secondary exchanges or in cold storage.
Which issuance platform and token framework is the best?
There are five broad-based security token issuance platforms that are world-class, whom offer a complete suites of related protocols. There are approximately 20 smaller vendors of high caliber, and several vertical niche-based issuance platforms, notable real estate, bonds and derivatives. There are also several platforms that are geographically focused, notably Germany, Switzerland and Singapore. Beyond existing platforms, it is entirely possible to contract with a blockchain development team and create your own application.
You have many options, and your decision should come down to the issuance platforms capabilities and fit (defined as: do you like working with one another). Sharkaroo can aid your company in choosing the right partners for your offering.
Do I have to accept cryptocurrencies for my security token?
Absolutely not. Unless you know that potential investors are holding considerable crypto assets you do not even have to accept them. We view crypto the same as AMEX, Visa or wire transfer, simply another payment option.
If you do decide to accept cryptocurrency investments, then you will likely want to convert this to a stable token, to remove potential volatility from your offering. There are multiple custodians that can provide this service and work with your escrow agent.
Is it possible to create a hybrid offering with traditional capital and security tokens?
Yes, this is a rapidly increasing demand as institutional and family fund investments find their way into security token offerings. They are not quite ready to invest in a tokenized asset, but are more than willing to support a novel effort on traditional terms.
Can I just create an international offering such as a Reg-S in the US, and sell my tokens anywhere?
From a US perspective, sure, as you are compliant with US laws and regulations. However, every single country has its own version of the SEC and Monetary Authority, and you need to be compliant with their laws, not the US. This is an emerging field, and cross border regulations have yet to catch up. As a general rule of thumb, any place you are offering tokens for sale, you must be registered and compliant.
Should I consider an Initial Exchange offering (IEO) instead of a security token offering (STO)?
Until a few weeks ago, our answer would have been a strict no; however there is now a major exchange on the market offering fully-compliant IEO’s. We will update details as we learn more.
Generally IEO listings come with both considerable upfront and backend expenses, with a cost of capital that exceeds traditional funding sources.
How are dividends or Free cash-flow distributed?
There are multiple solutions, however none of them simple when it comes to cross-border transactions. Please contact Sharkaroo to learn more.
Is it possible to issue tokens on multiple blockchain frameworks?
Soon. There are several initiatives underway, notably Polkadot and Cosmos Network (based upon Tendermint) which will allow for the possibility of multi-chain tokens. This should be considered an Alpha solution at present, with some adoption likely to occur in early 2020.
Do I need a tokenomics whitepaper?
Generally speaking no. White papers addressing tokenomics—the feasibility and economics behind a given token were all the rage when the ICO craze was in full swing—but are mainly irrelevant today, as STO’s are fully compliant with securities laws and do not need to get creative with economic theory.
A technical white paper is useful if your security token exhibits complex behaviour or is addressing a novel use case.
What does Ultimate Beneficial Owner (UBO) mean to my project?
UBO is a subcategory of Know Your Business/Client (KYB) requirements and will be required in the EU starting in 2020. The US is set to roll out FinCEN Customer Due Diligence Final Rule with the G-20 about to release a mandatory standard, thus Sharkaroo has adopted KYB/UBO as a global best-practice.
In practical terms, this means ownership of any major shareholder (5% or greater ownership) shell companies on the cap table will have beneficial owners identified, with KYC, AML, PEP, Sanctions, Bad Actor and Criminal checks performed on the individual shareholders. This is a legal requirement for financial service providers and the bar is intentionally set high by financial regulators.
Failing UBO will mean failing due diligence, without which your project cannot move forward.
Aside from KYB and UBO, what else can I expect during the due diligence stage of my offering?
Copy of your corporate charter and all related documents
Corporate structure clearly identifying all related legal entities
Major contracts with clients, vendors, partners
Full set of the last two years financials, ideally audited (audit is required by most jurisdictions prior to an offering) including cash on hand, liabilities and obligations
Any previous or pending lawsuits
Market position including competitive overview
Use of proceeds
Cap table and capitalization structure
3rd party asset appraisal or company valuation within last 90-days
Deeds, trust documents, proof of ownership on major assets
Any other information deemed pertinent by a financial service provider or where required due to regulatory compliance
Do I have to pay for due diligence on my project?
