The impact of COVID-19 is reshaping many facets of businesses, creating a unique chance for industry leaders to redefine problems, consider new solutions, and ultimately change long-established paradigms.
This applies to the capital markets, as companies and investors have adjusted to the new environment in various ways: For the first time in its 228-year existence, the New York Stock Exchange (NYSE) operated in all-electronic mode for over two months. Organizations have hosted virtual roadshows to continue along the path to their initial public offerings (IPOs).
As many companies face an increased need for capital, the COVID-19 crisis may be the catalyst for companies to consider new methods of raising capital, such as through token offerings.
As discussed in a previous blog post, tokenization is relatively new but has become a topic of interest for companies looking to raise capital, even prior to the health crisis. The US Securities and Exchange Commission recognizes that certain tokens offered to the public may be securities and therefore subject to their registration and filing requirements, giving rise to the term security token offerings (STOs).
STOs are similar to initial coin offerings (ICOs) in that both act as a means to raise funds, but STOs are offerings where the issuer explicitly acknowledges that the token is a security. STOs have the potential to benefit investors and companies in unique ways. For one, companies can raise funds for a specific project or division, unlike other forms of equity ownership in which investors typically are required to bet on the whole company. Firms can gain more flexibility, as STOs allow them to define a token’s rights and terms of ownership. STOs also have low barriers to investing as tokens may permit fractional ownership, which could allow companies to attract a wide pool of global investors, including those with a high appetite for risk.
Anyone interested in raising capital through an STO should know that it brings unique challenges compared to traditional financing. In fact, while the SEC has made it clear that it will work with participants to fundraise in more innovative ways, it was not until the summer of 2019 that we saw the first SEC-qualified token offering, which utilized the Reg A+ exemption from registration of securities. Thus, it will be critical for companies and investors to form a deeper understanding of the issues related to the following areas:
Accounting and tax planning: While the Internal Revenue Service has stated that virtual currencies should be treated as property for tax purposes, the SEC and other financial reporting regulators have yet to provide definitive guidance for how digital assets should be accounted for.
As an example, the token issuer in an STO may receive cryptocurrency in return for the token sold. Without definitive guidance, current thought leadership would suggest the issuer account for the cryptocurrency received as an intangible asset. But what would the other side of the accounting entry be? How should the issuer value the tokens they have sold and where would these appear on the balance sheet? These questions are among the many likely to arise for which answers have not been fully developed in practice or by regulators.
Given this uncertainty, companies considering an STO should anticipate additional costs and complexities in determining the appropriate accounting treatment for their fundraising event and aligning with potential tax planning strategies. It will take guidance from subject matter experts and flexibility on fundraising timeline to work through these ambiguities.
Cybersecurity diligence: The speed and size of the tokenization fundraising market has drawn the attention of hackers, who may look to exploit coding and other blockchain design errors. Any company contemplating an STO should consider an independent cybersecurity audit over the blockchain to ensure the proper policies and safeguards are in place. Further, while it is important to develop the blockchain and the token offering in a secure way, the largest risk to investors is the safe storage of cryptocurrencies. Companies will need to decide acceptable forms of payment for tokens and establish procedures to safely store cryptocurrency, whether it be in token wallets or custodial options.
Marketing and registration process: To date, fundraising through tokenization has typically been performed by early-stage companies and has less often included the traditional Wall Street investment banks and lawyers involved in traditional financing. Instead, companies and crypto-focused advisors tend to take the lead by giving investors a whitepaper that outlines the technical aspects of the project. In some cases, there may also be a legal agreement governing the purchase of tokens. This approach has its pros and cons: Whitepapers are less costly and can reach a wider audience, but forgoing the role of investment banks means investors will need to take a more proactive role examining the investment thesis, understanding the rights and obligations of the token, and vetting the management team. Investors may also be required to perform more of the commercial and operational due diligence of the project or company and will need to ensure they have proper access to information to do so.
Further, STO issuers are more likely to use a registration exemption, such as Regulation D or Regulation A+, to ease the regulatory burden of raising capital. However, this limits the types of investors and permitted soliciting activities. As a result, STO issuers may find it challenging to balance the marketing of their tokens while still complying with regulations, and finding the right advisors to assist them in doing so. Additionally, due to being subject to regulation that was created and implemented in the context of traditional capital raises, issuers may find that certain, more innovative features of their tokens may be difficult to implement as the regulatory environment hasn’t evolved fast enough.
Exchanges and liquidity: To date, most of the registered national exchanges, including the NYSE and Nasdaq, do not support the trading of security tokens. While many companies and existing exchanges are developing the infrastructure to support the trading of security tokens, issuers will likely find it more difficult to identify exchange and liquidity options in STOs as the regulatory and technological environment takes shape, as compared to this being a relatively straightforward choice when it comes to other forms of equity offerings.
As paradigms are updated and companies look for new methods of raising capital, tokenization may play a larger role in the capital markets. In addition to the considerations laid out above, it’s worth noting that new challenges and opportunities will emerge as the regulatory environment, technology and public sentiment evolve. The current regulatory uncertainties in light of the pace of advancement have made it difficult in actuality for some startups to raise capital through tokenization. Given the beauty of tokens is the democratization of capital concept we touched on in the first blog post, where investors gain access to investment opportunities never available to them before, it's a perverse outcome for STOs to follow the old rails of regulation where the impact is the opposite; we are applying horse and buggy regulatory concepts to a NASCAR reality. Token raises are different from other financing vehicles and therefore need to be regulated differently.
Going forward, it will be critical for governments and business leaders to work together to coordinate what those rules could look like, especially given the number of tokenization companies based in the US market. With updated regulation and a comprehensive upgrading of the underlying infrastructure, tokenization will continue to gain relevance in the near term and could further drive the prominence of STOs in the financial and investment market landscape. Technological advances will democratize the process of raising capital, giving issuers a new way to raise funds from the public and many more people a chance to invest and own a slice of US businesses. Will you be ready?