What are the differences?
The issuance of digital assets via blockchain is gaining more and more traction. Initial Coin Offerings (ICOs) and Security Token Offerings (STOs) have been heralded as the future of fundraising. However, they differ in some profound and important ways.
In today’s article, we will introduce these two types of raising capital with their pros and cons and highlight how they differ from each other and classical Initial Public Offerings (IPOs).
Digital, liquid contracts for fractions of corporate stock.
Means of payment on the platform of the issuing entity.
Units of the ownership of a company.
The term ICO stands for Initial Coin Offering. It describes the issuance of a so-called “utility token” (often likened to a coupon) that can be used as a means of payment on the platform of the issuing entity. Such a token does not entail any legal rights to a profit participation or voting rights in project decisions.
In late 2017 ICOs were hyped and marketed by countless dubious projects – eventually 80% of ICOs turned out to be scams which brought a bad name on the entire crypto scene. This is very unfortunate.
Legitimate and well-organized Initial Coin Offerings are a sound and cost-efficient way of issuing tokens for community-based projects, such as the content platform Steem.it. A major downside of ICOs is that only a few utility tokens have a sound tokenomics which can generate value to their holders, while majority of ICOs were (and still are) conducted improperly with regards to regulation. Many projects claimed to offer coupon-like “utility tokens” while the issued tokens rather resembled security-similar characteristics. Hence, they are unregulated and non-compliant within securities laws which is why ICO investors lack investor protection, while projects are under a lot of risk by being prosecuted by regulators and enforcement agencies.
Security token offerings are a securities offering with the aim of raising external financing during which tokens representing financial instruments are issued. These tokens are similar to regular securities in that they constitute legal rights such as a right to profit participation, dividends and co-determination/voting in important project decisions. Requiring compliance with securities laws of the respective jurisdiction where they are being issued or offered, STOs must be authorized and are regulated by national financial supervisory authorities.
The field of STOs is still relatively young, only a small number of STOs have been completed worldwide in jurisdictions such as Germany, Luxembourg and Estonia. Few countries have clear legal frameworks in place yet, rather STOs are analyzed, approved and monitored by regulators on a case-by-case basis. The exact characteristics of rights that a security token offers its owners can differ from project to project.
Some experts consider STOs to be a game changer for the financial markets, as they allow automated, speedy and cost-efficient issuing and transfer of security tokens via the blockchain. These low costs mean that also small and medium-sized companies can conduct an STO and investors profit from higher liquidity through their shares being traded on the secondary market through specialized STO exchanges. Investors gain real ownership of shares in a company if during the STO equity tokens are issued.
An IPO is an initial public offering, a process through which a public limited company issues its shares for sale and listing on a public stock exchange, e.g. the New York Stock Exchange. IPOs are underwritten by one or more investment banks (“underwriters”). These banks have responsibilities like determining the price of a stock, marketing it to potential investors, submitting necessary legal documents and launching the IPO.
Underwriters usually also guarantee that all the issued stocks will be sold during the IPO. The strong legal requirements for listing on a stock exchange and the involvement of these investment banks makes IPOs a costly and time-consuming process that typically only large corporations can afford. The benefits of an IPO for a company are access to equity capital and high liquidity through shares being traded on the stock exchange, investors get a right to receive dividends and vote at the annual general meeting (AGM).
It is essential to distinguish between ICOs and STOs – two fundraising measures using blockchain technology – and classical IPOs being conducted on the conventional stock exchange. Unfortunately, ICOs have gained a bad reputation as many projects held in 2017/2018 turned out to be frauds.
STOs on the other hand are an innovative, blockchain-based form of issuing of securities. As the offering and issuance process can be automated with blockchain-based smart contracts, expensive intermediaries can be eliminated, and a time-consuming underwriting shortened. This makes STOs accessible and attractive to SMEs in particular.