With the demise of Initial Coin Offerings (ICOs), startups are exploring new avenues of raising funds for their projects. This quest has led to the birth of Security Token Offerings (STOs). STOs originated as a way to avoid getting into crosshairs with the United States Securities Exchange Commission (SEC), which regarded all ICOs as investment contracts. However, this phenomenon is no longer restricted to the U.S., and is becoming popular globally as an alternative way to raise funds for companies and startups alike.
What is a Security Token?
A security token is a digital representation of traditional securities on the blockchain. There are some general conditions in which tokens are likely to be deemed as security tokens:
- Tokens representing or giving the right to equity shares in a company/enterprise;
- Tokens representing the right to a share in profit or ownership in a company;
- Tokens representing a loan or other debt obligations;
- Tokens which are backed by real assets like real estate;
- Tokens representing a unit of a mutual fund or collective investment scheme;
- Pre-functional utility tokens in the United States.
The list above is not exhaustive, and what constitutes a security token may differ among jurisdictions. What may be considered a security in one jurisdiction may not be a security in another.
Now that we have learnt what a security token is, the next thing that we are interested in is knowing what factors to consider when making an investment in an STO. Investing in an STO is much like investing in traditional securities of a company, but with added benefits and complexity of blockchain-based tokens.
Here are some of the things that you should consider when making an investment in an STO.
Project Concept / Idea
This is the starting point of an investment process. An investor should evaluate the problem the project is trying to solve. What are the pain points of its existing users and how does the project plan to solve these problems? How big is the addressable market? Is the scale of the problem large enough for a profitable business to be built from it? Formal research methodologies like industry analysis, mapping the value chain of the business/industry, Porter’s Five Forces Analysis, SWOT analysis and VIRO analysis can be very helpful here.
A good product idea gives it a great start, but it is not the only thing that matters. A good product does not always equal worthy investment. For example, Uber is a fantastic service which solves problems involving urban transportation, but it has incurred losses that run into billions of dollars in the process of building its business. By its own admission, it may never become profitable. Hence it is important to consider other factors as well when making an investment decision.
Robin Sharma said, “The bigger the dream, the more important the team.”
The team is the biggest contributing factor that can determine the success or failure of the project. Hence, it is very important to conduct due diligence on team members. Do they have relevant experience, background, as well as the network and capability to execute the project? Evaluating a team is easier said than done and can be a very subjective process. However, here are few tips to evaluate a team that would conduct a STO:
- Talk to the founders and the senior management team either in person or over the phone. It’s the best way to get to know them. Do not simply invest by looking at the whitepaper. There have been past instances where scam projects have created fake team members by using other people’s names and identities to promote their project. It is very easy these days to create photos and profiles of people who may not at all exist. This ensures that you are dealing with real people and not fabricated profiles.
- Check their past employment records by reviewing the relevant documents and conducting a reference check with previous employers and colleagues. Do not merely rely on browsing their LinkedIn profiles and reading whitepaper, as there are many times where a project team tends to inflate their achievements to make themselves look good. Remember that a whitepaper is not an official offering document and it has not been vetted by anyone. It’s just a marketing tool. Hence, your ability to sue the project for misrepresentation is limited.
- Check the employment relationship between the individual team members and project companies. Ensure that all the key team members are employed by the project company on a full-time basis. If they are on contract, examine the nature of that contractual relationship. Name-lending is prevalent in the crypto industry, where many people lend their names to a project to make the team look stronger, but are not actually working for the aforementioned projects.
- Be sure to review who are the advisors for the project and examine their role in the context of the project. Again, it is common to have a lot of advisors lending their name to the project without adding any real value. If you see too many advisors, then it should raise a red flag.
Again, all this is easier said than done. Project teams may not always have the relevant documents and may sometimes only provide it to investors who are looking to invest a significant sum. However, it is always prudent to attempt the necessary checks.
It is important to examine the stage that the project is at, as projects in their infancy stage have a higher risk of failure than projects which are revenue generating and thus more mature. Based on their risk tolerance, investors should select projects that meet their risk appetite. I would personally prefer to invest in a project which has a live product or service which has be tested or experienced. I would generally avoid projects which are at its conceptual phase as it is very difficult to convert an idea into an actual product, and even more difficult to get paying customers.
Investors need to carefully evaluate what instruments they are getting in return for their investments. Which company is issuing those instruments? It is common to have the issuing company registered in low tax offshore jurisdiction, which is used to raise funds, and actual operations or assets located elsewhere. This investor may not have direct ownership of assets or the operating company. Thus, investors need to examine the governance structure in place to protect their interests.
General Structure of a STO
Additionally, investors also need to consider whether the legal structure of the STO sound. In most jurisdiction there are no specific laws which allow or recognize the issue of securities in tokenised form. Thus, Security Token is more likely to be a contractual arrangement or a bilateral derivative contract between the issuing company and investor where investor is getting some economic exposure or right to the property or profits or revenue of the issuing company. Thus, it would be important to engage your own lawyer to examine that structure of STO is sound and your rights as an investor are well protected.
As an investor you make money only when you are able to exit the investment at profit. Hence, it is very important to have a clear understanding of how you are going to exit the investment.
Life was easy for investors in the case of ICOs. Invest in private sale and flip over after a public sale once the coins are listed on an exchange in a few months’ time. However, the same is not the case with security tokens, as there are currently no exchanges listing them. Thus, investors will have to wait for a foreseeable future before they are able to exit the investment and see returns. Even if exchanges can list security tokens, the listing is not ensured. The project will have to meet the eligibility norms on the exchange before it can be listed on it. Thus, it is important that the investors have a discussion with the project team on the exit alternatives and factor this when making their investment decision.
These are a just a few tips based on my experience and does not constitute an exhaustive due diligence list. I would encourage all investors to develop their own investment evaluation process and follow it in a disciplined manner. Most successful investors have a very well-defined investment process that they consistently follow. Hope you enjoyed reading this post. Please do let me know what you think about this post and share your tips on how to evaluate STOs in the comments section.