Funds STOs Full

Funds tokenization and STO

Executive Summary

Security Token Offerings (STOs) has evolved due to the regulatory complexity of ICOs

STOs provide a known contractually-bound, legally-enforceable framework that satisfies traditional investors based on their familiarity with these regulations from the traditional finance world. Security tokens provide financial rights (equity, dividends, profits share rights, voting rights, etc.) to investors

Security tokens (not essential to the usage of the product or service) will not replace utility tokens (essential to the usage of the product or service) but rather will co-exist with them

In comparison to today’s financial ecosystems, Security Tokens offer:

Increased liquidity and market depth
Fractional ownership
Rapid settlement and cost reduction
Automated compliance
Asset interoperability and new design space

STO Deal Value STO by industries

Pros

Increased liquidity & market depth – Most private assets in today’s world are relatively illiquid as they are too costly to trade. Security tokens allow issuers to lock in their investors’ funds for operational use without limiting the investors who can sell their tokens in a secondary market without requiring a capital redemption from the fund/ asset. Furthermore, a deeper market for ownership interests and the increase in investor liquidity is expected to be accompanied by an increase in value and financial activity as the associated risk is smaller. Also, the divisibility of these tokens make the investment in these assets much more accessible which will increase liquidity as well.
Fractional ownership – Currently high unit cost items are out of reach for individuals who do not want to use an intermediary (e.g. Commercial Real Estate REIT). Security tokens allow an efficient and transparent way to fractionalize high ticket items, which will lead to a path for retail investors to construct a true “market portfolio” without any intermediaries.
Rapid settlement – Currently in traditional markets exchanges settles trade in T+2 or T+3 which means that ownership will change only after 2-3 days. Through Security Tokens, settlement can occur immediately or in a much shorter timeframe.
Cost Reduction – Nowadays, following the issuance of securities there are a lot of administrative costs associated with ownership reconciliation (Dole shares). However, when ownership is tokenized all reconciliation can occur in real time in addition to allowing managers to run what-if scenarios and calculations under different assumptions to find optimizations.
Automated compliance – As these tokens are programmable, compliance can be automated to relax current frictions of trade, especially as these can vary across jurisdictions and entities and the multiple separate ledgers they are written in nowadays. With security tokens, most of these can be hard coded into the tokens to remove the existing friction. Some claim that this value prop is so significant that authorities will require securities to be tokenized for this reason alone.
Asset interoperability – Through standards such as ERC-20, investors can hold different types of assets together and allow these to automatically interact with and reference each other on the same platform. Also, investors will have the ability to self-custody these if they want to. The ability to move value in and out of diversified portfolios will impact the way we manage our short term liquidity needs.
Expansion of the design space – Security Tokens moves us closer to the economic concept of complete contracts by allowing us to build in contractual features that were previously infeasible or complex to execute (ownership characteristics, Access rights, Unbundling value, cross assets referencing, etc.).
24/7 markets – Currently the US markets are open from 9:30am- 4pm on weekdays and investors do not have the ability to trade outside of these hours. Around the clock trading will create collaborations across all time zones.

Cons

Security offerings face compliance within jurisdictional laws or frameworks. The issue of multiple jurisdictions in one smart contract. For example, a project-based in Estonia launches an STO and makes the token-purchase available in the USA. But without ensuring compliance with US securities laws the company runs the risk of being hauled up by the SEC.
Where is real liquidity? Most existing popular crypto-exchanges are frankly not ready to work with security tokens. The mounting legal problems means that it’s just risk they don’t want to take.
STOs can be very expensive to launch when compared to an ICO, primarily because of the need to include a slew of stakeholders that are critical to the process from under-writers to legal experts to sometimes even financial institutions
Security and investor protections. What happens if private keys are lost? Issuers have more rights in a security token framework, and there must be a clear system worked out to attest to this problem.
ICOs were a huge success from an adoption PoV fundamentally due to the low barrier of entry for investors but the same can’t be claimed of STOs. Many jurisdictions require investors in STOs to be accredited and pass a lot of steps in KYC process.
Downside of transparency. Bad investments and bad decisions from fund managers are clearly visible and can increase volatility of tokens.
KYC for token transfers on Secondary Market. What are the rules to transfer a token from Person A to Person B? When it comes to securities, we need to consider KYC/KYB (Know your Customer/Business), age, residency etc. For example, a twelve-year old is not allowed to buy securities in most jurisdictions. How would such limits of transfer be enforced in a system that is open-source, borderless and censorship resistant by design?
Hard to predict the price movement based on speculative sentiment of token holders
What is the legal connection between token and underlying asset?. If you can prove ownership of the key, you can cryptographically prove ownership to the digital token. What if two or more people can prove ownership because they both know the private key?

