Utility Tokens are totally new and game-changing, but before we can go to that new digital world, today’s investors and entrepreneurs need to do a lot of old analog stuff for a traditional early stage equity round. This is changing thanks to Security Token Offering (STO) and Initial Exchange Offering (IEO), which are two variants of a megratrend towards Tokenised Equity. Last week we looked at Utility Tokens. This week we look at Tokenised Equity. The future is not either/or it is and. In Legacy finance we use both Debt and Equity. In Crypto Token Finance we use both Utility and Tokenised Equity.
This is Part Three (Chapter 3) of The Blockchain Economy book. This serialised book is a practical guidebook for investors, entrepreneurs and employees who want to learn how to prosper during the transition to an economy where value exchange is permissionless and disintermediated. For the index/table of contents of The Blockchain Economy book please click here.
This chapter covers:
- STO vs IEO, two cousins with a different name
- How is a Security Token different from a Utility Token?
- How Security Tokens will disrupt 2 big cash spigots on Wall Street
- Why Security Tokens suffer from the blind men describing an elephant problem
- Real time settlement is the game-changer for investors.
- Easy fractionalisation brings in new capital which enables liquidity.
- Trust through verifiability and immutability.
- The appetite for early stage equity is driven by two megatrends.
- Its the company stupid (not the asset class or financing tool).
- Why the passive watch and wait and time your entry investor strategy no longer works.
- The R word – Regulation.
- The convergence of Legacy and Blockchain Finance
STO vs IEO, two cousins with a different name
A Security Token Offering (STO) and an Initial Exchange Offering (IEO) are two variants of a megratrend towards Tokenised Equity. They are two cousins with a different name. First the similarities and then the differences:
- Similarities: both are securities from a regulatory point of view and both use Blockchain networks to disrupt the old way of raising/investing early stage capital.
- Differences: An STO simply issues tokens onto Ethereum, just like an ICO. That Token may then get listed on an Exchange in order to get liquidity. An IEO lists on an Exchange from the start. Ilias Louis Hatzis describes the difference well in his Monday post on Daily Fintech when he writes “IEOs are like ICOs, except that the fund raising takes place on a specific exchange. From exchange to exchange, IEOs may slightly differ, but the basic idea is the same. The exchange performs, marketing, fundraising, and distribution and is paid a fee in the given token. When the IEO completes, the token is listed on the exchange for trading.”
In this chapter we use the name Security Token as the family name to refer to both cousins.
How is a Security Token different from a Utility Token?
This is the 101 part of this chapter.
Security and Utility Tokens have one thing in common (apart from the obvious which is the common use of the word Token). Both types of Tokens can be traded on Cryptocurrency exchanges (whether decentralized or centralized) as soon as they are issued and listed.
The key difference is that a Utility Token is a right to use something; it is not a financial instrument. Regulators, investors and entrepreneurs struggle with defining the difference because the concept of a Utility Token is so new and it has some characteristics that make it similar to a Security. The value of a Utility Token may go up and down in value based on the growth of the software/network in which you use that token. Most Utility Tokens have limited supply, which provides scarcity value, just like Equity. So the value of a Utility Token is tied to the success of the software/network in the market. These characteristics sound a bit like a Security.
However here are three major differences. A Utility Token does not give you:
- Dividends or Fixed Income.
- Capital Gains on sale of the business
- Voting Rights.
The simplest difference is Regulation. In a Utility Token, a company sells a license/right to use some software (maybe via an API key). That license/right is expressed as a Token. That Token can be resold and you may make a profit/loss on that Token. That transaction is unregulated. Normal commercial laws apply but that is different from being regulated.
Some Securities Regulators initially staked the claim that all Tokens that can be resold at a profit are Securities Tokens. This chapter analysed the recent clarifications on Utility Tokens by the US SEC. Regulators like to regulate and the bigger the domain they can regulate the better. So it is natural for Securities Regulators to want to regulate Utility Tokens as if they are Securities; but that could be regulatory over reach that has yet to be tested in the courts.
There are certainly examples of utilities that can be sold for a profit that are nothing to do with Securities. Consider a Taxi Medallion in NYC. That is regulated (by the Taxi & Limousine Commission) but nobody is suggesting that Taxi Medallions should be regulated by SEC.
Utility Tokens and Security Tokens will coexist in the market. Both have value but serve different functions.
In order to avoid trouble with Securities Regulators, entrepreneurs issuing Utility Tokens often choose to only raise money from accredited investors. Even if the Utility Token is judged by Regulators/Courts to be a Securities Token, raising money from accredited investors has different rules. This raises the question of the democratisation of finance which this chapter/post will return to later.
