Startup financing took a dramatic turn in 2017 as initial coin offerings (ICOs) burst onto the scene. In 2017 and 2018, more than $14 billion flowed into blockchain projects as investors looked to capitalize on crypto euphoria and the low barriers to entry made possible by the ICO funding model.
It has been less than a year since the market for ICOs went bust, but the impact of the new crowdfunding model will endure for many years to come as startups look to tokenize real assets and leverage the power of the crowd to finance their next major project. But in order to do so, these companies must follow standard securitization practices laid out by the U.S. Securities and Exchange Commission (SEC), which has deemed all crypto assets, except bitcoin and Ethereum, to be securities. At least, this is the case for projects seeking exposure to U.S. markets.
The SEC’s position on ICOs doesn’t differentiate between so-called utility tokens and security tokens. For all intents and purposes, new token offerings must comply with federal securities laws. Naturally, this has given rise to a new paradigm: the security token offering (STO).
Security Token Offering (STO): A Primer
What is the difference between an ICO and an STO? Image from Shutterstock.
While the SEC at times has been opaque about how it intends to treat ICOs, assets that do fall under its purview are governed by clear and defined regulations. Tokens that the SEC deems to be securities are commonly referred to as “security tokens.” This is not a universal definition, but a standard operating practice used by U.S. regulators when dealing with domestic ICOs that have the characteristics of a security.
A security token is any crypto-based asset that pays dividends, shares, profits or interest or invests in any other asset that too generates profits for the holder. Although ICOs have attempted to side-step this definition, the SEC administers the so-called Howey Test to determine whether an asset is indeed a security. The Howey Test says that a token is a security if it: (1) is an investment of money; (2) invests in a common enterprise; (3) has an expectation of profit; and (4) that profit is derived from the effort of others.
STO vs ICO: The Main Differences
Unlike an ICO, a security token is essentially an investment contract into an underlying asset; it has all the attributes of a security in that it is a fungible, negotiable financial instrument that represents actual monetary value. STOs are backed by real assets and follow the SEC’s guidance on compliance, issuance, and trading.