- The design of a security token--its legal rights, claims, and governance powers--is a critical feature in making digital securities attractive as investment opportunities.
- Many STOs, both successful and otherwise, involve legal instruments that seem vastly inferior, or at best difficult to compare to their traditional counterparts.
- The industry needs thoughtfully designed security tokens and coherent explanations of those designs to enable a richer ecosystem to emerge.
Security Token Offerings (STOs) aim to combine the most appealing aspects of so-called Initial Coin Offerings (ICOs) with the compliance and investor protections of security offerings. Unfortunately, the slow progress of the security token ecosystem has failed so far to deliver on these intentions. Measured by both number and dollar value, STOs have become only a small part of the industry. Many STOs that have come to market have been largely unappealing and in many cases even, ironically, managed to unite the worst of ICOs with the worst of securities markets. While perhaps harsh, this observation also speaks to the unique nature of securities, specifically their combination of promises of capital appreciation alongside of robust investor protections, and to the absence of many of these features in the STO world. These protections include timely disclosures of material developments related to the security and, ultimately, the ability of investors to protect their interests by voting to inform corporate policies and even oust corporate leadership. This last serves as both the ultimate guarantee of investor interests as well as a strong incentive for corporate leaders to ensure that firms are competently managed.
Ironically, while investors in traditional markets have begun to lament, and in some cases to rebel against, an emerging trend of dual share structures that serve to entrench corporate leaders while removing this core investor protection, much of the emerging security token market seems to be reflecting this trend of reducing management accountability and the rights of investors. While this is surely not the only reason the STO space has developed in such a lackluster fashion, it is easily identifiable as a reason for observers to remain skeptical of the STO market’s potential if this trend does not begin to change.
BlockChain Capital’s BCAP
Blockchain Capital is a venture capital firm investing in both equity and cryptoassets offered by blockchain technology companies. Blockchain Capital’s security token, BCAP, serves as proof of fund membership and provides holders with exposure to a portion of the fund’s profits. All post-fee profits are split: 50% to be reinvested in the fund and 50% to be used for optional redemptions or BCAP buybacks. In addition, after 10 years, Blockchain Capital reserves the option to buy out the BCAP supply at then-current fund NAV.
BCAP’s structure as a security token provides several notable comparisons to existing VC fund structures. The BCAP token is transferable on secondary markets, unlike most fund positions. However, BCAP tokens do not have a liquidation option or a redemption right; investors cannot withdraw funds directly or access the underlying investment, which is generally possible with traditional funds. Per the offering memorandum, Blockchain Capital “has no fixed termination date and is under no obligation to redeem the BCAP Tokens at any time.” This leaves investors looking to exit a BCAP position dependent on any bids that may exist on the secondary market, and without any option, however lengthy or punitive, to redeem directly from the fund itself. In conjunction with BCAP having the option but not the requirement to distribute the NAV to token holders after 10 years, this structure appears to offer fewer rights to LPs compared to a traditional fund structure with a target distribution date. As a result, it is unclear why the token price should track the NAV. Notably, the price of a BCAP token on OpenFinance as of October 17th is $1.95, having last traded on September 25th, while the reported NAV is $3.58.
REITBZ is a Brazillian Real Estate Investment Trust (REIT)-like vehicle and security token issued by BTG Pactual, a Latin American investment bank. The fund will invest in distressed properties in Rio de Janeiro and Sao Paulo. The offering raised $3.3 million in July 2019. Investors may receive dividends from rental income and profits from property sales.
Despite identifying itself as a security, REITBZ is noteworthy for a striking lack of investor rights or guarantees. Traditional REITs essentially act as an intermediary holding company owning real estate, and are in turn owned by shareholders; by extension, shareholders have a legal right to the underlying property. Per the whitepaper, however, REITBZ is “a security token that will grant purchasers economic exposure to Brazilian urban real estate … by means of periodic profit distributions. The Tokens will not (i) provide legal ownership over the Issuer’s shares or the Target Assets ... nor (iii) provide voting/governance/typical shareholding rights related to the Issuer.” Further, all dividends and profit distributions are to be made at the issuer’s ‘sole discretion,’ is in contrast to traditional REITs which are required to distribute 90% of all revenue as dividends to shareholders. In practice, investors may ultimately receive all appropriate gains and render this a non-issue. However, this uncertainty is a clear reason undermining this offerings competitiveness relative to non-blockchain options.
tZERO, given its well known relationship with Overstock.com and its polarizing founder Patrick Byrne, its large fundraising round in summer 2018, and its unique claim to be a core element of security token infrastructure while also having its revenue prospects inextricably bound to the fate of the larger security token ecosystem, is a particularly prominent member of the security token world.
The structure of the instrument is uncommon:
- Holders can receive a 10% dividend of “adjusted gross revenue” or their gross revenue minus “cost of goods sold.” This number would be larger than net profit, the traditional denominator for dividends in an equity instrument, though also confusing and without much precedent.
- Holders have no governance rights.
- The S1 filing makes reference to other potential classes of stock but does not specify them or the hierarchy of rights between TZROP holders and other shareholders.
Given the inability for token holders to make their voices heard, whether to impact corporate policies or weigh on dividend policies and distributions that might impact their investment positions, it seems difficult to form a complete investment thesis that TZROP holders have a defensible and enforceable claim on the value tZERO can generate in the emerging security token ecosystem. Investors in traditional securities are not accustomed to these kinds of ambiguities--or at least accustomed to some conventions constraining behavior--but with security tokens generally and the TZROP specifically, such ambiguities are rightly alarming.
While Smith + Crown has argued that a unique promise of security tokens lies in the potential to create new vehicles that can genuinely be considered ‘Securities Plus,’ results to date appear to suggest the STO space is too frequently looking uncomfortably close to a ‘Securities Minus’ universe. Responsibility for this lies on the entire industry, from founders to advisors to the funders, issuers, and tech partners that enable these projects to come to market as ostensibly appealing investment opportunities. At a bare minimum, STOs should follow the patterns established by Quadrant Biosciences and Elio Motors that offer straightforward equity on a blockchain, where even if no other changes are made to the design of a security, blockchain-based trading offers certain advantages while preserving customary investor representations and protections. But for the numerous projects offering non-voting STOs, with discretionary dividend promises tied to vague conditions, it must be said that these offerings represent little more than the facade of a security thinly masking the substanceless, unenforceability, ambiguity and even incoherence that characterized many ‘utility tokens’ during the ICO craze. Collectively, the industry must challenge itself to develop better, and more compelling security token structures and opportunities if the promises of the security token space are to be even weakly fulfilled.
Appendix - Differences in Security Token Rights
The following table compares the rights of various security tokens with their mirrored traditional financial instrument. This information is collected from whitepapers, offering memorandums, or similar documentation where available. Lack of comprehensive documentation in many cases prevents a more comprehensive survey across the entire security token landscape.
Note: It should be acknowledged that most security tokens also intend to bring liquidity benefits, though in practice this hasn’t yet materialized.