Last year venture capital funding was outperformed by Initial Coin Offerings. Despite the popularity of this form of crowdfunding which allows startups to forego the conventional early seed investment, the reputation of ICOs has fallen as a significant number of them have turned out to be scams. Additionally some of them are actually securities and have thus been found to have been violating U.S. securities laws.
In July last year a report was released by the U.S. Securities and Exchange Commission indicating that some of the tokens could be categorized as securities thus making them subject to regulation. This is expected to make security tokens the next megatrend in the cryptocurrency sector. By the year 2020 the overall market capitalization of security tokens is expected to reach $10 trillion.
However security tokens are not to be confused with utility tokens. While the former carries ownership rights the latter act as coupons and therefore do not grant the holder any stake or right in the assets or platform of a company.
When participating in Initial Coin Offerings most investors assume that the tokens they are purchasing are securities though this is not always necessarily the case. In order to tell whether a digital token is a security or not, the Howey Test can be applied. The test confirms whether a transaction qualifies to be identified as an investment contract or not. If a token does not meet the criteria it is not a security but if it does then it will be subject to additional regulatory and disclosure requirements.
According to the Howey Test some of the requirements that a token must meet in order to be categorized as an investment contract include the user investing money and expecting to make a profit from their investment.
Security tokens have various benefits and this includes the fact that they are more efficient and cheaper compared to conducting an Initial Coin Offering using utility tokens. These tokens also reduce legal risk as well as offering protection for contributors and the company. This is especially so since the U.S. Securities and Exchange Commission has raised enforcement initiatives.
Regulations and restrictions
Due to the many restrictions and regulations that are associated with securities a lot of organizations holding Initial Coin Offerings have taken all possible measures to prevent their tokens from being categorized as securities. This is because the ability of an organization to build a protocol or platform that will be widely adopted is severely limited when restrictions and regulations are placed regarding who can exchange or invest in tokens.
In order to invest in private securities offerings, only accredited investors can participate. There are various requirements that accredited investors need to fulfill and this includes net assets whose value is above $1 million and this should exclude their primary residence as well as an annual income of more than $200,000 as an individual or $300,000 if married. The latter must have been maintained for the previous two years and in the current year must be the expected income.
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