How Security Tokens will disrupt 2 big cash spigot on Wall Street
The two big cash spigots that Security Tokens will disrupt are:
- Venture Capital aka Growth Equity. We normally associate VC with Silicon Valley not Wall Street. Somewhere along the road to changing the world, Silicon Valley became Wall Street West. While maintaining the founding myth about funding early stage, huge VC Funds actually became Private Equity Funds that invested later and later in the growth stage. Series B in 2017 was like an IPO in 1997. Traditional VC Funds were then joined by other big pools of capital playing in the same market- Sovereign Wealth, Hedge Funds, Family Offices. Tokens, both Utility and Security, is a disruptive game changer as it gives founding teams another option. Passive Investors can still get in on the action but have to adjust their thinking in two ways. First, they have to take early stage risk. Second they have to answer the “why your cash?” question; what value will you add beyond cash? Tokens change the negotiating clout of founding teams and that is a big deal.
- IPO. An earlier chapter/post covered why riders on the IPO gravy train watch the telegram ICO in dismay. Earlier this week, Bloomberg had an update entitled How Telegram’s Crypto Coins May Attract $2.6 Billion. IPOs and ICOs now move from the $100m world to the $1 billion world. As the old joke goes “$100m here, $100m there, it does not sound like much but it all adds up”. Wall Street firms that do IPOs will move into the token world but will face more competition than they grew used to from companies that grew out of the token world.
In 1997, $100m was a medium sized IPO. From 1997 to 2017, $100m became a mega big VC round. In 2018, $100m became a midsize Token round. A few boardrooms on Wall Street have taken notice of this inconvenient truth and a few are still in denial. Many face the truth and are figuring out how to best participate, while publicly trashing the market until they figure it out.
Why Security Tokens suffer from the blind men describing an elephant problem
We don’t yet know how to talk about Security Tokens. It is like the ancient Indian fable about blind men describing an elephant. A group of blind men, who have never come across an elephant before, conceptualize what the elephant is like by touching it. Each blind man feels a different part of the elephant body, but only one part, such as the side or the tusk. They then describe the elephant based on their partial experience and their descriptions are in complete disagreement on what an elephant is. The moral of the parable is that humans have a tendency to project their partial experiences as the whole truth, ignore other people’s partial experiences, and one should consider that one may be partially right and may have partial information.
The parts of the elephant that get most often described are:
- the regulatory part, how a Security Token is different from a Utility Token.
- the market access part, what combination of wallet, KYC, Exchange and broker will build the very lucrative tollbooth between issuer and investor.
- the governance part, how all the analog administrivia functions of a legacy equity transaction and ownership can be digitised and automated.
Real time settlement is the game-changer for investors
In January 2016, I ran a workshop in Luxembourg with people who really understood the nuances of fund operations and payments. I raised the prospect of Real Time Settlement in Capital Markets and took a straw poll among the participants. This small but super knowledgeable group indicated overwhelming agreement that real time settlement a) would be mainstream within 10 years and b) that it would change the capital markets industry in fundamental ways.
If I had asked, at that January 2016 workshop in Luxembourg, “how many people think we will see Real Time Settlement in live deployment within 2-years”, I suspect very few hands would have gone up. That more rapid traction happened with the ICO disruption that went mainstream in the summer of 2017. Change normally comes from an intense need from people left out of the status quo – early stage entrepreneurs in this case.
Trading and Settlement in Legacy Finance is the story of the race car and the donkey. We measure trading in fractions of a second. That is the race car. Then we climb out of that speed machine and get onto the old grey donkey to do settlement.
“A settlement period is the period of time between the settlement date and the transaction date that is allotted to the parties of a transaction to satisfy the transaction’s obligations. The buyer must make payment within the settlement period while the seller must deliver the purchased security within this period. For certificates of deposit and commercial paper, the transaction must be settled on the same day; for U.S. treasuries, it is the next day (T+1). Forex transactions are settled in two days (T+2).”
All of that changes when we move to Real Time Settlement or to be more technically accurate – concurrent Delivery Versus Payment (DVP), which was defined by Bank of International Settlements (BIS) over 23 years ago in 1992:
- Transfer has to be final & unconditional and concurrent. Any time lag between the two is ripe for fraud; all the post trade settlement processes are designed to manage this fraud risk. This concurrency requirement is absolute. Just faster (e.g. getting from T+3 to a few hours or even minutes) does not meet the concurrency requirement, because hours or minutes are eons to a fraudster.
