Utility or Security Token? First and most important rule of doing an ICO: Know Thyself

Flag Theory Weekly Letter – Thursday, May 17th, 2018

ICOs are currently on the everyone’s minds. In 2017 they exceeded venture capital financing and became the number one method to finance blockchain startups. The trend is exponentially growing. 

To date in 2018 ICOs have already raised more funds than in the whole year of 2017.

However, ICOs present some problems. In addition to continuous scams (intentional or unintentional), many of the utility tokens offered are actually securities and violate securities laws in several jurisdictions. The following is just for illustrative purposes, it is not, nor intends to be a legal opinion.

Utility Tokens & Security Tokens

There are two types of tokens, utility tokens, and security tokens. 

A utility token may represent future access rights to a company’s product or service. A utility token is not designed to be an investment; we could compare it to a gift card or use rights or a software license. It is meant to provide some utility within a product, service, or network. 

Most ICO’s claim to be utility tokens but there are not many utility tokens that are truly structured as such or that end up having this function.

Some securities commissions may determine the nature of the token by its actual use and not according to the way in which they were sold at the time of sale.

This could lead to tokens initially structured as utility tokens but then they get classified as security tokens by various regulators.

The second type of token is the security token. Security tokens are backed by assets and can represent equity, debt, dividend, ownership, voting rights or other assets.

These tokens are subject to securities laws and regulations. 

These regulations establish many limitations and restrictions on who can invest and trade the tokens. Normally, only accredited investors can invest in private securities offers. Both utility tokens and securities tokens would be they are subject to KYC/AML & CTF regulations, which many ICO’s are not currently carrying out.

ICOs can choose to register their issuance under regulatory frameworks in the countries where the sale takes place. In the US this involves filing a Series Regulation D or Regulation S or Regulation A+ with the SEC. Whichever Series chosen depends on the type of issuance.

In many ways, a securities token market and ecosystem make things easier and more straight forwards for investors, entrepreneurs, and regulators – but mostly for investors. When buying a security, investors have a clear contractual relationship with the project as an investor. 

As an owner of a product, there are few (if any) enforceable rights against a utility token ICO. 

However, as a bonafide investor in a project (be it debt or equity) the investor will typically be protected by existing legislation and case law (both criminal and civil). This is good for investors – and in many ways, it is good for entrepreneurs as it keeps them more accountable. This is just one reason why a movement towards a securities token market may be for the best. 

Why a Blockchain-based Securities Token Market will happen

Institutional capital has been sitting on the sidelines and wants into this new asset class. However, current forms of utility tokens are largely unsuitable under the existing LP agreements or investment mandates that institutions must comply with.

Currently, there are restrictions on venture capital funds that prevent LP investors from trading. However, raising funds for venture capital funds through the issuance of a token will allow investors to access liquidity and not have to wait for the typical 5-10 years to sell their investment.

Hedge funds, family offices, pension funds, etc. especially those with a diversification of funds mandate all would like to have exposure of some to crypto capital markets. 

In addition, blockchain-based tokens are largely divisible, reducing the minimum investments required. 

Among other advantages, utilizing the blockchain for token issuances includes the elimination of a series of intermediaries (namely banks) which will lead to a reduction in costs, faster execution, and greater accessibility.

However, there are a series of challenges that are slowing down the development of this new Market.

Challenges for Security Token Offerings (STO)

In comparison with the unregulated tokens (utility tokens), the secondary trading and the liquidity of security tokens are lower or almost non-existent since security tokens cannot be freely traded and are subject to restrictions, limitations, and barriers to entry, which we have commented above, that also vary between jurisdictions.

Exchanges at this point only cover utility tokens, in fact, we’ve seen exchanges de-list tokens that have elements of a security token. At the moment there are no licensed security token exchange platforms, although there are several private companies working on it and we expect an advance in this matter shortly.

The legal documentation is perhaps the most complex element of a securities dealer. For instance, the mandatory disclosures in the US, HK, SG, Korea, and any other country are all different. When doing a utility token ICO, this doesn’t need to be considered in the same level of detail.

Marketing restrictions and the mandatory disclosures of a regulated security token make a big difference.

Across multiple jurisdictions, there are mandatory disclosures and other filings that must be done. Doing a securities offering is a ‘well-trodden path’ that many have walked before. You can do it, it’s 100% possible. You just need the right legal advice and documentation. But, some of the other key elements relate to marketing: 

• Securities ICO – start with no one and add jurisdictions. Most projects assume they can’t do marketing (except to professional investors).
  
• Utility ICO – start with the whole world and subtract jurisdictions. Most projects assume they can do public marketing.

It’s clear that tokens can be sold as a security, or sold as a utility. The problem is when a token is both a utility and a security – I’ve recently begun to see projects that want to be both.

Here is a link to a flowchart about a securities token. This is not legal or tax or financial advice for your specific situation, but meant for illustrative/informational purposes.

If you come to us for help with structuring a token sale, be it for a securities token or utilities token, we can help you assemble the corporate structure, banking, KYC compliance, and legal help from lawyers and accountants in our global network – but the first thing we need you to be very clear on: are you a utility, or are you a security token.

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