Security Token Basics: What Are Security Tokens?
The history of virtual tokens thus far has involved various attempts to limit the likelihood of being classified as a security under U.S. law. During 2017, many blockchain developers designed their virtual tokens as utility tokens (as distinct from security tokens) in the hope that doing so would insulate them from U.S. securities regulations.
A security token is a virtual token that represents partial ownership of a business, financial interest, or real-world asset, and it has always been widely understood that security tokens must comply with securities regulations.
But the Securities and Exchange Commission (SEC) has made clear that the practical distinctions between utility tokens and security tokens are irrelevant from a legal perspective. As it becomes more obvious that all token sales are subject to U.S. securities laws, more developers are beginning to seriously explore security tokens as a viable capitalization option.
Developers that do so will find that security tokens provide a wide range of flexibility in structuring investors’ interests, as well as numerous advantages over more traditional types of securities.
Types of Security Tokens
Security tokens remain in their infancy, and the potential variety of security tokens has not yet been realized. At a general level, today security tokens can be thought of as falling into one of four categories: equity tokens, asset tokens, debt tokens, and profit-sharing tokens.
Equity tokens represent an ownership or other financial interest in a business entity or business venture. Such interests may include the right to control the business, the right to distributions from the business, or both. The extent of any such right may vary.
For example, holders of equity tokens may have unlimited, direct-democratic control over all business decisions. Or they may function more like shareholders in a corporation, with general management being delegated to a board-of-directors-style body; or more like limited partners in a partnership, with very limited control over the business.
Asset tokens represent ownership of a real-world asset, such as real estate, diamonds, or fine art. Such tokens may afford rights similar to equity tokens. For example, a token representing ownership of a shopping center could entitle its holders to control the real estate (choose whom to lease to, e.g.) and receive distributions (e.g., out of rents).
Tokens can also represent partial ownership of a liability. Such debt tokens could be issued by corporations or municipalities in place of traditional bonds. Or home mortgages could be crowdfunded using debt tokens, with payments on the mortgage being divided amongst tokenholders based on their holdings.
Security tokens may provide their holders with a right to money distributions from the issuer, without a right to control its business. Profit-sharing tokens may be used in the future to compensate employees, who can then hold the tokens and continue to receive distributions or sell them for a quick, lump-sum payment.
Although security tokens may seem like they only change the form of traditional investments—replacing a stock certificate with a virtual token, e.g.—the tokenization of traditional securities and development of new ones could revolutionize securities markets worldwide. Tokenization affords several major advantages over traditional forms of securities:
- Security tokens exist on a blockchain. Blockchains are distributed ledgers specifically designed to prevent fraudulent changes to records of prior transactions. As a result, those transactions are immutable.
- Traditional private securities cannot be easily transferred, and their prices are discounted by as much as 30% for this lack of liquidity. But virtual tokens can be easily transferred to anyone with an Internet connection, unlocking greater potential value for assets.
- Virtual tokens can also be made highly divisible, allowing for sales of fractional interests that eliminate the practical need for minimum-investment amounts.
Of course, some of the advantages offered by tokenization of securities may be offset by adverse regulations. This topic will be discussed in more detail in a subsequent article in this series.
Security token offerings (STO) represent a promising new method of raising funds for blockchain startups. Such tokens offer flexibility for developers and investors alike, allowing for varying degrees of control over and financial rights in the underlying asset, whether a business, financial interest, or real-world property. And tokenizing securities affords numerous advantages for all involved.
Of course, sales of such tokens remain subject to the requirements of U.S. and other securities laws, but in this regard, they are actually no different from utility tokens. Accordingly, companies interested in exploring the issuance of a security token to investors should consult a knowledgeable blockchain lawyer beginning in the earliest planning stages.
Other ResourcesALL ARTICLES
Our Founding Partner
Max Dilendorf, Esq.
Max Dilendorf is an internationally recognized authority and pioneer in legal issues involving cryptocurrencies and blockchain technology. Max is an early adopter who joined the blockchain industry in 2016. Max was named a 2018-22 New York Metro Super Lawyer in digital asset and cryptocurrency law practice. ...Learn More
Adam is one of the nation’s leading young whistleblower lawyers. He brings with him a special ability not just to litigate, but to investigate – and understand – complex organizations and transactions. His extensive familiarity with tech issues is built on a computer science degree and work as a ...Learn More
Bari Zahn, Esq.
Bari Zahn has nearly 20 years of experience practicing at global law firms in New York. Bari has represented a broad array of multinational clients on U.S. and cross-border transactions. She has supervised legal teams worldwide and has extensive management experience as the Founder, former CEO and General ...Learn More
Steve contributes extensive business and problem-solving experience to challenges that may require litigation – or may help avoid it. Indeed, his perspective on litigation is influenced by his experience as a three-time internet start-up CEO.
Steve served on Ronald Reagan’s 1980 presidential campaign ...Learn More
Pamela A. Fuller, Esq.
Pamela A. Fuller is a corporate and international tax attorney, with over two decades of experience. She advises a wide range of clients–including private and public companies, joint ventures, private equity and hedge funds, C-Suite executives, private U.S and foreign individual clients, and government ...Learn More
Ivanna has 7 years of law practice in Europe, namely in the field of corporate law, M&A transactions, banking and finance. As a senior associate, she advised local, EU, US and multinational clients with respect to their business activities in Ukraine.
Particularly, Ivanna, together with junior associates ...Learn More
Robin Gerofsky Kaptzan, Esq.
A New York licensed attorney with three decades of legal and business experience in the U.S. and Asia, Robin recently joined the law firm as a partner and leads the Asia-Pacific practice. While acting as an international business lawyer and global corporate general counsel, Robin is sought out by clients to ...Learn More
Julia joined Dilendorf Law Firm in 2021. She handles all aspects of firm administration while providing paralegal support and litigation management. Julia also has a broad base of knowledge in human resources and communications.
Prior to joining Dilendorf team, Julia worked as an administrative assistant ...Learn More
Laina Dowd is currently a third-year law student at Suffolk University Law School in Boston, Massachusetts, where she serves as Symposium Editor for the Journal of Health and Biomedical Law. In addition to her editorial board role, she is also an active member of the Middle Eastern and South Asian Law Student ...Learn More