The Guide to Smart Securities

There is a tremendous amount of information about security tokens discussing either the regulatory, technology, platforms or protocols told from the lens of each solution provider. We’ve attempted to create a common sense guide to the entire process to help companies with a framework with which to evaluate whether a security token offering (STO) makes sense for them.

Business Review

The first step is to take inventory of your business, including your strategy, financials, business plan, and capital needs. This assessment will drive the strategy, timing and expense of your STO.

Selecting Ecosystem partners

A security token offering is a collaboration between an array of service provider disciplines. Because the ecosystem features both silo solutions and overlapping service offers, choices are complicated. The right advisors can significantly accelerate your learning process.

Legal

Your attorney prepares your offering documents. Those documents may, or may not, have to be filed with the SEC or another regulatory agency. The quality and accuracy of these documents could mean the difference between raising capital in a few weeks or having to deal with months of back-and-forth with regulators. Remember, we aren’t inventing securities here. There are rules for Reg A, Reg D and S-1 offerings. Not so common is the lawyer who can describe the relevant features of a security token in terms that align with the SEC’s understanding of how a security needs to operate in order to be in compliance.

It is important that you engage with an attorney prior to raising any new funds, whether you intend to do a private placement or a public offering to make sure you don’t inadvertently make any decisions that will encumber your offering.

Broker/Dealer

While a broker/dealer is not mandated in every case, certain states require that a licensed broker/dealer be engaged in order to solicit investors in their state. In light of that, many security tokens are engaging a broker/dealer to leverage their license, help them raise capital or both. The broker/dealer is responsible for doing the due diligence on the company, including bad-actor checks, and performs the compliance functions necessary to clear trades.

The broker/dealer will also file the necessary forms with FINRA, and any filings required at the state level as required in each jurisdiction.

Money Services Business and Technology Platforms

Depending on the securities law under which you do your offering, you may require the services of a money service business, a technology platform, or both. For example, during a security token offering under Reg A, there may be a large investor pool with small amounts of money that just passes through a bank account. In some cases, those payments will be made through debit or credit card processors. In such cases, an issuer or broker/dealer might utilize a technology platform and a money services business (such as a merchant services provider) who will (a) Help satisfy the Know Your Customer and Anti-Money Laundering checks on investors and (b) collect the investor funds and hold them in a bank account until each trade is cleared and (c) produce a list of investors and token allocations. These companies charge in various ways for the services provided.

Coding the Token

A security token is a smart contract that is deployed to a blockchain. The code contains certain features that restrict the token from violating any securities regulations, including ensuring that the individuals who are investing in or trading the token have passed KYC/AML. Similarly, the security token has features that allow it to be “managed” by a transfer agent (if you are using one) so that it can be transferred in the event of death, divorce or settlement. 

Companies can either hire a development shop to create their smart contract and whitelist or can engage one of several platforms that are standing up “token factories” whereby you can enter a limited number of custom parameters (company name, # of decimals in your token, dividend, etc.), upload your cap table, and mint your tokens. In any case, it’s essential that you form a relationship with your transfer agent before you deploy your smart contract to ensure sufficient time to onboard your protocol and manage key infrastructure. In the case of a custom security token, it is wise to engage a 3rd party audit of the smart contract prior to deployment.

Transfer Agent

In a Regulation A or S-1 offering, a transfer agent acts on behalf of the issuer to manage token transfers during issuance, and throughout the lifecycle of a token. Like a security, when people die, get divorced or split property for any reason, the transfer agent is responsible to see that all the legal requirements are met to “prove” the legitimacy of the transfer, and then to execute that transfer. In the case of a security token, the transfer agent will hold a “Master” private key that will enable them to execute a “forced transfer” in these cases, including cases of theft or loss of private key on behalf of the investor. 

