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What is a security token offering (STO)?

Igor Grigorchenko

News editor

Jun 21, 2022 at 11:53

Initial Coin Offering (ICO) became a cult phenomenon on the crypto market in 2017–2018. It is when people voluntarily pay in cryptocurrency for tokens of a future project.

As a rule, blockchain in such projects acted as the primary source of innovation. During this time, more than a hundred successful ICO campaigns were conducted, and huge amounts of money were raised, but there were no more than a dozen genuinely successful and implemented projects.

Poor investor protection, lack of control over the spending of funds, and the often unfulfilled plans gave ICOs a lousy reputation.

Nevertheless, the procedure of collective financing of promising projects was positively perceived by the crypto community. All that was needed was an improved version of such campaigns, and over time it emerged — It is a hybrid of ICO and IPO procedures, specially adapted for the crypto market.

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And now, a couple of years later, the blockchain industry has acknowledged that the ICO has been replaced by a new, more legitimate method of raising investments called STO. It is nothing entirely new, although going to market with securitized tokens was not popular at the time of the ICO’s popularity.

Many projects and investors still do not always understand the difference between STO and ICO. There are also less known variants — DAOICO and IEO. In this article, we will consider the fundamental difference between STO and ICO and list their pros and cons.

 What is a security token offering (STO)?

STO (Security Token Offering) is a professional form of cryptocurrency investing in which the owner of tokenized securities is a project co-owner.

It is more challenging to acquire tokenized securities (compared to regular ICO tokens) because only accredited investors can access them. The pros of this method are that both the investor and the project are more confident. In this scheme, opportunities for fraud or any unpleasant surprises are greatly reduced. But hence the disadvantages, because not everyone can become a licensed investor. The overall STO procedure is more complicated and lengthy.

Below we will explain it all in more detail.

How does an STO work?

STO is the public sale of a company’s shares to investors under the guise of a tokenized asset.

By buying a token at the first stage of STO, the investor becomes the owner of a share in the startup. Here we can draw an analogy with ordinary shares traded on the stock market.

STO does not always use blockchain because the tokens distributed by this method are, in fact, ordinary shares. Therein lies the main advantage of STO — because tokens are considered shares, crowdfunding is conducted under the strict control of regulators like the SEC.

In the long run, STO has a much better chance of remaining a popular way to raise money in the crypto market. Even companies that have succeeded in ICOs are now facing financial penalties from regulators. Therefore, the choice of future investors will be more and more apparent.

Source: e-zigurat.com

 

How is an STO different from an IPO?

An IPO is a standard way of raising capital for the stock market by which a private company offers shares of its organization to retail investors through the issuance of shares.

These shares are sold on a public exchange and are usually traded freely on the open market. Everything is done under the financial regulations of the US SEC.

STO is an attempt to implement IPO approaches to the crypto industry. To conduct STOs, organizations must comply with several legal and compliance protocols, and investors who buy these tokens may be subject to certain regulatory restrictions.

In addition, security tokens sold through STOs have unique features that give them a potential advantage over IPOs. Because security tokens are most often transferred via blockchain, ownership information is automatically verified and stored in an immutable but publicly available format.

It reduces the cost of raising capital from the issuer’s perspective. It also simplifies the STO process for investors, who would otherwise have to manage multiple types of documentation and make their investments through a financial intermediary, as they do in an IPO.

What are the types of security tokens?

To understand the varieties of security tokens, let’s first look at the difference between security and utility tokens. It is the most basic level of classification that needs to be clearly understood.

Utility tokens give their holders access directly to the products and services of the company that issued those tokens.  Understanding that these tokens are not originally supposed to be an investment is essential. Sometimes, a discount or bonus on a product/service is possible, but only as part of a project.

Here is an example: one of our hypothetical clients, the Super Blockchain project, has its SBC tokens, which can be further used within the project — paying for mobile communications, internet, and various service packages. The token has an understandable utility and limited use.

But this type of token does not entitle, for example, to a share in that company’s profits. Therefore, utility tokens are not supposed to fall under securities laws, which has made it very easy for crypto projects to enter ICOs, especially legally, expanding the potential token buyer base many times over.

