Every blockchain project has its own token ecosystem with tokens offering different kinds of benefits to the users.
For example, a dapp’s token can be used to give a user access to the project’s service once it’s ready. Or, it can be used to make payments on the platform. Tokens can even give users ownership in the project (and a share in its profits).
As such, there are no rules as to “what” a dapp’s token should do.
You’re free to innovate ways in which your ICO investors will be able to use your tokens to interact with your platform.
BUT most tokens fall into two types: 1) Security tokens, and 2) Utility tokens.
Let’s now understand the utility and security tokens in detail and then see how they compare with each other.
What are security tokens
Security tokens are like stock investments. Digital assets. They give ICO investors ownership rights in a project. The investors also get a share of the profits.
In a way you could say that:
For X tokens, your ICO investors will get Y percent of your project’s profits.
As you can understand, security tokens hold monetary value as they bring or (or promise to bring) monetary returns to a user.
So basically, security tokens are “securities” in the traditional financial sense.
Which means they’re subject to the same laws as traditional securities.
Here’s an example:
PinkDate, the first-of-its-kind escort blockchain project, is offering its investors security tokens. PinkDate’s whitepaper explains its tokens as “shares of the company”:
PDP tokens will represent shares of the company and will give the holder of these tokens the right to redeem dividend payouts. PDP tokens will also be tradeable on decentralized exchanges (to be announced).
PinkDate is the first ICO to pay dividends based on profit. Every quarter PinkDate will pay out 50% of Net Profits through dividends. Anyone holding PDP tokens will be able to log into our investor portal and elect to receive their share of dividends in Bitcoin, Ether, Monero, or Bitcoin Cash.
Another example of a security token is the one from the VRBex (a crypto-assets exchange project) ICO. The benefits for the token holder include, “paying a quarterly cumulative dividend of 15% core operating revenue.”
Praetorian, a real estate blockchain venture, is another company to offer security tokens. Its whitepaper states: “[…] reward PAX Token Holders with a distribution based on the particular token holders ownership percentage of all outstanding PAX Tokens.”
Let’s now look at utility tokens.
What are utility tokens
Utility tokens give ICO investors usage rights to a product.
For example, if you’re launching an Uber-like decentralized platform, then your investors can use your app’s utility tokens to use or pay for booking a ride on your platform.
Why utility tokens — just like security tokens – aren’t always exempt from laws on securities
On the surface, utility tokens don’t offer monetary value — and so, they aren’t considered as securities by many.
BUT, in a way, most utility tokens are also securities because:
- They’re tradable and can result in financial gains. For instance, if a user buys your tokens for X dollars and sells them off at 10X dollars, then they’re monetarily benefiting from their investment.
- They’re advertised in a way that users expect financial returns from their investments in them. The $152 million DAO ICO that offered its users tokens in exchange for ether is a great case study on how even utility tokens can take the form of security tokens.
The United States Securities and Exchange Commission (SEC) investigated the DAO ICO to see if its token sales fell under SEC’s securities laws. In its investigation, SEC found that the DAO tokens were, in fact, securities. SEC noted:
According to promotional materials, The DAO would earn profits by funding projects that would provide DAO Token holders a return on investment.
The various promotional materials disseminated by Slock.it’s co-founders touted that DAO Token holders would receive “rewards,” which the White Paper defined as, “any [ETH] received by a DAO [Entity] generated from projects the DAO [Entity] funded.”
DAO Token holders were not restricted from re-selling DAO Tokens acquired in the offering, and DAO Token holders could sell their DAO Tokens in a variety of ways in the secondary market and thereby monetize their investment as discussed below.
Andrew Chapin, a co-founder of Benja (a blockchain-based ad network), wanted to be SURE that even SEC thought that Benja was only selling utility tokens. So he reached out to the SEC with an email explaining benjaCoin (Benja’s native tokens) to be pure utility tokens. Here are some excerpts from Chapin’s letter:
The benjaCoin is a digital token for participation and use of the Benja merchandise advertisement network and does not confer ownership of a stake in the business.
NOTE: benjaCoin is a cryptotoken for use by the current and future participants in the Benja merchandise ad network and it is not to be used for any other purpose.
For those of you considering participation in our crowdsale: please be advised that #BNC has one single purpose: to buy/sell ads on Benja.
Unlike in the Benja project where the token looks like a clear utility one, many blockchain startups try to package their security tokens as utility tokens. Just so they can be exempted from securities laws.
In some cases, even the team doesn’t realize that their utility tokens are, in fact, securities.
But there’s a way to identify the token type correctly. It’s called the Howey test.
The Howey Test
The tokens you saw above look (from PinkDate, VERbex, Praetorian and Benja) are explicit examples of security and utility tokens.
But, of course, in most ICOs, you’ll find some overlap.
To make sure you’re offering the right token (security or utility), run it through the Howey Test.
Even the SEC recommended Chapin to look into the Howey Test.
So what’s the Howey Test?
The 71-year old Howey Test is used to determine if the asset in question is actually an investment that falls under securities.
In the case of your ICO, your tokens are the digital assets your investors get. So to determine if these tokens are investments that fall under securities, evaluate how they score on the following Howey Test pointers:
- An investment of money
- In a common enterprise
- With an expectation of profits predominantly from the efforts of others.
Learn how SEC found these provisions to apply to the DAO ICO in its detailed report.
Summing it up: Security Vs. Utility Tokens
1) What a token means to the user:
Represents usage rights.
2) What the token means from the investment viewpoint:
Passes the Howey test and falls under securities.
Fails the Howey test (but can still fall under securities).
3) What it takes to issue the token:
Difficult to issue as it has KYC, AML, and other compliance needs.
Extremely easy to issue.
4) Who can buy the tokens:
Only users meeting a certain economic criteria can invest. (This limits an ICO’s reach considerably.
Any user can invest as there’s no eligibility criteria.
5) The token trading experience:
Security tokens can be traded on only a few select security token trading platforms.
Users can choose among tens of trading platforms.
Offering security tokens
To offer security tokens, currently you need to work with a bunch of regulatory bodies and other service providers (for eg. a company that does KYC of your investors.
As you can imagine, this makes offering security tokens much more complex than issuing utility tokens.
But you’ve some really promising blockchain solutions like PolyMath, Harbor, and Securitize that aim to make the issuance and sales of security tokens easy and convenient. Trevor Koverko, CEO of Polymath projects that by the end of 2018 “security tokens will have eclipsed utility tokens in the market cap.”
Even though offering security tokens needs efforts, it’s a legally safer and more compliant option. One that’s also regulation-friendly.
Wrapping it up
Technology almost always precedes regulations. It’s the same with blockchain.
Now that blockchain is on its way to get mainstream, most countries are building regulatory frameworks to govern how ICOs generate funds.
We don’t believe that the impending regulations will treat all tokens as securities, but yes, they WILL need you to think deeper when you plan your project’s tokens.
They’ll also need you to review HOW you explain your tokens.
A dapp can — and in most cases will — have different types of tokens. The challenge will be understanding the compliance needs over them. Get in touch if you have a question about issuing tokens.
Kapitalized is a blockchain and token venture advisory that helps early-stage ventures launch and run ICOs. Get in touch if you’re looking to launch your ICO or need an ICO audit.
Also published on Medium.