At the height of the hype and fraud of the 2017 ICO bubble, a number of unflattering comparisons were made between ICOs and penny stocks — and not without good reason. Both penny stocks and ICOs have a track record of fraudulent activity resulting from bad actors capitalizing on a lack of regulatory disclosure and uninformed investors. A shared basis of fraud is largely where the comparisons end for utility token ICOs, however, as the basic nature of a utility token differs so significantly from stock. For the burgeoning security tokens industry on the other hand, we are able to carry the analogy further — to the level of a model across a number of key factors including trading activity, investor profiles, and information landscape.

While penny stocks have earned a poor reputation over the years, they are not inherently bad companies. The SEC defines a ‘penny stock’ as a stock that trades below $5.00 and they caution investors about the risks of investing — mostly around the lack of information regarding these companies. The term’s connotation, however, does not necessarily mean the company itself lacks value. In some cases, they are perfectly legitimate, compliant, growth-oriented micro- and small-cap companies that have chosen to issue publicly tradable equity to raise capital — sound familiar?

There has been a lot of hype around the coming benefits of tokenized assets, particularly around cost-efficiencies and ease of investing, trading, and capital formation. While I believe security tokens do offer significant advantages in these realms for investors, I also believe we need to think critically about the actual logistics of this burgeoning industry. Because security tokens are financial assets with which we are already familiar (equity, debt, real estate, etc.) created in a digital, tokenized form, this is much simpler to do than for utility tokens. This is not to critique the potential for innovation that security tokens offer, but to remind people that models exist to help us predict the effects of those innovations.

In the following comparison, rather than look at penny stocks specifically, which are predominantly defined by price (and therefore highly dependent on number of shares issued), we will look at publicly traded nano- (<$50M market cap), micro- (<$300M market cap), and small-cap (<$2B market cap) companies. While the penny stock connotation is accurate in spirit, the company’s market cap is where the meat of the comparison lies.

In comparing these small publically traded companies and security token offerings, there are three main areas that we can expect to operate in similar ways: trading activity, investor profiles, and the information landscape.

The glaring omission in this comparison is the companies themselves. This is due to the fact that in recent history large-scale funding of early stage high potential companies has shifted from small IPOs to a system of venture capital, angel investors, and private equity. Security tokens will likely lead many early growth-oriented companies to issue public shares through Regulation D 506(c) and A+, meaning the number of high quality (though still very high-risk) companies issuing tokenized equity will be higher than that which currently exists in the penny stock market. It almost goes without saying that there will also be sub-optimal companies that tokenize their equity and likely accompanying uninformed investors who fail to realize that tokenization of equity has no impact on company fundamentals.

Trading Activity

Increased liquidity has been perhaps the most touted advantage of security token offerings, but to what degree will it be realized? According to Finviz stock screener, there are almost 4,000 small, micro, and nano-cap companies trading on national exchanges with 82% seeing an average daily trading volume under 500k shares (a typical breakpoint for whether institutional investors will consider a stock sufficiently liquid to consider an investment). For micro- to nano-cap companies specifically, 89% of companies do not break the 500k average volume line and 62% have less than 100k in daily average volume. In other words, liquidity will certainly increase compared to the typical VC wait-period of 5–7 years for an exit, but most tokenized companies will likely fail to generate liquidity sufficient for the average investor.

Investor Profiles

There’s been speculation around who is going to be investing in security tokens, with many claiming it will be a different crowd than the mix of get-rich-quick unsophisticated investors and more knowledgeable speculative investors that the ICO market saw. These are similar to the types of investors we see in the small-cap markets, though for the expertise of the speculative investors certainly shifts. Continuing to use those markets as our guide, it seems likely that the security token investors will be quite similar to the ICO investors in sophistication and approach — though there will likely be a lower number of the hype-driven uninformed variety.

Regarding institutional investors, based on the current breakdown of institutional vs. individual ownership in publicly traded companies we see that businesses will likely have to break through the micro-cap barrier to gain serious institutional buy-in.

Information Landscape

Information asymmetry is the root cause of unsophisticated investors making disastrous investment decisions, but it’s also one of the biggest hurdles to a small cap company hoping to generate a fair stock price and higher trading volume. Typically, the predominant way an investor gains information regarding a potential investment is from SEC filings and coverage by sell-side analysts. Many of the companies choosing to tokenize their equity will do so through Regulation D (often 506(c)) and Regulation A+, both of which have less rigorous filing requirements than an IPO process.

In other words, investors will have even less information than current publicly traded small cap companies. Not to mention the fact that they will potentially be younger with less financial history. Even if they become full reporting companies under Section 12(g) of the Exchange Act, they will still have had a less thorough original registration process.

In addition to the lack of regulated reporting information, smaller companies have a harder time gaining analyst coverage, which is pivotal in helping fill the information gap and providing guidance for investors. As a company grows, so does the coverage and analyst attention, but even a large number of microcap companies have no coverage at all. While the hype of a new-fangled technology might help drive analyst coverage for early tokenizing companies, that will likely last for only so long and reach so far.

Final Thoughts

While the VC model can be exclusionary and a valuable company at times has a hard time finding VC funding and the lock-up period is quite long, the system is not that broken. Security tokens need to prove themselves to be a significantly better capital formation option for companies — not just different and “on the blockchain.” It’s clear that security tokens have the raw materials to accomplish that value-add, but it is not guaranteed.

There is a current proliferation of security token offering and Alternative Trading System (ATS) services cropping up, and there seems to be a “build it and they will come” belief in the security token space. It seems likely that investors will indeed come to the platforms, but liquidity is generated by much more than general market depth and without it, the investors will not stay for long.

We can find a solution to the security token liquidity problem in one of the foundational concepts of blockchain technology: transparency. Tokenizing companies are going to have to reduce the information asymmetry to drive volume and limit bid-ask spreads.

Security tokens promise to bring a level of legitimacy to the cryptoasset space that was so lacking with ICOs, but having a deliberate strategy of transparency and freedom of information is the only way to ensure these tokenizing companies are traded in the market as they should be — as speculative investments for investors that have a high-risk profile. This is not a regulatory need; it is a market need.