The downside of such simplicity was that a large number of fraudsters quickly came into the crypto industry.

Source: merehead.com

What security tokens are?

Security tokens can be equated to securities. They can give their owners the right of ownership and are regulated by laws accordingly. So the SEC has ruled that security tokens are subject to the same federal laws as standard securities.

This type of token can be backed by company assets, such as stock, the right to receive dividends, or voting rights. For investors who believe in the company, it is a more transparent and secure investment.

Now we are ready to go deeper into the details of this class of tokens. There are three main categories of security tokens: 

  • Equity tokens. Upon entering STO, each token is equated to a company’s stock, giving its holders equal voting and dividend rights, and the holders themselves are equated to actual shareholders.
  • Reserve Assets Tokens. Suitable for organizations that trade physical commodities, such as real estate, gold, etc. Thus, the tokens can be protected by reserves of underlying assets.
  • Debt Token. Unlike stock or asset tokenization, this type of securitization token is a debt token with the promise of a subsequent redemption of these tokens from investors.

As you may have noticed, all the above categories are pretty familiar to the classical securities market.

What are the advantages of STO?

Because financial regulators consider this type of token to be securities, it protects token holders and, most importantly, gives them absolute rights to the assets. The government becomes an implicit participant and guarantor in this procedure.

STO is a less risky investment scheme than standard ICO tokens. And even if you are somehow cheated, you have legal opportunities to protect and defend your rights (even if we are talking about poorly regulated crypto-assets).

What are the disadvantages of STO?

The STO procedure is much more complicated than an ICO.

STO is a long and complicated procedure for the conduct and participation in which many additional conditions must be met. The investor’s desire to take part in an STO is not enough.

Compliance with the entire criteria list is often problematic for small investors. It limits the ability of STO public sales to attract a significant number of investors, not limited by their capital or geography (in ICOs, there are no such restrictions).

The more legitimate way always leads to limitations, which can be significant for the general public and small private investors but are standard for professional investors.

Source: Stobox platform

 

What is the future of STO platforms?

So, STO solves the legal problems and removes the potential dangers of an ICO. What else is needed for STO’s success in the future?

All experts state that the main factor of STO success is the availability of a working product. For 90% of people in the market, the lack of at least a prototype is the main stop factor. After many problems with ICOs, no one believes in promises anymore. Even an ordinary MVP can show how the product will work and whether it has a future. It does not guarantee that the project will “take off,” but it can reduce the risks.

The next factor for future success is to have at least some profit, a proof that your concept for making money works. Any facts, data, and product testing results in the market will be invaluable here!

So, the legal security of investors, availability of a working product, and any proof of the product’s profitability are essential for the future success of STO. It is essentially the formula for the success of any STO project, which is proved by real examples from the market. It should be noted that there are few projects in the market today that meet all three criteria. But even two of these criteria are a good claim for the success of STO.

The death of ICO and the transition of all businesses to STO is the promised evolution of the industry. Venture capital investments will get a second wind due to the relative ease and accessibility of STO. A possible STO “boom” and another solid bullish trend in all cryptocurrencies is to be expected in 2023. It will affect Ethereum significantly, and during the ICO fever, the vast majority of STO tokens will be created on Ethereum for lack of a better alternative. It is STO that will allow institutional investors to participate in projects entirely legally.

At the same time, new regulations for ICOs/STOs will be introduced over the next few years, including in the US. Platforms that previously specialized in ICOs will change their focus to STOs. Still, most will die out obtaining the necessary licenses, without which it will be illegal to conduct any crypto campaigns in the future.

The token sales model will also change: creators will no longer be able to set the price of their digital assets themselves. They will have to meet buyers’ expectations and their estimates of value. Going public will no longer crash the rate, leaving investors with nothing. Of course, it doesn’t insure against a drop in value, but now only the success or failure of the business itself will determine the price of an STO token.

How will future STO sales play out? Tokens will be sold according to the usual model for classical IPOs — through exchange instruments. Models themselves will also increase — from a simple listing of a new token on the exchange (Initial Exchange Token Offering) to complex auction models — Auction-based Initial Coin Offering, Auction-based Initial Token Offering, Exchange-based Security Token Offering, and so on.

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