Ecosystem

The STO world is comprised out of multiple verticals:

Trading exchanges – Create the secondary market for security tokens. Can be Token exchanges, Hybrid platforms (usually provides issuance and secondary market trading services) or Incumbent adapted stock exchanges.
Custody & Trust – hold tokenized assets on behalf of their clients to protect them against theft or loss.
Broker Dealers – Focus on providing brokerage services.
Issuance – Provide the issuance protocol for company to perform their STO.
Legal – Provide the legal services and framework to issue the tokens.
Compliance – In the space to comply with regulation, STO should encompass compliance for KYC/ AML, accredited investors checks, holding periods, investors limits and more.

Protocols and compliance standards

Ethereum based Security Token Stack (https://hackernoon.com/security-token-2-0-protocols-debt-tokens-af17d5c91a25)

Most issuers have different compliance standards:

DS-Protocol- developed by Securitize and focus on the entire lifecycle of the STO including compliance and primary issuance
R-Token- developed by Harbor and focus on Real Estate and accredited investorsST20/ ERC 1400- developed by Polymath and offers the ability to interoperate with several other token standards
ERC 1450- developed by StartEngine and allows investors to possession on their tokenized certificate but cannot transfer it
SRC20- developed by SWARM fund and based on the SWM utility token. Can interoperate with other compliant platform
ERC 884- each token represents a single share in a Delaware corp.
ERC 1404- developed by Tokensoft and allows issuers to restrict the transfer of these tokens
Debt Tokens – tokens that represent a debt instrument or cash generating vehicle based on coupons and their associated risk. Bonds have already been issued on the blockchain on the governmental level and corporate level. These can be structured as tokenized debt or on-chain issued debt. (i.e. Dharma protocol)
Hybrid/ Convertible Tokens – tokens that convert between debt and equity based on their behavior. This enables a combination of equity like with debt-like features in a single financial product. This allows the holder to balance the risk and return and hedge themselves against different market conditions. These can be structured as convertible debt security token, off-chain convertible equity token or convertible preference equity security token. (i.e. Two token waterfall)
Derivative Tokens – tokens that derive its value from underlying tokens based on a future/ forward model, options model or swap model.
Dual Token Issuance – issuing a combination of security and utility tokens to allow fund raising through the STO and then power the platform with the utility token to achieve better decentralization. (i.e. Siafunds)

Regulatory Frameworks

Examples of tokenized funds

Blockchain capital

Raised: $10M with 10M tokens available

Conducted: April 2017

Initial Price: $1.00 USD per token

Current Price: $3.74

Token & Platform: BCAP (erc-20), Issued on Tokenhub, Migrated to Securitize

BCAP Offering Memorandum

Blockchain Capital pioneered the world’s first ever tokenized investment fund and, by extension, the blockchain industry’s first security token, the BCAP, which the company sold through a security token offering in April of 2017. BCAP latest NAV: https://blockchainloop.com/blockchain-capital-releases-q2-2019-bcap-token-nav/

$3.74, The BCAP portfolio is up 274.5% since inception, post-STO from April 2017, and has a Net IRR of 80.8%. Performance figures are net of all management fees and carry.

Deeper Dive:

Initially BCAP utilized Tokenhub platform developed by Argon Group to issue it’s tokens, which also acted as the offering’s underwriter. Legal advisory was provided by London-based Allen & Overy LLP.

But they transferred their tokens to Securitize Platform in September 2018. This was made in order to further enhance the compliance process with respect to securities regulations and transfer restrictions applicable to the BCAP tokens. This upgrade is expected to provide BCAP Token holders with liquidity on secondary trading platforms that are integrated with the Securitize and it’s Digital Securities Protocol (the protocol enable digital securities to be traded in a compliant way across global marketplaces and exchanges).

Token Design:

In the case of the BCAP token, they only have an indirect economic interest in the fund (meaning BCAP tokens have no distribution or dividend rights). Their choice was driven mainly by what their lawyers told them that they could do while now the market has evolved and SpiceVC for example on the other hand was allowed for a different scheme.

How BCAP tokens work. When one of the portfolio companies of Blockchain Capital exits (either a company is sold or does an IPO or if they hold tokens from an ICO they sell them) and BCAP receives the proceedings from the exit, the fund will reinvest at least 50% of the exit proceedings in the fund while it reserves the right to use between 0% to 49% of the proceedings to repurchase tokens in the open market and burning them on the blockchain effectively lifting the value of the token as well as increasing the NAV (Net Asset Value per token) of the fund.

So as a BCAP token holder the only way you make money is when the token appreciates in value and then selling it in the open market, you never receive any money directly from BCAP. In this model in order to make money out of their token you need to rely on secondary market liquidity (for you to sell as well as for them to do buybacks) and effectively exit the fund to realize gains (since you need to sell the tokens).

