How do I start the Equity Token Offering

Briefly explained: Opportunities and limitations of equity tokens as startup financing

For many companies, going public is time-consuming and costly. Some young companies are now relying on equity tokens as a cheaper and faster alternative. But is this hope justified and what opportunities and risks arise from it?

Use of equity tokens to finance startups.

In our first crypto special from "Briefly explained" we have already discussed the differences between utility tokens and equity tokens. Equity tokens are securities-like tokens for which the token owners are entitled to claims under the law of obligations and co-determination. This results in the same rights and obligations for investors and companies as if it were a classic security.

When it comes to corporate financing through the issue of equity tokens, the term Equity Token Offering (ETO) is generally used. Utility tokens, on the other hand, enable access to certain services or products, similar to a key, an admission ticket or a voucher. Due to the low regulatory requirements, utility tokens were preferred by many companies to finance their projects, which was initially not intended by the regulations. Due to the collapse of the prices of crypto currencies in general and utility tokens in particular, they suffered a considerable loss of confidence. Equity tokens should now regain investor confidence for new crypto investments with stronger investor rights.

Advantages of equity tokens for issuers compared to issuing shares

The companies as issuers of equity tokens see many advantages in this compared to the issue of traditional shares. They often emphasize the cost and time savings. It takes an average of at least a year for companies to go public. This process is not only time-consuming, it can also cost several million euros. Tokenization is significantly faster and cheaper. However, it has to be said that a successful ETO campaign now requires significantly more time and a considerably larger marketing budget than in previous years.

The same applies to the issue of utility tokens for corporate financing, which is also called ICO. Another plus point emphasized by ETO fans is that token issuance involves fewer formalities and the purchase is made directly between the issuer and the investor, which is cheaper for the investor. The lack of involvement of banks and other financial institutions in the trading process is primarily intended to reach people who are not currently participating in traditional IPOs. However, the lack of banks and stock exchanges as intermediaries can in turn encourage fraud, as the token issue is not checked for seriousness by another checking authority. The volumes that ETO issuers try to collect are usually in the range of 50 to 500 million euros. Amounts that can hardly be drawn by investors from the blockchain and IT scene, which was still battered by the ICO hype of 2017 and 2018. The now stricter regulatory requirements for the issuance of tokens also play a role here.

More stringent regulatory requirements do not only have advantages

Due to the status as a security-like token assigned by BaFin, equity tokens are subject to the German Securities Trading Act and the EU Prospectus Regulation. This means that unrestrictedly tradable equity tokens may only be offered in Germany if a comprehensive securities prospectus has been prepared and approved by BaFin.

However, once the equity token's securities prospectus has been approved, the issuer can also use it in other countries in the European Economic Area. This is initially positive. For example, if BaFin approves a securities prospectus for an ETO and the issuer also wants to offer the tokens in France, the French financial market regulator has no way of prohibiting the public offering of the tokens as securities in France.

However, if classified as an equity token, this also has implications for all other potential target countries outside the EU. Because with the classification as security-like tokens, the tokens are no longer subject to the respective securities trading law, which makes internationalization of the tokens beyond the borders of the EEA at the speed of the utility tokens impossible. This problem also explains why a crypto showcase project like Ripple does everything to ensure that it is still not classified as an equity token.

Avoiding the prospectus requirement for ETOs is possible, but not useful

However, there are also ways of avoiding the prospectus requirement for equity tokens. For example, there is no prospectus requirement for private placements. This means that no prospectus has to be drawn up and approved for equity tokens that are exclusively offered non-publicly to a small, previously known group of investors.

This sounds tempting at first, but no new investors can be won through private placement, which seems unattractive for most issuers of equity tokens. A private placement usually only makes sense to carry out a pre-sale in the Family & Friends phase for the actual ETO. An equity token can also be exempted from the prospectus requirement if it is only aimed at institutional investors. Another possibility to avoid the obligation to publish a prospectus is a minimum investment of 100,000 euros.

There are also other exemptions for ETOs with a hard cap of a maximum of EUR 8 million. An equity token exempted from the obligation to publish a securities prospectus is considerably more attractive, because either only a small sum of a maximum of EUR 8 million may be earned or scaling with small amounts from private investors is not possible. In the past, the latter was usually the panacea for successful crypto projects, which is why an ETO without a securities prospectus is not an option for most companies.

