tokenization

Tokenization Overview & Checklist

How to launch a tokenized securities offering?

Securities Tokenization

Securities tokenization is a process in which a class of a corporate entity’s securities are converted into digital tokens on a blockchain. These tokens represent a pari passu ownership interest in the entity’s securities – albeit in digital representation as opposed to the standard book entry method of shareholder accounting. This concept is part of the broader trend of asset tokenization, where traditional assets like real estate, art, or commodities are converted into digital tokens on a blockchain.

Benefits of Tokenization

  • High-volume liquidity. Tokenization can make the buying and selling process more efficient and also convert the value of the securities to cash much faster.
  • Fractional ownership. Through tokenization the securities can be split into more pieces and more easily than otherwise. This attracts smaller investors who otherwise would not have access to certain classes of preferred equity.
  • Globalization. Tokenization facilitates cross-border trading and global interoperability among securities –  offering you greater access to global investment markets.
  • No intermediaries. Native peer-to-peer tokenization models eliminate the need for costly intermediaries.
  • Blockchain immutability. Securities and shareholder records are maintained across the globe in antiquated paper-based systems, and differ from one country to the next. In the context of tokenized interests in securities, it standardizes ownership interests and offers investors greater security in their ownership.
  • Instant transactions. Transactions in this process are instantaneous and efficient, because they’re all done peer-to-peer without the need for additional involvement or intermediaries such as market makers or broker-dealers in traditional equity markets.
  • Lower entry cost. Tokenized securities is synonymous with fractional ownership, which lowers the inherent barriers to entry to private entity investments as well as higher-priced hybrid preferred securities. 
  • High security. Blockchain-based tokenization – when done properly, minimizes the risk and the investor’s perception of risk regarding rug-pulls and related crypto scams.
  • Simplified management. Secondary transactions are easy to execute and they are absolutely simple to follow through with. This is true with returns and also allows for the specific governance needed for voting rights. 

Tokenization Strategy

The underlying concept of the tokenization of corporate securities is the linking and conversion of the underlying class of securities into digital assets (eg, representations of value). At a core level, this requires:

  1. The establishment of a business entity with at least two (2) classes* of securities:
    1. Class “A” shares which provide the owners/promoters with full discretion and control over the operation and management of the company, together with residual income/dividends; and
    2. Class “B” shares which provide investors solely with income/dividend rights and limited to no ability to direct the affairs of the company.
  2. Defining Tokenomics:
    1. Linking Class “B” (ie, investor class) shares with an inextricable right to receive profits from corporate operations, which is accomplished by proper corporate formation and organizational documentation;
    2. Blockchain considerations – selecting blockchain (ETH, SOL, Stellar, etc), establishing token metrics (max supply, decimal, etc), profit distribution smart contracts (rents received, property sale, etc) and, finally, token deployment; and
    3. Creating proper valuation metrics – dividing the corporation valuation by max token supply to arrive at an estimated price per token taking into consideration network fees, etc.
  3. Token Offering: offering an tokenized security will constitute the sale of a security in nearly all jurisdictions:
    1. Defining token sale parameters, including:
      1. Pre-Sale (?) & discount, stages, start & end dates, if applicable; and
      2. Geographic limitations vis-a-vi investors (example: sell to US investors or no?), if any; and
    2. Preparation of complaint offering prospectus and subscription agreement giving consideration to: and
      1. Domicile of business entity (notable to application of securities laws); 
      2. Residency of prospective investors – the prospectus provided to, for example, US residents will differ in some part from that given to investors residing in Australia.
    3. Manner of sale, including:
      1. Sales & marketing channels – digital, organic and/or engagement of licensed securities dealers;
      2. Maintaining compliance with varied solicitation rules across various jurisdictions, including, without limitation, marketing copy, paying of sales commissions and more; and
      3. Closing and settlement – adhering to both legal requirements and common standards regarding delivery of tokens to investors.

