Getting Started with Your Security Token Offering

On April 18, 2019, we conducted a joint webinar on raising capital by conducting security token offerings.  My colleague and I covered the legal side of how to conduct an STO in compliance with applicable laws.  The team at tZERO handled the technical and logistical aspects of hosting an STO and actually generating tokens.  They also addressed such questions as secondary trading of the security tokens.  You can view the entire webinar here: https://www.youtube.com/watch?v=r2oSwVmIE9s

After the webinar, I created the following guide summarizing certain points that a potential STO issuer should consider.  Here is my step-by-step guide:

Step 1: Understand the regulations

Conducting a securities token offering involves issuing securities. Every offer and sale of securities must be registered with the Securities and Exchange Commission (the “SEC”) pursuant to the registration requirements of Section 5 of the Securities Act of 1933 (the “Securities Act”) unless such offering qualifies for one of existing exemptions. I previously posted a brief summary of several commonly used exemptions and regulations here.

Step 2: Understand the technology

Choosing the correct blockchain for your token is the next big decision you have to make. It needs to be secure and integrate well with different platforms and exchanges (just imagine what a costly mistake would be selecting a blockchain that does not work with your chosen security token exchange!). Most of the token industry issues tokens based on the Ethereum blockchain and the ERC-20 protocol because of its interoperability and simplicity to design. However, the ERC-20 token does not have any transfer restrictions.

The following are the four standards that build on top of ERC-20 protocol and that are specifically designed for security tokens:

ST-20 developed by Polymath
R-Token developed by Harbor
ERC-1400
ERC-1404 developed by Tokensoft

Each has a unique set of conditions tailored specifically to security tokens. Often, the choice of a platform for token issuance will help determine which standard will be used since several platforms have their own standards, such as Polymath and Harbor.

Step 3: Choose the token issuance platform

Choosing the right platform has a direct effect on the success of the offering. Several platforms have emerged that offer tokenization services to issuers. Some provide only technical assistance in generating the tokens, whereas others offer a more comprehensive set of services that include, in addition to tokenization, assistance with determining the terms of the offering, smart contracts creations, KYC/AML built-in checks, marketing assistance, and integrations with other blockchain participants.

Examples of token issuance platforms include Securitize, Polymath, tZERO, Securrency, Harbor, and Swarm, among others. Given that the platforms offer different services at different pricing points, issuers should obtain quotes from several platforms and choose the one best suited for their needs and budget.

Step 4: Set up the issuer entity and resolve corporate governance questions

The legal structure of the issuer varies greatly, and occasionally we see the issuer setting up a separate subsidiary to conduct a securities token offering. Although it is possible to form a foreign entity to conduct the STO, such a structure requires compliance with the laws governing the issuance of tokens in the home jurisdiction as well as compliance with the laws of each country where the investors are located. Also, setting up a foreign entity will preclude reliance on certain exemptions described in my separate post, such as Regulation CF or Regulation A+ (both Tier 1 and Tier 2).

Step 5: Structure the terms of your security tokens

There are no standard terms for security tokens. Some are structured to be more like shares in a corporation and offer voting and dividend rights. Others evidence a loan and the right to be repaid with interest, which may sometimes be convertible into an equity-like instrument. Yet other tokens can represent a profits interest or a revenue share, or simply a fractional ownership of an asset. One of the initial steps of an STO process is creating a summary of the token terms together with a competent legal adviser.

Step 6: Select your STO team

The very first step in conducting a successful security token offering is assembling a team of service providers with prior experience in STO issuances. You will need to select a legal adviser, a token issuance platform, and possibly a marketing agency and a broker-dealer. Depending on the type of offering you elect to conduct, you may also need to retain services of a transfer agent and engage local counsel in jurisdictions where you intend to sell the tokens.  In the future, I'll write about what types of services to expect from your legal adviser.

Step 7: Understand resale restrictions and secondary trading

It is important to carefully select the right exchange for your security tokens. Many exchanges allow trading of cryptocurrencies and utility tokens. Hosting the trading of security tokens requires exchanges to get additional regulatory approvals.  It is my understanding that there are currently only two U.S. centralized exchanges that are authorized to trade security tokens: tZERO and
OpenFinance.

There are several others that are in the process of getting the necessary regulatory approvals to trade security tokens. You should learn the listing requirements and understand the regulatory compliance of the exchanges ahead of conducting your STO.

I hope this guide, together with the webinar, will help you find answers to some of your questions regarding raising capital through the issuance of security tokens.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.