A Brief History of Security Token Offerings: How Did We Get Here?

By John Wu_San Francisco, CA_

Table of Contents

• Introduction: Raising from Sand Hill VC’s
• Enter: The Problem with Venture Capital
• Enter: The Rise of Crowdfunding Platforms
• Enter: The Rise of the Initial Coin Offering
• Enter: Munchee and the SEC’s Cease and Desist Orders
• Enter: The Howey Test
• Enter: The Birth of the Security Token Offering
• Enter: The Marketplaces That List Security Tokens
• Enter: The Rise of Security Tokens
• Enter: When Security Tokens Look More Like Traditional Investments

Introduction: Raising from Sand Hill VC’s

Sand Hill has long been legendary for having the smartest “value-add” investors that will help any entrepreneur make the right hires and secure their first couple of marquee customers. With the likes of the legendary John Doerr and Mary Meeker, investors at Kleiner Perkins Caulfield and Byers and Steve Jurvetson of DFJ, every entrepreneur who wanted to “make it” knew the pecking order in the world of venture capital and sought to obtain investments from the brand name funds.

Enter: The Problem with Venture Capital

With the growth of the VC industry as well as the establishment of well-known firms which raised larger and larger funds, the size of unicorn companies that venture capital liked to fund became larger and larger and many repeat “serial” entrepreneurs already familiar to these reputable VC firms became the same likely recipients of a majority of checks from venture firms.

With a growing number of studies and statistics around those who received funding, the conclusions seemed to be that venture capital was not able to properly allocate funds to underrepresented minorities such as females or new entrepreneurs that were not part of the existing “in-crowd.” Ultimately the personality-driven industry of venture capital and the ability of investors to allocate capital may not have been the most meritocratic way to allocate capital to the best and brightest projects without personal bias that would allow minorities, females, and first-time entrepreneurs to start companies.

Darlings of Silicon Valley such as Juicero and Luxe, backed by the legendary firms on Sand Hill, also simultaneously laid off scores of employees as these companies failed to break even and achieve profitability.

News outlets mused — had Silicon Valley lost its touch? How did these companies obtain hundreds of millions of dollars from Sand Hill VC’s for selling $400 juicers and on-demand parking valet services which would never be practical or affordable to the average middle-class consumer? Had Silicon Valley VC’s lost touch with the wants and needs of the average consumer and instead, decided to fund projects that they and their peers, the top 1%, would find valuable or had popular “celebrity” CEO’s at the helm?

Enter: The Rise of Crowdfunding Platforms

Hardware companies, infamous for their required upfront capital expenditures and high failure rates, had long been able to circumvent the VC route by using crowdfunding as a strategy. The great thing about crowdfunding was that your backers were also your initial customers who were pledging to pre-order the product that you were trying to build — a great way to prove out demand and the existence of product market fit.

It was easier for those who did not fit the Silicon Valley entrepreneur stereotype to appeal to a wider audience on the Internet using advertising and social media. Not necessarily constrained to appealing to the select few VC’s who invested in hardware in Silicon Valley, a cottage industry sprouted up of agencies that helped these companies make sleek marketing videos and viral social media posts to promote their crowdfunding campaigns.

Enter: The Rise of the Initial Coin Offering

With the launch of the idea of “Bitcoin” and alternatively “Ethereum,” blockchain technology platforms with ecosystems where tokens were a means of payment or other utility were created from what seemed to be thin air, with early backers of projects showing their support by buying tokens that were native to their respective platform. In the same way that crowdfunding platforms allowed aspiring entrepreneurs to raise money from potential users of their product, simultaneously achieving “product market fit,” these Initial Coin Offerings allowed companies to engage with token buyer participants who would also be potential users of their products. Blockchain technology and smart contracts allowed for the token buyers to claim ownership to these digital assets / virtual currencies without the involvement of a third party doing the accounting to prevent double spending.

Initially, companies were able to raise millions overnight with a theoretical “white paper” and little to no progress on an actual product with little need for investment banks or private placement agents and no need to make the rounds on Sand Hill. In this unregulated industry, the cost of capital from raising money using utility tokens was significantly cheaper than raising money via the traditional equity route.

With any profit opportunity in an industry that lacks regulation, unscrupulous characters can target the amateur consumer. With the increasing frequency of “scam” coins that did not deliver the product detailed in their white papers, the CFTC and SEC took a more active stance and increased oversight of the industry.

Enter: Munchee and the SEC’s Cease and Desist Orders

The SEC was destined to make an example of someone, so when a company called Munchee (an Instagram meets Yelp) on the blockchain stated that it would guarantee listings on exchanges in order to provide investors liquidity and also stated that the price of the Munchee token would grow as a result of the company’s hard work (as opposed to any actions taken by the token holder), the SEC deemed the token to be a security rather than a utility token. The executives of the company were given a cease and desist order by the SEC and were ordered to halt their token sale and refund the funds that they had raised so far.