The transfer agent is also responsible for issuing dividends, and — in some cases — 1099’s at the end of the year. In particular for security tokens, the transfer agent is a key partner to ensure that all activities are in compliance with SEC regulations. The transfer agent will also manage wallets (on behalf of the issuer) that are designated for employee and advisor token awards.

KYC/AML

Fortunately, there are a handful of excellent platforms for running KYC/AML checks on prospective investors prior to accepting their money. These platforms are highly automated and return a near-instantaneous “red/yellow/green” rating on a potential investor. From there, the broker/dealer can elect to clear yellows and reds by manually following up with each investor to remediate any issue. 

Marketing

This is the wildcard expense. If you are the Kardashians, you aren’t spending a dollar on marketing. You’re adding a link to your STO on Instagram and turning on the money-counter. If you’re not the Kardashians but have a million loyal email subscribers, you might not need to spend a lot of money marketing, either.

However, if you’re like most companies, you will need to run a bonafide marketing campaign to stimulate interest in your offering. Many issuers stand up on day one to begin to collect indications of interest, a formal website, which will normally include a whitepaper, your investor deck and an engaging description of your company. You will need social media, possibly public relations help and digital advertising. You’ll need to determine your budget for all phases of marketing.

The Offering Period

All of the preparation work comes together during the security token offering. For an S-1 or Reg A public offering, the process comes together in some variation of this form:

The issuer’s public website features an “invest now” call to action.

Prospective investors submit their name, address and contact information, along with the documentation required to validate accreditation or KYC/AML status. This data is captured in the issuer’s system and relayed to a 3rd party KYC/AML provider. Note: In some cases, issuers choose to accept investment dollars at the same time as KYC/AML is being conducted. This means that — for investors who do not pass — issuers must either clear the KYC/AML issue or return the investment. Some issuers, in an effort to reduce the friction of the investment process, do not capture wallet address information for delivery of the tokens on issuance. This may necessitate chasing down wallet addresses after the fact in order to effect the transfer of the tokens.

During the offering period, the issuer may send updates to investors to set expectations vis a vis timing of the issuance, or to communicate meaningful company events.

Once the issuance is complete, issuer — supported by the broker/dealer or money services platform — sends the list of investors, wallet addresses, and token allocations to the transfer agent. Depending on the structure of the smart contract, the transfer agent will trigger the minting of the token by the smart contract, or simply transfer the tokens to the investor wallet in accordance with the instruction provided by the issuer.

Alternative Trading System (ATS)

After you’ve issued your token, want to have it have liquidity! Depending on the type of registration statement you filed, your token will either commence trading immediately or will have a hold period. The smart contract code, in concert with the whitelist, is the method to restrict trading and transfers for a given period of time. 

Just like traditional securities, you will “list” your token on a trading platform known as an alternative trading system or ATS, or perhaps on a national exchange. These decisions must be made early on in the process to ensure that your investors have a smooth experience from the moment they purchase your token through to issuance and trading. You will also want to ensure that your transfer agent and the exchange are engaged and coordinated vis a vis transferring tokens to the exchange, and back to investor’s private wallets.

Token Lifecycle Management

If your token is in the trading markets, your primary partner is your transfer agent. Because they have the list of your investors, security token transfer agents can also serve as your investor communications department. The modern transfer agent will have multi-channel capabilities including interactive GDPR compliant email and SMS services and can either provide these services or expose an API that you can leverage when you want to communicate with your investors.

The Security Token Group Hug

Issuing a security token is a cohesive, collaborative exercise across your chosen ecosystem of advisors and service providers. Different from many corporate projects, progress is made through collaborations across disciplines that traditionally existed as silos – business, technology, legal and marketing. By including the expertise of each, every step of the way, companies can successfully raise capital with a security token offering and join the movement to tokenize the world.

About OKTO.io

OKTO creates SEC Compliant platforms for transfer agents, broker/dealers, money transfer companies, issuers, KYC/AML providers and accountants using a state of the art low-code application platform. OKTO is a wholly owned division of SLINGR.io.