Equity tokens continue to be a niche market

Actually, 2019 was already proclaimed the big year of the ETOs. However, no major showcase project on the scale of Etherum, Ripple or Bitcoin has yet been found. The latest flagship objects like Telegram with their token “Gram” rely on the tried and tested token type of the utility token or Facebook with their project “Libra” prefer to use the token type of the stablecoin, in which the course is secured with a corresponding deposit in real money. This also shows a look at one of the first ETO exchanges, “Neufund”, in which Peter Thelen, among others, invested. Compared to the previous most media-effective ICOs, with which several hundred million euros each could be collected, the ETOs on Neufund only come together three years after the platform was launched to the sum of 17.4 million euros.

Neufund platform: So far only an external ETO

Of the total sum of 17.4 million euros, 91% of the money (just under 16.0 million euros) flowed indirectly into the Neufund operator platform itself, and just 1.4 million euros were able to do so in the first three years for an external company, namely the startup Greyp, on the Neufund platform. In addition, the 16.0 million euros for the Neufund platform were not collected through a classic ETO. The first EUR 12.6 million was invested by a total of 1,000 professional investors in the form of business angels, private equity and venture capital firms as part of an initial capital building mechanism. In this case, the Initial Capital Building Mechanism means that in the first 18 months after purchasing the tokens, investors could only use them to invest in newly issued equity tokens via Neufund. The other 3.4 million euros were collected by Fifth Force GmbH, the operating company behind the Neufund platform.

However, the ETO in its original form was not approved by the Bafin, as Neufund planned the issue as an asset bond and this was not accepted by the Bafin. The solution was to raise the minimum price to 100,000 euros, which again excluded small investors.

In addition, the 1.4 million euros that were collected by the external startup Greyp, in contrast to the two previous corporate financings, were no longer shown as a German offering, but as a Liechtenstein offering. At that time, the Bafin criticized the fact that no securities prospectus was drawn up in accordance with German guidelines. It is reasonable to assume that no ETO about Newfound has yet fully met the requirements of the Bafin securities catalog. There is also a large discrepancy between the 1.4 million euros collected in reality and the amount between 50 and 500 million euros mentioned at the beginning, which most companies hope for through an ETO. This could also be one of the reasons why with mySwoop, EmFlux Motors and NGRAVE only three out of ten of the companies announced in 2018 are listed as future ETOs.

Equity tokens are currently just a well-intentioned compromise

At the same time, utility tokens are currently experiencing a noticeable increase in the form of initial exchange offerings. The respective crypto exchange acts as an intermediary to confirm the seriousness of the company and issues the new tokens to its own users. Due to the large number of users on the exchanges, it can be ensured that there is correspondingly high demand even after the new tokens have been issued and that there is good tradability.

In the case of an initial exchange offering with equity tokens, not only the company as the issuer, but also the offering platform is responsible for the securities prospectus. In addition, in this case, the full MiFID II and MiFIR regulations apply in accordance with European supervisory law. This is also the reason why crypto exchanges only offer utility tokens in the initial exchange offering. Accordingly, equity tokens seem more like a well-intentioned but poorly implemented compromise from the old, unregulated crypto world and the very regulated world of securities. Because they are classified as securities-like tokens, they have to meet the same regulations as securities that prevent them from being traded as easily as utility tokens.

Initial exchange offering of equity tokens by banks could be the solution

The greatest chance of helping equity tokens achieve the desired breakthrough would be for banks and online brokers such as comdirect to act as a platform for an initial exchange offering and thus make the equity tokens available to their customers. Because banks and online brokers already meet all the necessary regulations for securities trading. In addition, the existing customer base of these institutes could offer the equity tokens to a large number of potential investors who have not yet invested in equity tokens. The initial exchange offering of equity tokens would in turn create interesting new sales opportunities for banks and online brokers.

This is also one of the reasons why we at comdirect Startup Garage are open to blockchain ideas of all kinds. With a view to the future, it remains exciting to see which new ideas will help equity tokens to achieve the long-awaited breakthrough. Because it should really only be a matter of time before equity tokens replace the previous utility tokens as the preferred crypto investment and thus as a means of financing for startups and young companies. This would then benefit investors, companies and banks.

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