How to raise funds? Comparing ICO and STO

Justyna Laskowska
Justyna LaskowskaFebruary 23, 2022
7 minutes to read
Tokenization - comparing Initial Coin Offering (ICO) and Security Token Offering (STO)

Initial Coin Offering (ICO) has become the first popular blockchain-based capital raising process. Over time, Security Token Offering (STO), which is based on other legal regulations, appeared as an alternative way to raise funds.

Fundraising history: from ICO to STO

Since Bitcoin’s inception in 2009, the use of blockchain - a combination of distributed ledger technology (DLT) with a cryptographic security layer - has been growing steadily. However, it was several years after mining the first block of the BTC network, when solutions were developed that enabled the use of the chain of blocks to raise initial capital and service shareholders afterward.

The first method of financing projects based on tokenization was the Initial Coin Offering. An ICO is similar in design to an Initial Public Offering (IPO) in that both allow start-ups and entrepreneurs to raise funds. While securities are issued in exchange for investment in an IPO, digital coins or tokens are offered to investors in an ICO.

Investors were most attracted to the ICO by the simplicity of the entire process and the chance to earn money quickly. In fact, many have made a fortune investing in cryptocurrency projects. The huge profits also attracted fraudsters who tried to seize the opportunity.

Criminals were eager to take advantage of the fact that the ICO can be carried out by virtually anyone, which was associated with fraud, and as a result led to the ban on ICOs in many countries.

Over time, alternatives to Initial Coin Offering also appeared. Today, the most popular of them is STO.

Security Token Offering

Like ICO, Security Token Offering is also the initial sale of tokens to raise funds for the project’s activities (most often related to cryptocurrencies, although this is not a requirement). However, instead of offering utility tokens, investors get the deed of ownership of a given property in exchange for an investment (security token).

The tokens issued under the STO are based on specific assets. Often, security tokens are called digital stocks, because in fact they most resemble securities known from the traditional financial market.

The investment token offer is financial securities secured with the company’s revenues, profits, or tangible assets. Security token companies provide investors with rights such as voting and revenue distribution.

STO and blockchain (examples of tokens)

As in the case of the traditional stock exchange, also in the case of STO, there are several types of investment instruments. The most common types of security tokens are:

  • asset-based tokens - they represent the ownership of assets such as real estate or goods. Resource-based tokens solve the trust and transaction complexity issues. Developers building resource-based investment tokens most often use Ethereum blockchains and Neo,

  • equity tokens - are secured by shares or the company’s capital. These types of tokens represent the value of shares issued by companies on the blockchain. Owning stock-based investment tokens entitles investors to company profits and gives them the right to vote. Chain-based equity tokens enable investors to comply with securities laws,

  • debt tokens - these types of tokens represent financial debt instruments such as corporate bonds, loans, or real estate mortgages. Debt token prices are determined based on risk and dividend. These tokens are issued with the promise of a high return on investment to attract the maximum number of investors.

Differences between ICO and STO

Initial Coin Offering is already a well-known way to raise seed capital. To understand Security Token Offering easier, we decided to compare STO to ICO. Both solutions are based on asset tokenization. In both cases, tokens that represent the value are emitted. However, the similarities end there.

The biggest difference is the legal requirements. Almost anyone can start an ICO, and you do not need to comply with dozens of regulatory provisions associated with traditional methods of fundraising to complete this process. This makes the entire process much easier to carry out.

Rather, STO is strictly governed by the laws and regulations of the jurisdiction in which it is held. Moreover, an investor buying tokens actually becomes a shareholder of the startup. Hence, STO is often described as a compromise between an IPO and an ICO.

Advantages and disadvantages of STO

The popularity of STO has grown rapidly in recent years. This is due to the advantages of this type of fundraising. The most important of them we named below.

  • Increased security - due to the fact that STO is subject to legal regulations (imposed by, among others, SEC in the United States or FINMA in Europe), the probability of fraud is minimal.

  • The actual value of tokens - Security Token Offering issues security tokens that are secured by the issuer’s funds, and therefore have real value.

  • Saving time and money - the time it takes to get started and run a successful STO is usually much shorter than with a more conventional IPO. Security Token Offering is also a more profitable method of raising money compared to IPO, especially for smaller and medium-sized companies. Companies such as Goldman Sachs, Morgan Stanley, and JP Morgan, who mediate the process, are most often used in an IPO. They are some of the largest companies in the world and their fees are not cheap. On top of that, there are advisers. Thanks to STO, it is possible to obtain cheaper, but more effective companies to raise money from investors.

  • Global reach and availability - STO’s huge advantage over traditional solutions is the use of technology that allows you to attract investors from every corner of the world. The benefit is that STO tokens tend to be more liquid than other types of assets (global outlets).

  • Ownership - probably the most attractive feature of this type of capital raising: partial ownership. Tokens issued under STO most often represent shares in the project, and this allows voting rights and profits from the startup’s revenues.

Security Token Offering, however, is not a flawless solution. Like any method of fundraising for startups, STO has several disadvantages.

  • A higher entry threshold - to become an investor through STO, you must meet the legal requirements related to identity verification and no administrative contraindications to invest. This, of course, also raises higher legal costs.

  • Presence on the crypto exchange - to trade security tokens, owners have to wait for them to be added to the cryptocurrency exchanges. In the case of smaller projects, this expectation can be quite long.

  • young market - one of the most important factors distinguishing IPO from STO is the fact that the IPO has existed for centuries, while security tokens have only been issued for several years. This means that not all aspects of the new market have been fully tested yet, and therefore investing in this type of project may be burdened with a much greater risk.

Security Token Offering is regulated by law all over the world. However, they differ according to jurisdiction. The US Securities and Exchange Commission (SEC), the world’s most important financial regulator, treats STO tokens in the same way as securities. For this reason, issuers must register their projects with the SEC before issuing tokens.

In 2018, the German Federal Financial Services Authority (BaFin) classified STO as a separate class of securities as they are traded on financial markets. Accordingly, all STO investment projects in Germany must be registered with BaFin.

Regulations concerning STO were introduced, among others, by Switzerland, Japan, China, and Canada. The European Union regulates STO under MiFID II. In Poland, Security Token Offering is subject to the Act on Trading in Financial Instruments and the Act on Counteracting Money Laundering and Terrorism Financing.

Security Token Offering: Examples

In recent years, there have been many successful attempts to raise funds through the issuance of investment tokens. The most famous are:

  • Blockchain Capital A venture capital company that invests in other companies. Blockchain Capital has raised over $ 10 million under its STO, and today it manages over $ 400 million in assets.

  • Nexo In 2018, over $ 52 million was raised as part of STO for the Nexo project. Today, it is one of the largest crypto-secured loan companies.

  • INX The exchange has raised over 330 million dollars during the STO.

Security Token Offering is an innovative way to raise capital, which today is presented as an alternative to Initial Coin Offering. There is no definite answer to which fundraising method is better. Both systems have their advantages and disadvantages. ICO still offers a number of opportunities, while STO is gaining popularity among representatives of the traditional stock market.

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