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Converting pre-product utility tokens to equity via a re-compliance offering

March 7, 2019

Understanding the differences between utility and security tokens: the theme park analogy

To better understand the difference between a utility token and a security token, I like to use a theme park analogy. A utility token is fundamentally designed to give  token holders some utility or service. Using a theme park as an analogy, that utility or service could be a ticket for a ride in the park.

The Initial Coin Offering (ICO) boom in 2017/18 saw businesses pre-selling their utility or service tokens, or ‘tickets to ride’ at their theme park. However, many of these ICOs were still pre-product, had only a business plan or website, much like a pre-built theme park without any rides yet.

In comparison, a security token, as its name suggests, is a financial security backed by the laws and regulations of its offering jurisdiction. The investment class can be in the form of a royalty, share equity, units in a trust, and other types of securities or asset-backed securities. In the case of our theme park, a security token offering could be in the form of tokenized shares representing a financial stake in the underlying business or a percentage of ticket sales.

See here for a related post examining the security token process in more detail.

The re-compliance offering

In 2017 and 2018 we saw unprecedented investment into pre-product ICOs, often with the expectation of a working product within 6 –12 months of investment to provide utility value to token investors. However, many ICOs in the market that are now 12 – 24 months post investment are still pending a product release, requiring more time and in some cases more capital to finalise a working product and deliver utility to their token.

A re-compliance offering suits many ICO companies that are still at the pre-product, pre-utility, or pre-service stage. It allows their existing utility token holders the opportunity to convert their utility tokens into security tokens. This would then allow the company to carry on its business via a more traditional model and accept cash for services once their platform has commercialized.

Re-complying as a security token can benefit companies in the following ways.

  • Flexibility to carry out a more typical business model by exchanging product or services for cash.
  • Ability for the company to raise additional funds via a STO.
  • Conversion to a regulated financial product to assist in bringing investor confidence back to the company.
  • Provides the company with a complete legal framework for additional growth, funding, possible exit strategies or M&A interest.
  • Enables company equity to become tradable once STO exchanges come online.

Investors benefit from re-compliance in the following ways.

  • Reduced regulatory uncertainty through conversion of utility tokens of a pre-utility company into a legal, securitized financial product.
  • Gives investors the ability to receive a ROI as the company grows, through possible dividends or trade sale.
  • Provides the option to top up investment via a security token offering within a business and industry that the investor has already shown interest in through their first investment round.

While becoming a security token is not suitable for all ICO companies, the majority of ICOs are still pre-product, pre-utility businesses, but have many large investors at the service or utility level. Therefore, it seems appropriate to offer those investors the opportunity to become company shareholders, owning part of the company IP that their capital contributed to building.

DigitalX works with legal advisors and security token issuance providers to understand global requirements for STOs and assist companies going through this process. To discuss any of these strategies, contact DigitalX.

The information in this article is general in nature. Any advice it contains is general advice only and has been prepared without taking into account the objectives, financial situation or needs of any particular person. The article content is not intended to be a substitute for professional advice and readers are urged to seek their own appropriate advice before making decisions. Any reference to a particular investment is not a recommendation to buy, sell or hold the investment.

Author: Steven Bryson-Haynes, DigitalX Ltd Head of Corporate