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16/05/2019
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by Christian Meisser

Security Token Offerings (STO) in Switzerland: Tokenization of Shares

"Die beständige Ausgleichung der beständigen Ungleichheiten vollzieht sich umso rascher […] je mobiler das Kapital, d.h. je leichter es übertragbar ist von einer Sphäre und von einem Ort zum andern; […]." Karl Marx, Das Kapital Band III, Teil II, Kapitel 10

"The incessant equilibration of constant divergences is accomplished so much more quickly, […] the more mobile the capital, i.e., the more easily it can be shifted from one sphere and from one place to another; […]." Karl Marx, Capital Vol. III Part II Chapter 10


A better form of ICO

With the tokenization of shares, small to medium sized businesses from every industry gain access to liquidity and can increase the attractiveness of their shares for investors. In the following, we analyze the benefits and outline how shares can be tokenized in Switzerland.

Initial coin offerings (ICOs) have shown the incredible potential of the blockchain technology to enable a global crowd-powered capital market: Startups were able to raise millions from micro-contributions from thousands of investors, and investors from around the world gained exposure to investment opportunities by the click of a button. New trading venues appeared daily and people around the world checked their smart phones constantly to follow the price jumps of the obscure tokens they have bought. However, the absence of legally enforceable rights and the accountability deficit (see our article on Donation ICOs) have left many ICO investors disappointed, and the ICO market has all but collapsed. In the view of many, this collapse simply clears the stage for a better type of ICOs: The Security Token Offering (STO).

What are Security Tokens?

The definition is broad and still emerging – in simplified terms, a common approach by regulators is to label any token which someone buys with an investment purpose as a security token. While even a utility token may fall under this definition, the typical security token represents (i) an asset such as gold, a Ferrari or intellectual property rights in a movie, or (ii) a financial market instrument such as shares or bonds in companies.

There are countless ways of structuring security tokens with a varying degree of legal enforceability, and many security tokens are far from being a secure investment: The rights tied to a security token are often needlessly complex, with discount schedules, dividend rights and conversion rights mixed with other financial benefits and participation rights. The legal structure itself remains also mostly clouded in mystery and the actual enforceability often more than doubtful. Thus, the investment adage also holds true for security tokens: Do not invest in anything you do not understand. What most people understand, and courts know how to enforce, are the rights that come with common shares in a company. Why not, then, simply tokenize shares of a company? More complex structures can be the right choice under special circumstances. However, for most companies, the tokenization of traditional shares is usually the best solution: Easy, fast, and low-cost. The following guide is therefore solely focused on this – the tokenization of shares of Swiss companies. But before we look at the how, let's look at the why.

Why tokenize your shares?

There are the obvious benefits that distributed ledger technology / blockchain bring to the management of data: The administrative burden for the controller of the database is decreased, i.e., the share register is updated automatically and instantly, with minimum effort required by the administrator. Those who know the joys of managing a share register will appreciate the benefit of this – and if this is your main goal, centralized solutions for "digital shares " that run on private blockchains (or existing share register management software) can be a user-friendly option.

With the tokenization of shares on a public blockchain, the full potential benefits of the blockchain can be reaped. First, this allows the direct transfer of shares without intermediary, and thus without any counter-party or central-party risk, across the globe. Then, there is the ever growing number of smart-contract-based-applications, with a lot of promising ideas being developed, for example:

  • Fundraising: Shares can be sold and money can be raised without intermediary directly through the website of the company;

  • Trading: Decentralized exchanges allow for the direct peer-to-peer trading and settlement of shares transactions without counterparty risk;

  • Enforcement of contracts: Compliance with shareholders' agreements can be enforced and executed automatically;

  • Collateral: Shares can be used as collateral to secure debt obligations;

  • Share plans for employees: Employee stock plans can be executed automatically without expensive administration;

  • Voting: Voting rights of shares can be assigned to activist investors for a more active shareholder participation in companies;

  • Means of payment: Shares, instead of cash, can be used by the company as a means of payment for services

…and these are just the most obvious examples. But how can you tokenize your shares?

How to tokenize your shares?

The tokenization of shares itself is quite straightforward and the legal setup and tech implementation can be completed in a matter of weeks. The more complex part is a public fundraising campaign.

The legal set-up 

The legal concept of connecting a share of a company to a token so that the token cannot be transferred without transferring the share and vice versa is quickly gaining traction in Switzerland. Leading scholars and law firms are clearly in support, the Federal Council is preparing a change in law to cement the concept in the Swiss Code of Obligations, and more and more companies are doing it. There are variations in how to achieve the goal from a legal perspective, but in general the process is simple: The general assembly of the company decides on the tokenization, the board of directors implements the tokenization, and the company and buyers of the share tokens agree to the share token terms established by the board of directors. These share token terms set out key concepts such as the process to follow in case the tokens are lost or stolen.

The technical implementation

More consequential than the legal implementation is the technical implementation: The offered solutions today vary from centralized solutions on private blockchains to decentralized solutions on public blockchains. The private solutions are run by a service provider and typically require the company to pay an ongoing service fee and every shareholder to sign-up on the platform. These solutions are typically easy to use and comparable in their function to normal share register management software. In contrast, the decentralized solutions on a public blockchain run, once implemented, independently without any central party risk and allow access to the applications offered on the chosen public blockchain.

Crowdfunding and public offering

For those who wish to reach a greater investor base with a fund-raising campaign, things are more complex: Every country has different rules around the marketing of investment opportunities, and the type of marketing (social media marketing, targeted outreach, reverse solicitation etc.), the type of investor (retail investors, high net-worth individuals, funds), and the targeted countries have to be carefully considered to find an appropriate fit between costs and investor outreach.

In Switzerland, the rules are quite liberal and the required prospectus for the public offering of shares in a small or medium sized operating company can be drafted without excessive cost. Also, from 1 January 2020, no prospectus is required in case of a public offering of less than CHF 8 million per annum.

Conclusion

For large companies, the existing financial infrastructures already offer liquidity through the stock exchanges and many other services that allow companies and their shareholders to make the most of their shares. These traditional infrastructures are, however, rather inefficient and too costly for most small and medium sized companies. With tokenized shares, these companies can gain access to the developing blockchain based capital markets and benefit from a multitude of developing applications.