Primary Legal & Compliance Considerations

Generally speaking, the primary legal and compliance considerations one should consider and address before offering tokenized real estate for sale include:

  1. Compliance with prevailing securities laws: The laws of each jurisdiction in which promoters intend to offer tokens will govern those specific transactions. This includes investor disclosures, manner of solicitation and sale and notice/registration requirements (if any) with the applicable securities regulators (for instance, in the US, the filing of a Form D will be required);
  2. Licensing & Compliance: If done properly, a tokenized real estate scheme can be self-governed and also does not trigger cryptocurrency licensing requirements, but the laws are not uniform across jurisdictions. Moreover, AML & KYC requirements for securities offerings are also not uniform and must be acknowledged; and
  3. Investor Suitability: Again, each jurisdiction imparts certain investor suitability requirements for parties who participate in the private offering of securities. This will vary depending on not only the jurisdiction in which you intend to offer the tokens for sale but also the domicile of the business entity. Finally, exemptions for the sale of security tokens to non-sophisticated (eg, “retail”) investors – such as crowdfunding in the United States, are varied and must be examined on a jurisdictional basis.

Profit Models

Promoters of tokenized securities offerings can earn a return in various means. This must be determined before token deployment so the proper smart contracts can be written. While there are no specific legal requirements which dictate how promoters may receive profit, there are common methodologies, including:

  1. Basic Profit Allocation: sharing a percentage of corporate profits (ie, dividends) received together with profits earned upon distribution;
  2. Management Fees: earning a fixed fee on a periodic basis irrespective of the profits generated by the issuer corporation; or
  3. Combined Model: earning a profit allocation together with an ongoing management or administrative fee.

Tokenization Checklist

Important questions to consider before embarking upon a tokenized securities offering include:

  • Centralized or centralized model?
  • Which smart contracts are required – dividend distribution, etc?
  • Upon which blockchain to build?
  • Where to incorporate – what does the corporate statute allow?
  • Type of tokenized security – preferred share, preferred share with coupon?
  • Local regulations concerning the fractional ownership of securities?
  • Local regulations concerning the foreign ownership of securities?
  • Ratio of tokenization?
  • Accounting for corporate debt obligations?
  • Securities law considerations?
  • Investor traceability considerations?
  • Automated AML/KYC options?
  • Investor suitability verification options?
  • Manner of sale & solicitation – affiliate & finder’s fees?
  • Identifying fiat banking for proceeds of tokenized securities sales?
  • Identifying payment rail providers (IBAN, Swift, card payment, ACH, etc)?

Conclusion

Tokenization of securities offerings are becoming an increasingly large subset of all securities offerings – especially for blockchain-related companies. But, as with all things crypto & blockchain, maintaining compliance on an unclear and ever-changing landscape can be particularly difficult.

If you have questions regarding tokenization and surrounding issues, be sure to reach out

You can also book a free consultation here.

About Adam Tracy

Adam Tracy is a payments expert and entrepreneur who specializes in payment systems, blockchain technology, digital currencies, and other emerging technologies. He is the founder of Blockrunner, LLC that provides consulting services to clients in the blockchain, payments and cryptocurrency arenas.

Tracy has been involved in the payments industry as an attorney, consultant and entrepreneur since 2005, while he was become an expert in blockchain and cryptocurrency since its advent in 2013. Tracy has worked with a wide range of clients, including startups, established businesses, and investor – both in the United States and worldwide. He has advised clients on a wide range of compliance, legal and operational issues related to payment transfer systems, crypto token generation and architecture, cryptocurrency exchanges, regulatory licensing, smart contracts, and other blockchain applications.

In addition to his consulting work, Tracy has founded several companies in the payments, blockchain and cryptocurrency space, including a digital asset hedge fund, licensed electronic money institution and a blockchain-based tokenization platform. He is also a proponent of decentralized finance (DeFi) and has been involved in various DeFi projects.

Tracy is also a frequent speaker and writer on blockchain and cryptocurrency topics. He has been featured in a wide range of publications, including Forbes, Hollywood Reporters, CNBC, Reuters, CoinDesk, and Bitcoin.com.

Find Adam: https://linktr.ee/adamtracy

Blockrunner, LLC., is a financial services match-making marketplace and consulting company. We are not a bank, FI/NBFI, Payment Service Provider, deposit taking institution, trust, or money services business of any kind. We are not regulated by any financial regulator. Banking, Payment, Processing, and Licensing services are provided by our participating members. This website is for informational purposes only and does not constitute legal advice. If you need legal advice, please consult a licensed attorney in your jurisdiction.

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