Issue of transferring tokens

One possible issue of STO model is given that tokens are P2P tradable, you cannot stop people from selling them or simply transferring them to other persons and you effectively lose control of who the token holder is (in spite of having done KYC and AML checks on the original investors).

In the case of BCAP, this is not a problem given that they never return money directly to token holders so if the tokens end up in the “wrong hands”, it is not their concern anymore.

Regulatory framework

Given that Blockchain Capital is US based, their primary objective during their ICO seemed to be compliance with the SEC regulations. For that, they came up with a clever way of being able to sell to US investors without registering with the SEC as a security – by following the terms of Rule 506c of the SEC’S Regulation D, which spells out conditions under which offers of securities are exempt from normal registration rules, and Section 3(c)(1) of the Investment Company Act of 1940.

That meant, in Blockchain Capital and Spice VC (they used this framework too) case, offering sales documents to a maximum of 99 prospective investors, who had to register on its website, certify that they are accredited, provide proof of identification and respect applicable lock-up periods before selling their tokens.

Liquidity:

There is almost no liquidity on BCAP trading. In the beginning the only exchange where BCAP was listed was Liqui.io, but they’ve delisted them after few months due to regulatory concerns. It was hard for the team to get listed anywhere due to it’s security-token nature.

In 2018 OpenFinance has launched a regulated alternative trading system (ATS) for security tokens and in December 2018 they’ve announced move from beta to full trading functionality of security tokens with BCAP as it’s first partner and first official listing of security-token on regulated exchange.

SharesPost, a registered broker-dealer, ATS and registered investment advisor, said in January 2019 it had executed its first secondary transaction with BCAP tokens issued by Blockchain Capital. Though CEO John Wu told CoinDesk that it was essentially a proof-of-concept transaction. “This was a small trade, it’s like a pilot program, we’re ‘running the water through the pipes’ to make sure,” he explained. “To our knowledge, this was the first trade of digital securities by an Alternative Trading System and broker dealer in which the ATS custodied the digital securities. This clears the path for companies to do compliant STO’s in the U.S. and provide their investors with secondary liquidity.”

Aftermath:

Seems like after the experiment with first ever tokenized fund and STO, Blockchain Capital reverted to standard vc fund structure and closed their $150M Blockchain Capital IV fund in March 2018. Source: WSJ

SpiceVC

https://spicevc.com/

Raised: $15M

Conducted: 2017
Initial Price: $1.00 USD per token

Current Price: $1.3

Token & Platform: SPICE (erc-20), Issued & managed by Securitize

SPiCE Venture Capital (SPICE) is a liquid tokenized fund created by SPiCE. Founded in 2017.

The key innovation of the SPiCE token is that it is designed as a financial commitment to pay its holders the net revenues for all future investment exits executed by SPiCE VC. The SPiCE token acts as a digital security, guaranteeing that its holders receive a claim on the performance of the performance of the underlying portfolio.

The fund is closed-ended; whenever a liquidity event occurs, all net proceeds are distributed among token holders on a pro rata basis. Individuals receive a percentage of every exit proportionate to the percentage of SPiCE tokens they possess. These proceeds and the appreciation of the token are reported in SPiCE’s quarterly Net Asset Value (NAV) reports.

They take a 15% carry, after they have returned 100% of the originally invested amount.

Management fee is at 2.5%, which is very fair considering that this is a small fund.

They are publishing quarterly NAV disclosures. But, this report illustrates the problem with VC funds doing disclosure. They provide no details for their claim that the NAV is $1.308. There is no way to guess what investments (or even the largest category, “unused funds”) have had mark-to-market events. They list four portfolio companies, but they do not reveal if one of those companies is 1% or 30% of the NAV. So, it would be difficult to bid for their security even if you had an opinion about the portfolio companies.

They note that “We, at SPiCE VC are trying to hold the stick at both ends: on one hand to create a transparent report for our investors, while on the other hand, respecting the portfolio companies’ need for keeping their performance and financial information private.”

Deeper Dive:

SpiceVC has followed and upgraded the model which Blockchain Capital’s created while working on their first-ever fund tokenization, STO and which was the first VC fund to provide liquidity to investors via a token.

They didn’t use TokenHub but instead created their own token issuance and management platform which was later span-off as Securitize (which became the leader in the industry and projects like Blockchain Capital and Science Blockchain migrated from Tokenhub to Securitize and it’s DS Protocol).

Token Design:

Their token has direct economic interest in the fund. Every time there is an exit in the portfolio, they are sending the pro-rata amount to each token holder and buying back a percentage of their tokens directly from them effectively reducing the number of tokens that exist until the entire fund is liquidated and there are no tokens left.