- Transfer must be on a gross (trade for trade) basis. Any attempt at netting creates delay and creates a multi-tier market infrastructure that will impede innovation. We have Real Time Gross Settlement (RTGS) today – between Central Banks. The disruptive change is RTGS between individuals and companies in a permissionless network (i.e the way that the Internet works).
The conceptual requirements have been known a long time. We had to wait all this time for a technology to enable this. Then along came Blockchain…
Note that the donkey does NOT need to become as fast as the race car. In fact, it might be good for the race car to slow down a bit as few can argue that High Frequency Trading (HFT) adds much value other than for HFT traders. What matters is that trading and settlement happens at the same time. This is precisely what happens on Crypto Exchanges. You send something with BTC or ETH and get a Token instantly in your wallet. Smart Contracts enable simple conditional multi-party logic (when party A does X, send Y to Party B).
VC Funds tell the story that investors don’t want liquidity in early stage equity, because those VC Funds need long term committed capital. It is true that investor don’t need liquidity, but there are three reasons why investors want liquidity.
These are the three reasons why investors want liquidity:
- optionality. You invest in Startup A, but then see a better deal in Startup B and you want to sell your equity in Startup A in order to buy that better deal in Startup B without changing your allocation to early stage equity.
- irrational exuberance. If you think Startup A is worth $100m but the market is offering $200m, you should sell.
- macro story. For example, today we are at the late stage of a big bull market. Investors may want to change their macro allocations and reduce exposure to early stage equity Regardless of whether changing allocation is the right move, having the option to do so is clearly desirable.
Liquidity is what makes Blockchain Token Finance different from traditional crowdfunding. Investors can source early stage deals through crowdfunding networks, but still need to wait for exit to get capital appreciation.
Real time settlement is a big step towards liquidity, but it is only the first step. The fact that you can put your asset up for sale does not mean that any buyers will notice, so it is only the first step; for example, I can put my home up for sale via a blog post but that does not mean buyers will find my house. To get to liquidity we also need the two other benefits of Blockchain which we cover below – easy fractionalisation and trust through verifiability and immutability. Real time settlement is only one step, but it is a critical first step. Blockchain Token Finance needs real time settlement and easy fractionalisation and trust through verifiability and immutability.
Easy fractionalisation brings in new capital which enables liquidity
Today an LP (Limited Partner aka High Net Worth Individual or Institution) can sell early stage equity assets through Secondary Markets, but the supply of buyers are limited. Easy fractionalisation brings in new capital (aka buyers), which enables liquidity.
A Security Token is referred to as an Asset Token in some jurisdictions (e.g in Switzerland which is leading the pack in Crypto Token Finance). Any asset can be tokenised – it could be Public Equity, Private Equity, Real Estate, Funds, Bonds, Gold, Diamonds, IP Assets, etc.
- Real Time Settlement – described above.
- Easy Fractionalisation; for example buying a share of a commercial property not the whole building.
- Trust through verifiability and immutability – described below
Easy fractionalisation through tokenisation will open up many new markets to a much bigger pool of investors. That leads to liquidity. It is a win/win/win:
- Win 1: entrepreneurs can more easily raise capital.
- Win 2: investors can get liquidity more quickly.
- Win 3: intermediaries who add value will have many more assets to work with.
Easy Fractionalisation through tokenisation applies to any asset. We focus on the early stage equity assets for two reasons:
- that is where there is huge unmet need on the issuer side. Ask any entrepreneur how much they love raising early stage capital the legacy way.
- Investor appetite for early stage equity is driven by two megatrends (see below)
Now lets look at the third enabler of Blockchain Token Finance – trust through verifiability and immutability.
Trust through verifiability and immutability
If you are an accredited High Net Worth Investor (HNWI) who is active in Angel Investing or you run a VC fund or invest in VC Funds, you might say “who needs Tokens, I can sell assets on secondary markets today”. True, because HNWI have lawyers and accountants and other professionals who can do the required due diligence (DD) work and deal with all the paperwork. Real time settlement enables those assets to be traded immediately. Fractionalisation brings in more buyers. None of this makes sense if you are dealing with scanned documents, analog audit processes and all the other paraphernalia of Legacy Finance. Blockchain based data that is verifiable and immutable can change that game.
We are still in the early stages of Security Tokens with changes coming that will enable:
- accounting due diligence through XBRL (please see this Chapter for more).
- legal due diligence through machine-readable smart contracts. (please see this Chapter for more).
- team due diligence through online KYC sources (is XYZ CEO really living in YYY country and does he/she have a criminal record).
- cap table transparency (registers of who owns what).
This could be seen as incremental efficiency improvement to the mechanics of investing, but add them all together and add real time settlement and easy fractionalisation and you can see a game-changing disruption to Legacy Finance.
