A better form of ICO
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, 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 incessantly to follow the price jumps of the often obscure tokens they have bought. However, the lack of legally enforceable rights and accountability has 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 many a utility token falls under this definition, the typical security token represents (i) a physical asset such as gold or a Ferrari, 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 is 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.
How to tokenize your shares?
The legal foundation
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 are in support and the Federal Council is preparing a change in law to cement the concept in the Swiss Code of Obligations. There are variations in how to achieve the goal from a legal perspective, but in general it is quite straightforward: 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.
Crowdfunding and public offering
More complex than the tokenization itself is the offering of the share tokens to investors in a crowdfunding campaign: 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 investors (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 typically be drafted without excessive legal costs. Also, from 1 January 2020, no prospectus is required in case of a public offering of less than CHF 8 million per annum.
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. For the centralized solutions, the underlying blockchain is private and the company, as well as each shareholder, are typically required to sign up on the platform of the operator of the private blockchain. These solutions are comparable in their function to normal share register management software and are dependent on a central single point of failure (the operator of the platform). The decentralized solutions run on a public blockchain and, once implemented, run independently of any central party.
Why tokenize your shares?
There are the obvious benefits that a distributed ledger technology / a 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, the centralized solutions for “share tokenization” (or existing share register management software) can be a user-friendly option.
For the decentralized solutions on a public blockchain, the full power of blockchain-technology can be harnessed: This is first and foremost the direct transfer of shares without intermediary, and thus without any counter-party or central-party risk. This key advantage of assets on a public blockchain develops its full potential in combination with additional smart-contract-based applications. The development of such applications is evolving fast, and a lot of promising ideas are being implemented: Money can be raised with intermediary directly through the website of the company, decentralized exchange smart contracts allow for the direct peer-to-peer trading of shares without counterparty risk, the compliance with shareholders’ agreements can be enforced and executed automatically, shares can be used as collateral to secure debt obligations, employee stock plans can be executed automatically without expensive administration, the voting rights of shares can be assigned to activist investors for a more active shareholder participation in companies, shares can be used by the company as a means of payment for services – and these are just the most obvious examples.
For publicly traded companies, a lot of these advantages are already reality. For small and medium sized companies, the full potential of their shares lies idle as the shares are illiquid. With tokenized shares, small and medium sized companies have finally the opportunity to use the shares to their full potential and further grow their business.