Enter: The Howey Test

After Munchee’s demise, companies placed even more emphasis on consulting with law firms such as Cooley, the creator of the Simple Agreement for Future Tokens (“SAFT”) that was piloted with the debut of Protocol Lab’s Filecoin ICO. The SAFT itself was a security that had to be marketed to accredited investors, however, once the tokens were minted in the ecosystem and the product was mature, the tokens would gain “utility” and would be able to be sold to the public in a crowdsale.

The utility of the token was crucial, especially since most cryptocurrency exchanges did not have the proper broker-dealer and ATS registrations to list security tokens and trade these unregistered digital securities. After doing an initial coin offering, purchasers of tokens that were not utility tokens would not be able to recognize any “profits” or capital appreciations if their tokens were not listed on exchanges.

Enter: The Birth of the Security Token Offering

Early investment firms such as Science Blockchain were able to raise money by “tokenizing” their funds or raising money from investors through tokens in order to use these funds to invest. With the success of the initial coin offerings invested in by Science, Science token holders would be entitled to the tokens of each of Science’s portfolio companies, similar to being entitled to a dividend. The only piece missing was the fact that token holders were not able to recognize any capital appreciation by selling their security tokens to other buyers on a secondary market, due to the lack of exchanges with the proper registrations to trade security tokens.

Enter: The Marketplaces That List Security Tokens

In 2018, companies such as Templum, T-Zero, Coinbase and Sharespost announced their progress in being closer to listing security tokens on their respective exchanges. Companies such as Sharespost were uniquely positioned to take advantage of this opportunity with an existing broker dealer and ATS registration and the ability to offer the opportunity for any exchange to compliantly settle security token transactions in the U.S. through Sharespost’s GLASS Settlement Network.

Enter: The Rise of Security Tokens

With the rise of security token liquidity, companies are now considering raising funds using security tokens. These assets are “securities” and are only legally marketable to accredited investors ($1M+ net worth or $200K+ annual salary for two years). Therefore, the pool of security token buyers is much smaller than utility token buyers. These security token offerings must have their primary issuance conducted by those who are registered as broker-dealers. With this higher barrier to entry and increased “professionalism” for those who wish to facilitate security token offerings, the competitive landscape of vendors is less crowded than for utility token offerings and vendors can charge more, charging from 3–10% on average for all funds raised for their clients plus monthly retainers, success fees, etc.

Enter: When Security Tokens Look More Like Traditional Investments

Although mentions of blockchain or cryptocurrency may elicit doubt and skepticism in many circles on Main Street due to the scams that have plagued the Initial Coin Offering ecosystem, once security token offerings start to look more like stocks, bonds and alternative investments, the security token may become the next new asset class that rounds out a well-diversified portfolio.

I predict that security tokens will usher in the participation of hedge funds, wealth management platforms, and many traditional institutional investors and in the process, make blockchain-related technologies more mainstream. It will behoove exchanges or virtual currency platforms to adopt the same kind of user interface that Robinhood has by allowing users to trade digital assets and regular stocks easily in one place and also integrate the appropriate digital asset wallets into one easy-to-use platform.

I am very bullish on the blockchain-enabled ecosystem and believe that “security tokens” will help cryptocurrency lose the stigma currently associated with the term that has prompted popular thought leaders such as Warren Buffett and Jamie Dimon to issue statements indicating skepticism toward cryptocurrencies. The answer to many of the struggles of blockchain-related digital assets is to gain mainstream adoption and acceptance. This is the first of many blog posts where I will write about the security token ecosystem, and I hope we will be able to continue our dialogue around the topic — please do not hesitate to comment on this post or any subsequent posts on my Medium or Twitter.

___

Thank you kind reader for taking the time to read through my blog! If we haven’t met yet, it’s an honor to make your acquaintance. My name is John Wu and I am currently CEO of Sharespost’s Digital Assets Group. My primary aim is to bridge the gap between professional “institution-grade” asset management and cryptocurrency/blockchain investing.

As a tech investor and entrepreneur, I have always strived to identify disruptive trends before they are well-discovered and well-understood. In the last three years, I have focused on digital assets and blockchain technology. I have invested in cryptocurrencies, and tokens — as well as VC equity of startups building the financial system of the future using blockchain and distributed ledger. I started my investing career at Tiger Management. Later, at Kingdon Capital, I invested in companies across Technology, Media, Telecom, FinTech, and Services. I founded Sureview Capital in 2010 with a strategic investment from Blackstone and raised approximately $400M in AUM. If you’d like to connect, please drop me a line on LinkedIn here.