Sergey Baloyan

@baloyan

The core difference between STO and ICO for projects and investors

March 6th 2019

A lot of buzz is going on in the blockchain industry with the recent trend of STOs. However, we can’t say it’s an absolutely new concept as there were some STOs even during the days of ICO hype. During these bloom days of ICOs, entering into the market with security tokens was not very popular, we’ll figure out why after this article. Even now, many projects and investors who are looking to dive in and invests on STOs do not understand the what makes it different to ICOs.

In this article, we’ll deal with the fundamentals that make STOs different from ICOs.

To full understand the differences between security and utility tokens, you need to understand their nature, and most importantly their purpose and use cases.

Utility tokens in their principle give their holders access directly to the products and services of the company that issued these tokens. It’s important to understand that in these cases, they are regarded as a tool, and not an investment. Every utility token should have a specific use case within the system. On some occasions, incentives and bonuses are possible on some products or services, but once again only within the project. Specific example: one of our clients, the Bubbletone Blockchain project has UMT tokens, which can later be used inside the project, paying for mobile communications, the Internet and various service packages. Token has a clear utility and limited use. I published earlier on my Medium channel with an even more simpler explanation and an example that will be clear even to your grandmother.

You should know that this type of token keeps from the total token supply to a part of the company or the undivided share of the profit. This can be studied while going through their token-metrics. Therefore, it is assumed that utility tokens fall outside the scope of laws on securities, which greatly facilitated the process of issuing projects to ICOs, especially in legal terms, repeatedly expanding the base of potential token buyers.

Nevertheless, it can be assumed that the price (and value) of such a token may increase with an increase in the demand for a product or a project service. Thus, the token’s utility did not prevent projects from knocking down huge sums from their token sales, and to the purchasers of these tokens from reselling them in the trading market and increase or lose their capital.

Afterwards, a great number of scammers noticed the ICO buzz and quickly made entrance into the industry. These projects themselves often came out on ICO with illusive ideas, but with only one motive; to collect investments. This strategy exposed heavy investors and shows that they were not under any protection. Many projects did not fulfill their set plans and promises they made during their marketing or through their whitepaper. Some of them disappeared or ended further development. Frequent lawsuits against roundly fraudulent companies stimulate the market, but nevertheless there was a huge number of con men. This led to many investors losing interest in the ICOs and increasing pressure from regulators.

The latter became especially active by the middle and the end of 2018, because in reality many utility tokens are actually used only for speculative purposes; all talk, no action. This forced many projects not to accept investments from residents of the United States, one of the largest markets, in their aim to avoid the formidable hands of the American SEC.

In conclusion of the ICO theme, I want to say that in my opinion, this way of fundraising for projects has the right for existence and most likely one way or another will exist. Good, real projects with the correct tokenomics and marketing will still have their own community and investors. There will definitely be projects in which the utility token is a suitable model, where it is truly a utility. But the current situation has smoothly led the market to looking for a compromise that first of all protects the interests of the investor.

So, behind a smokescreen of fundraising, STO appeared on the scene. As mentioned earlier, security tokens entered the market during the active surge of the ICO and this type of investment has been discussed for a long time. For example, one of our clients, the Paygine project, has been already entered the market with a registered security token in May 2018, giving certain non-utilitarian benefits to its potential buyers.

But for the most part, until recently, companies gave more preference to ICO. Truth be told, this is often explained by the reluctance to provide investors with significant benefits (of which we speak further) and what is equally important is to go through a more complex legal framework, which is required if you correctly invest in STOs.

So, what is the Security Token Offering and what could be the security tokens?

Security tokens, in fact, can be equated to securities. They can give their owners, for example, ownership that is accordingly regulated. So in the US, the SEC resolved that security tokens are knuckle under to the same federal laws as standard securities.

This type of token can be backed by company assets, such as stocks, the right to receive dividends or the right to vote. And undoubtedly for investors who believe in a company, this is a more transparent and safer type of investment. Since financial regulators consider such type of tokens as securities, this protects the tokens holders, and most importantly — gives them real rights.

There are three main categories of security tokens:

- Equity tokens: When entering STO with this type of token, each token is equal to the company’s shares, giving their owners equal voting and dividend rights, and the holders themselves are equal to actual shareholders.

- Reserve Assets Tokens: Suitable for organizations that trade in physical goods, such as real property assets, gold, etc. Thus, tokens can be protected by reserves of underlying assets.

- Debt Token: In distinction from the tokenization of shares or assets, this type of token security is essentially debt-based, with the promise of the subsequent redemption of these tokens from investors.

As you can see, all of these categories are quite familiar to the classic bond market. And most often STOs offer their investors real benefits: dividends, equity, right to vote, rights to the distribution of profits, call feature (buy-back rights).

- Who are STO investors — are they the same as ICO?

But, besides the token functionality itself, there are several fundamentally important things, including those that distinguish STO from ICO.

First, security tokens must be registered with the appropriate financial authority, including those depending on the country of the issuer’s jurisdiction and the geography of potential sales (for example, SEC in the USA). This is a major advantage in providing additional security and transparency for investors. Nevertheless, it significantly increases the legal costs for the project in order to comply with financial regulations and rules in this market.

Secondly, the fact that security tokens are regular equate with securities, limit the type of investors who can invest in this type of tokens. In fact, only accredited investors can invest. Requirements include at least one of the following conditions:

- Annual income of more than 200,000 USD per person or 300,000 USD per couple;

- Net assets of more than 1 000 000 USD, excluding the investor’s main residence;

- Institutions with assets of more than 5 000 000 USD;

- Legal entity completely belonging to accredited investors.

Compliance with these criteria is often problematic for small investors. This narrows the possibilities of STOs in public sales to attract the largest number of investors, not limited to their own capital or geography, as it was with most ICOs.

However, these are the rules of the game. More legitimate ways always lead to restrictions that can be a limitation for the general group of small private investors, but standard for professional investors.

Certain changes and restrictions have affected marketing activities and promotion of token sales, but that will be the topic of the next article.

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