By making the mechanics of investing massively more efficient, it changes the game; but that is all about how you invest in early stage equity. Next we deal with the why. What is driving investor appetite for early stage equity?
Investor appetite for early stage equity is driven by two megatrends
- software is eating the world (hat tip to Marc Andreessen). The takeaway for investors – it is better to be in a risky venture like Airbnb than a safe old Hotel stock that is being disrupted by Airbnb or a risky Fintech rather than a safe old bank, etc.
- decline of of the traditional IPO and reduction in public growth stage stocks. Late stage private equity has replaced the public markets. See this research from California Institute of Technology; “private capital going to startups four or more years past their first financing round has grown by a factor of 20 since 1992.” This led to a historically abnormal valuation inversion when private companies are valued higher (on paper at least) than public companies; because the pricing discipline of shorting and large numbers of investors is missing in private markets; it becomes a clubby world of insiders who say “if you buy my overvalued stock I will buy your overvalued stock”.
In short, investors need to get into the early stage. The question is how? The answer is Security Tokens.
The next question is which companies do you invest in? At this stage some old fashioned maxims rule.
Its the company stupid (not the asset class or financing tool)
- Legacy Finance primarily uses Equity + Debt.
- Blockchain Finance primarily uses Security + Utility Tokens. A Security Token is very similar to Equity but a Utility Token is a fundamentally new asset class/financing tool.
What is the same is the company being financed. The big message for investors is “it’s the company stupid (not the asset class or financing tool).” The constant that does not change is that you invest in a specific company which you think will do well. That means doing some traditional things like looking at plans and teams and getting to know the entrepreneur. Above all focus on timing (see this research for why timing matters more than any other factor).
Timing really matters. The message to investors is get in early because timing your late entry via watch and wait strategy no longer works in most cases.
Why the watch and wait, late entry strategy no longer works
Most legacy VC investors run away from early stage product risk. This flight from product risk, makes no sense because the cost to build the MVP (Minimum Viable Product) has fallen about 50x in last decade or so, thanks to open source, cloud services, APIs and remote working. So now the MVP is often funded by one of these new types of investors:
- A company that knows the market and does a Blockchain spin off.
- An executive leaving a company that knows the market who uses personal cash to fund the MVP.
- A software services business using the talent bench.
- A developer building the MVP during free time from a day job (moonlighting, passion projects).
Passive investors have historically tried to invest when they see the MVP get market traction, when the venture moves to Product Market Fit (PMF) and then Scale. The real money is made after PMF, during the Scale phase. That passive watch and wait and time your entry strategy worked brilliantly in the Social Media wave of innovation. Peter Thiel famously invested in Facebook when all they needed was capital to buy servers. However that strategy does not work so well during the Blockchain wave of innovation.
There are three reasons why the passive watch and wait and time your entry strategy does not work so well during the Blockchain wave of innovation:
- Utility Tokens are a tool to a) get to PMF and b) finance the journey from PMF to Scale. A Utility Token bought by an early adopter user is both market validation and capital.
- When more than 50% of the 7 billion people on the planet have mobile phone access to the Internet, the trajectory from PMF to Scale can be very fast – too fast for a watch and wait and time your entry strategy. The investors in the early stage Security and Utility Tokens get a first shot at funding the Scale stage, leaving the passive late stage investors looking on enviously.
- In a decentralised system the infrastructure (those servers that Peter Thiel funded) are provided by users.
The R word – Regulation
Security Tokens are…securities. As such they are highly regulated. The regulation is changing fast as jurisdictions compete to get the high quality startups into their economy. America has the amended Reg A crowdfunding and the UK, Switzerland, EU and Singapore all have Security Token initiatives.
Today the market is largely restricted to “accredited” investors ie people with a certain net worth. The idea is that Security Tokens just enables them to do more efficiently what they are already doing. Whether regulators eventually find a way for the general public to invest (so it is not just a story of how the rich get richer) without letting in too many scammers remains to be seen. The technology to enable truly democratised investing exists, so this may simply be a question of time and political will.
Regulation has two facets:
- the jurisdiction governing the venture that is raising money. In simple terms, if it “goes to court” in what country is that court located?
- the jurisdiction governing the investor.
For example a venture may use Malta or Gibraltar as jurisdiction and use that as a base to sell globally but may choose not to accept US investors because they consider the regulation risk to be too high.
The convergence of Legacy Finance and Blockchain Finance
Legacy Finance has four main asset classes:
- commodities (Gold, Diamonds, oil, art, etc)
Blockchain Finance also has four asset classes but they are very different:
- Security Token (representing Equity and Debt and some Physical Assets).