Yes. This will either be a unique line item, or it will be bundled in the onboarding fees. Due diligence requirements vary greatly from financial service providers and typically range from $5,000 - $50,000 per provider. The most stringent due diligence is typically performed by the primary broker-dealer or for compliance with government regulations.
In the case of a broker-dealer syndicate marketing your offering in multiple jurisdictions there may unfortunately be duplication of due diligence and fees. This is on no fault of their own, rather the way the financial reporting is setup by financial authorities, these agencies are completely responsible for the compliance information they supply to the government and typically must perform their own due diligence process and cannot trust another organizations work. This is hopelessly outdated and make-work project, but it is our current reality…until a fintech solves it.
Do I need to use a broker-dealer on my STO Offering?
While this is not a regulatory necessity in all jurisdictions, it is a best practice, for the simple reason of your offering is operating under the broker-dealers regulatory umbrella. All Sharkaroo managed projects require a primary broker-dealer, exempt market dealer or lead investment bank to provide regulatory compliance.
Broker-dealers and Investment Banks do charge a project fee (onboarding), monthly retainer while the project is active and a success-fee (commission).
TokenSoft is the one issuance platform on the market that we know of with integrated broker-dealer status. It is worth mentioning that they have just launched an internal Know Your Business (KYB) service.
Can I create shares that are convertible to tokens?
Yes, there are multiple issuance platforms and smart contacts on the market that allow for equity to token and token to equity conversion. There is a requirement for a stable coin parity or par value on equity for this to function properly. To-date convertible tokens are more a theoretical than practical application.
Why would you want a convertible token in the first place? Many institutional funds are expressly forbidden from investing in crypto-assets, either by regulation or corporate charters, they can however invest in an equity that has an option to convert at some future date when their restrictions will likely be lifted.
Is Crypto SECURITY insurance available for an STO project?
Yes insurance for security token issuance typically falls under several insurers crypto classification. It is possible to insure some or all of your STO against most common business coverage including specific insurance for securities breaches. Third party audit testing on platform, and especially on smart contracts is generally required prior to issuing insurance.
Insuring your project, at the absolute minimum vs. a data breach, should be considered a standard practice.
What token governance is required?
Shareholders or Debtors Agreement
Reservation Agreement (if early sales are being conducted)
Technical White Paper (if complex offering)
Do I need to create an offering memorandum or prospectus, or is a pitch deck sufficient?
Sharkaroo strenuously recommends creating an prospectus for all digital securities offerings, it is required in many jurisdictions. While this does add a cost to the offering it also complies to nearly all current and future changes in compliance and regulations in a rapidly changing market. Beyond compliance, it allows your investors and their advisors a clear view into your companies status, finances and roadmap. A side-benefit is that the act of preparing a prospectus tends to focus your vision on your company or projects key objectives and path to achieve these.
CRE: Can I use traditional waterfall distribution?
Yes, there are three major issuance platforms on the market with waterfall distribution of free cash flow. Customizing smart contracts on other platforms to allow for this should be easily achievable within 60-days.
Distribution of cash or crypto proceeds—within a single country—is also straight forward, however, projects with a multi-jurisdictional investor network or syndicate will take some homework, and may require more than one solution.
CRE: How is the property or portfolio actually tokenized?
All standard commercial real estate tasks are completed: survey, environmental, CUP, appraisal etc.
Funds used to purchase land or building
Fractional or complete property title transferred to SPV.
Listing on secondary exchange once lock-up period complete.
Is it possible to tokenize debt?
Yes, debt and even revenue share can be tokenized. However, tokenizing debt in the form of a secondary loan, mezzanine financing or even a bond issuance is currently a niche market within digital securities, with few if any successful case studies yet. A debt offer will be blazing the trail and inventing procedures and best practices as it goes. Debt tokenization can be particularly interesting for commercial real estate, where cost of capital should be on par or better than mezzanine, construction financing or hard-money loans while allowing token holders a share of the upside.
Going another direction, tokenized debt is an interesting alternative to traditional venture capital or private equity funding if the businesses cash flow supports this.
This FAQ is the Sharkaroo Team’s opinion, based from our experience and industry best practices. We are not securities or crypto lawyers and this FAQ in no-way represents a legal opinion. Always check with your own lawyer, or in the event of a multi-jurisdictional offering, team of lawyers. The tokenization market is evolving quickly, weekly in some cases, while we will strive to keep this FAQ up to date, some material may become dated.