If you have been following the crypto space, you have invariably heard debate over the legality of utility tokens. The argument being — if the token has true “utility,” in that it is necessary for consumers to use the network, then it should not be labeled a security. The SEC however, has pushed back saying in any case if you sell a token in order to develop the network it will be used on, then it is a security.

No one would argue a casino chip is not a security, it is merely a physical token used to gamble in the casinos. That being said, if you sell a casino chip to the public to then go build the casino where they chips will be used, then you guessed it… its a security.

Rather than trying to skirt existing securities regulations with the utility token argument in order to raise funds to actually build the project, companies need to start looking towards fully compliant securities tokens. It is these tokens that have the potential to revolutionize how companies raise capital and how investors invest their money, unlocking trillions of dollars of value.

Problems with Current System

Raising money in the public markets is no trivial task. Whether is equities, debt or real estate it is a long and expensive process. For this example, we’ll take a look at raising money through the public equities market — or an IPO.

For starters, this process typically takes at least one to two years from start to finish. Companies need to file an S-1, the initial registration form required by the SEC. This form includes things like the use of proceeds, the company’s business model and competition, a prospectus of the security itself, and offering price methodology. It is typically hundreds of pages and according to the Office of Management and Budget (OMB), it takes an average of 972 hours to complete. Keep in mind these are also companies with at least ~$100MM in revenue, so for a smaller company would be even more burdensome to complete.

According to a PwC report, companies typically incur average costs of $4.2 million in order to go public (broken down in chart below). In addition, there is an underwriter fee of around 4%-7% of gross proceeds as well as $1.5MM per year in financial reporting, legal and compliance costs once going public. The cost and time required to go public can be a substantial burden for many companies and prevents them from accessing the liquidity of public markets.

Printing alone can cost up to $2 million….

While these exact costs are specific to IPO’s, other means of fundraising incur similar costs. This is because there are always bankers and lawyers involved in the process, and the reason that Security tokens can provide dramatic improvements.

Benefits of Security Tokens

So what exactly constitutes a security token?

According to ConsenSys’ Digital Asset Taxonomy:

“tokens whose intrinsic characteristics are inherently unique to financial instruments. These intrinsic characteristics include, for example, equity ownership in a company, an interest in a fund, as well as structured debt, loans and dividend rights.”

There is nothing fundamentally different about security tokens when compared to their traditional counterpart. Intrinsically they are the same thing, the difference arises in how they are created and exchanged, which is where the improvements occur.

Those middlemen I was talking can all be nearly eliminated. Banks are no longer necessary, as companies can utilize token platforms such as those by CoinList, ICOBox, or IndieGoGo to launch their securities. Smart contracts will remove the need for lawyers, code will be law, and these platforms will help ensure fundraising is regulatorily compliant.

Once launched, the securities will be traded on exchanges such as tZero or Templum that will take settlement time from a couple days to minutes. These exchanges will open the securities up to a global pool of liquidity, giving investors the flexibility to readily sell private securities that traditionally have been illiquid. This increased liquidity cannot be understated, Aswath Damodoran, one of the most famous academics in corporate finance and valuation, estimates the liquidity premium to be around 20%-30% (40%-50% for foreign private firms). When you apply that to global privatized securities worth trillions, you can see how much value this increased liquidity can unlock.

An additional benefit is the divisibility of assets. If you want exposure to a real estate, you can purchase a a Real Estate Investment Trust (REIT). However, if you can’t afford the minimum investment, you are out of luck. What security tokens offer are the possibility to invest any amount of money into a security like this, or even take it one step further and be able to invest in the individual component parts of a REIT.

How is This All Possible?

The Securities Act of 1933 was the first major federal legislation that regulated the offer and sale of securities. For nearly a century it “protected” the average investor from higher risk investments. However this protection also meant that if you weren’t an accredited investor you could not participate in any of the upside from these high risk/high reward investments. This was until 2012, when the JOBS act was passed which allowed exceptions to be made to allow companies to raise money in ways besides an IPO or traditional venture capital. Under this act, companies were able to have alternatives to needing an expensive, time consuming IPO to access public markets. Alternatively, investors could now participate in early stage investing without necessarily being accredited. Below is a high level summary of these exemptions from having to register a security with the SEC:

As you can see, companies have various options depending on the amount of money they want to raise and the amount of time and money they want to spend on the security offering.

The Real Difference Maker

So far I have made an argument on how security tokens improve upon the existing infrastructure for both companies and investors in terms of cost and time efficiency, liquidity, and divisibility. But the real reason securities tokens will create trillions of dollars in value are the new and innovative uses that have not been possible in legacy systems.

By converting securities into a series of smart contracts, the possibilities become far reaching. Imagine creating an equity, but with various incentive mechanisms for true believers in the company by making the voting power or dividend share proportional to the amount of time the security is held. Conversely, if you are holding a security strictly for capital appreciation, what if you could sell off the voting rights or dividend stream. This is only the tip of the iceberg. The possibilities are seemingly endless once you introduce the concept of a programmable security.

For further reading these articles are truly a must read by some forward thinkers in the space.

The Official Guide to Tokenized Securities — Anthony Pompliano

Traditional Asset Tokenization; and The Security Token Thesis — Stephen McKeon