So if SpiceVC exit 10% of fund, they will return that 10% to all token holders proportionally to how many tokens they hold and remove from each wallet 10% of the tokens and burn them in the blockchain. In this case token holder do not need to sell his tokens to make money (although he is free to do so in the secondary market if he chooses to do it) compared to BCAP model where the only way to “cash out the profits” is to sell tokens.

The maximum token supply could have reached as high as 130 million if SPiCE’s hard cap of US$100 million is met. But they’ve only raised $15M which is equivalent of around 12 million tokens which were allocated in the first closing.

Two separate SPiCE tokens are listed on Etherscan as a result of SPiCE upgrading its token to support Securitize’s Digital Securities (DS) Protocol, and the outdated tokens will be burned in the near future.

Only 8.5M tokens appear in circulation as some investors chose not to receive their tokens until they have an account with a custodian; SPiCE VC claims they are keeping those tokens in a treasury and not deploying them to the blockchain until investors are ready.

Regulatory Framework:

Spice VC followed Blockchain Capital model by using the terms of Rule 506c of the SEC’S Regulation D. With a maximum of 99 accredited investors. This allowed them to not register with the SEC as a security.

Liquidity:

Spice.VC currently only available for trading on OpenFinance Network – first regulated ATS for security tokens.

SPiCE has partnered with Bancor to create a reserve of SPiCE tokens. The reserve will use the Bancor protocol but the SPiCE token will not be openly traded on the Bancor network; the only way to access this reserve will be through completing KYC and AML accreditation through SPiCE VC. According to SPiCE’s current documentation, the firm will hold up to five percent of its capital to use BNT as a connector token in the SPiCE token’s smart contract.

This will provide SPiCE token holders some liquidity by allowing them to convert their SPiCE tokens to BNT or ETH. Token holders will not be exchanging tokens with one another and will exchange tokens directly with the reserve and therefore the fund.

Bancor’s algorithm adjusts the price of each conversion and allows the fund to offer additional liquidity to its investors. This solution will be available even in the US — where trading securities is limited due to investment lockups — because investors will receive liquidity directly from the fund via the reserve.

https://medium.com/pink-sky-group/tokenizing-securities-and-spice-vc-779da198a225

Science Blockchain

https://www.science-inc.com

Raised: $13M out of $100M hardcap raised in 2017

Conducted: November 2017
Initial Price: $1.00 USD per token

Current Price: $0.59

Token & Platform: SCI2 (erc-20), Issued by TokenHub, migrated to Securitize

Science Blockchain is an incubator fund tailored specifically towards start-ups working within Blockchain. They were one of the first companies to successfully undergo an STO.

22X

https://www.22xfund.com/

Raised: $2M

Conducted: March 2018
Initial Price: $1.00 USD per token, $0.85 for pre-sale

Current Price: -

Token & Platform: 22X (erc-20), Issued & managed by Securitize

This fund provide access to Invest in the 22nd Batch of 500 Startups companies through 22X Fund. 500 Startups is a global venture capital seed fund with a well-known accelerator program headquartered in Silicon Valley. There are 25 startups in that batch.

This is the first tokenized opportunity to invest in a group of pre-vetted early stage startups using 1 token. And you can get proceeds from the startups as they grow, exit, or IPO, or trade the 22X Fund token. 22X Fund holds up to 10% equity in each participating company.

Each of these tokens represents a 1:1 share within the 22x fund. The money raised during this token offering will be provided as funding to 30 pre-vetted start-ups, to help them develop.

BlueOcean Ventures (BOV)

https://blueocean.swiss/

Prides itself with being the first tokenized MedTech VC fund, operated by a Swiss VC firm specializing in ventures from the MedTech field.

It has issued a tradeable token (BOV) to give investors access to the highly illiquid asset class of European MedTech and life science venture capital investments.

The goal of their STO was to provide accredited investors the chance to invest in carefully selected pre-vetted MedTech start-ups.

Cosimo X (COSIMO) by Cosimo Ventures

https://cosimox.com/cosimo-x-fund/

It is a new blockchain tokenized VC fund focusing on early-stage deep tech companies concentrating on blockchain technology, across industries like artificial intelligence, virtual reality, Internet-of-Things, and cybersecurity.

Providing their portfolio companies with advice and support, Cosimo X will also be steering them toward successful initial coin offerings and Series A funding round.

Other:

Kenetic Capital is partnering with Venture Smart Asia to launch a security token fund in early 2020. Jehan Chu, managing partner of Kenetic Capital, believes the tokenized fund will untangle the “barnacles that have been weighing down the ship of capital market progress”. https://www.scmp.com/business/money/wealth/article/2179295/will-there-be-adults-room-when-tokens-disrupt-financial-order