- Payment Token aka new currency (including the new generation of Stablecoins). This similar to Currencies in Legacy Finance
- Utility Token that represents the right to use something.
- Asset Token, that represents an asset in the real world. This can be like commodities in Legacy Finance, but these tokens open up a lot more assets for investing and trading.
These worlds are converging. One form of convergence is coming from competition from smaller regional stock exchanges that can offer real time settlement because they also own the settlement layer. One example is SIX in Switzerland. Another example, early into the game, is the Australian Stock Exchange (ASX). They are starting to compete with the Crypto Exchanges operating 24/7 in a less regulated environment.
How Security Tokens may prove Thomas Piketty wrong – phew!
Piketty’s best-selling book Capital in the Twenty-First Century argues that growing wealth concentration and inequality is unstoppable (other than through global coordination around a progressive global wealth tax, which is difficult because wealth is very mobile and can easily shift to more tax friendly jurisdictions).
The optimistic view is that this bleak future is avoidable thanks to three big trends happening at the same time:
- The fall in the cost to build new technology thanks to cloud, open source and open APIs.
- The fall in the cost to bring new technology to market now that more than 50% of the 7 billion people on the planet can be reached digitally via their mobile phones.
- The ability to raise capital and trade assets online.
I am an optimist, mostly because 3 has recently been added to the entrepreneur’s toolbox.
1&2 have been true for a while, but the same investors guarded the tollbooth for the ventures capitalising on that trend. For investors paying attention, this was a golden age. The third trend changes the balance of power between entrepreneur and investor. Now entrepreneurs need less capital for game-changing ventures and have more options to raise that capital.
What is that trust fund kid to do? Invest in hotels while they are being disrupted by Airbnb? Or get in on the next AirbnBb They will have to work harder to do the latter. So maybe Piketty will be wrong (and be happy to be wrong)?
The blurring boundaries in the battle for control over the tollbooth
The big market battle is over who will control the tollbooths between entrepreneur and investor. Today the tollbooth is controlled by firms on Wall Street (East and West). These firms in the analog world fall into distinct categories:
- Investment Bankers.
Digital disruption always blurs the boundaries between discrete categories in the analog world. New digital entrants start by adopting the names from the analog world but soon discover that moving into an adjacent category is often as simple as adding another button to click.
For example, Wallets and Exchanges that operate KYC controls have strong tollbooth power in the the digital world and become more like brokers. A Wallet becomes like a Bank, a place you store your money and where money gets “wired” from when you want to do a transaction.
However, “there is an app for that” is not enough even if app becomes a wallet or a service. Automated digital services are not enough for wealthy people. Humans buy from humans if they have the luxury of choice and wealthy people have the luxury of choice. So there will be the equivalent of today’s Investment Bankers/Merchant Bankers, who work on the mantra of “schmooze offline, transact online”. They leave the lunch by sending the ICO transaction service to the investor’s mobile phone.
The money today is in connecting entrepreneurs to accredited (aka wealthy) investors. Thomas Piketty is heard saying “I told you so, the rich get richer”. The regulators maintain this by proclaiming their defence of the unaccredited (aka poor aka dumb) investors. This is a transitional stage because wealth is no guaranty of being a smart investor. Many entrepreneurs are brilliant at accumulating wealth by creating a business and lousy at investing. On the other hand, many poor people are great, disciplined investors albeit investing small amounts.
Regulation should focus on disciplining bad behaviour rather than simply defining an arbitrary boundary of who can invest. That will help protect all investors (including dumb but wealthy investors) and allow for the democratisation of capital markets. Today, the regulators are acting as if public equities markets are the only real market and that Token markets are niche at best and a passing fad at worst. That is like seeing Amazon in 1998 and saying that e-commerce was niche or passing fad.
The tollbooths to the huge unaccredited market include services like Coinbase (more accounts than Schwab) and Robinhood (growing like a weed thanks to zero fee trading).
This trend to democratisation has an added layer because of the new wealth formation in the Rest Of The World where the underlying foundations are not Anglo Saxon Protestantism and where markets need to accommodate Muslim, Confucian and Hindu realities practiced by billions.
In 1997, $100m was a medium sized IPO. From 1997 to 2017, $100m became a mega big VC round. In 2018, $100m has become a midsize Token round. A few boardrooms on Wall Street have taken notice of this inconvenient truth and a few are still in denial. Many face the truth and are figuring out how to best participate while publicly trashing the market until they figure it out.
Bernard Lunn is the CEO of Daily Fintech and author of The Blockchain Economy. He provides advisory services to companies involved with Fintech (reach out to julia at daily fintech dot com to discuss his services).