Security Token Offering (STO)

What is a security token offering?

Security token offering (STO, offering of investment tokens) denotes the issue of digital tokens that embody rights like a security. Typical rights are a claim to interest, to a share in profit or to repayment of a nominal amount. Tokens are digital units that are held on a blockchain or in another electronic register. In an STO, they are offered under the rules of capital markets law, that is, like bonds or other securities.

The STO arose as a regulated answer to the initial coin offering, in which many tokens were sold without a clear legal basis. The parties involved are the issuer, that is, the company that issues the tokens, a technical service provider, where applicable a registrar that operates the electronic register, distribution platforms and the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin). The investors' rights are set out in the bond or issue terms; the information given to investors is governed by a prospectus or an information sheet.

Legal framework: capital markets law rather than crypto regulation

Security tokens are as a rule financial instruments, that is, securities or comparable investment instruments within the meaning of European financial markets law. The Markets in Crypto-Assets Regulation (MiCAR, also MiCA) expressly excludes financial instruments from its scope. A public offering is therefore in principle subject to the prospectus requirement under the EU Prospectus Regulation. The German Securities Prospectus Act (Wertpapierprospektgesetz) supplements it and, under certain conditions, provides for a shorter securities information sheet (Wertpapier-Informationsblatt) for smaller offerings.

Not every token with a payment claim is a security. Subordinated loans or profit participation rights (Genussrechte) represented as tokens (tokenised) that are not transferable like securities can be subject to the German Asset Investment Act (Vermögensanlagengesetz) as an asset investment. Whether a security, an asset investment or a crypto-asset is involved determines information requirements, distribution channels and liability and must be clarified under supervisory law before issue.

Electronic securities under the eWpG

The German Electronic Securities Act (Gesetz über elektronische Wertpapiere, eWpG) permits securities to be issued without a paper certificate. Entry in an electronic securities register takes the place of the certificate. The Act distinguishes two forms: the central register, which a central securities depository or a custodian maintains, and the crypto securities register on a tamper-proof recording system such as a blockchain. Maintaining a crypto securities register is an activity that requires a licence and is supervised by BaFin.

Originally, the eWpG covered mainly bearer bonds, that is, bonds; its scope has since been extended, including to shares. Which types of securities can be issued electronically follows from the version currently in force. Shares in a GmbH (German limited liability company) do not belong to them: they are not securities, and their assignment requires notarial authentication under Section 15 (3) of the German Limited Liability Companies Act (GmbHG). A token in a GmbH can therefore only represent claims under the law of obligations, that is, contractual payment claims such as a profit participation, but not the status of shareholder. Genuine company shares in electronic form presuppose a legal form whose shares are securities, above all the stock corporation (Aktiengesellschaft).

Fields of use and limits in corporate financing

In practice, security tokens are used mainly for bonds, project and real estate financings and fund units. Advantages cited are faster settlement, smaller denominations and automated payments to investors. The hoped-for tradability, however, does not materialise by itself: trading venues for tokenised securities are still being built. Since 2023, the EU has been testing, in a pilot regime, trading and settlement systems based on distributed ledgers (distributed ledger technology, DLT), which include blockchains.

For technology companies in funding rounds from EUR 1 million, an STO is seldom an alternative. Venture capital investors acquire shares with voting, information and preferential rights, which a token in a GmbH cannot convey. Tokenised profit rights create an additional group of investors that does not appear in the cap table, the overview of the shareholders and their shares. Their claims must nevertheless be taken into account in every later round and on a sale. In addition there are costs for the prospectus or information sheet, register keeping and distribution.

Worked example

A mid-sized company issues an electronic bond (debenture) of EUR 2 million in a crypto securities register: 2,000 tokens at EUR 1,000 each, interest of 7% a year, a term of five years, repayment at the end. For the example, one-off costs of EUR 120,000 for documentation and issue and ongoing costs of EUR 25,000 a year for register keeping and paying agent are assumed.

• Issue volume: 2,000 × EUR 1,000 = EUR 2,000,000
• Interest per year: 7% of EUR 2,000,000 = EUR 140,000
• Interest over the term: 5 × EUR 140,000 = EUR 700,000
• Ongoing costs over the term: 5 × EUR 25,000 = EUR 125,000
• Total costs: EUR 700,000 + 120,000 + 125,000 = EUR 945,000
• Average burden per year: 945,000 / 5 = EUR 189,000, simplified without interest effects 9.45% of the issue volume
• Amount actually available after the one-off costs: 2,000,000 minus 120,000 = EUR 1,880,000; relative to that, the annual burden is 189,000 / 1,880,000 = about 10.1%
• Repayment after five years: EUR 2,000,000 from liquidity or refinancing

The example shows that an STO in the form of a bond is debt financing. It does not dilute the shareholders but burdens liquidity and debt service, that is, the ongoing interest and repayment payments. The comparison is therefore a bank loan, a Schuldschein loan or venture debt, not an equity round.

Distinction from related terms

• Initial coin offering: issue of crypto-assets, usually with usage rights rather than investment rights, under the rules of MiCAR.
• Schuldschein loan: a large-volume loan placed through banks with institutional investors. It is not a security and is not traded on the stock exchange.
• Mezzanine capital: financing between equity and debt, such as profit participation rights or subordinated loans. An STO can represent such instruments in token form.
• Crowdfunding: financing by many small investors through a platform, often with subordinated loans and without a blockchain.

Common mistakes

• Technology before legal form. The choice of blockchain does not replace the question of which right the token embodies and which supervisory regime applies.
• Tradability assumed. A tokenised security is only as liquid as the market on which it is traded.
• GmbH shares planned as tokens. Because of the authentication requirement, the status of shareholder cannot be transferred by token.
• Later rounds not considered. Profit or repayment claims of token holders reduce what is left for new investors and buyers.
• Distribution effort underestimated. Investors must be won, identified and informed on an ongoing basis, as with any other issue.

Frequently asked questions

Does MiCAR apply to security tokens?

No. Security tokens are financial instruments and are subject to capital markets law, in particular the prospectus requirement under the EU Prospectus Regulation.

Can a GmbH tokenise its shares?

No. Shares in a GmbH are not securities, and their assignment must be notarially authenticated. What is possible is the issue of tokens that embody contractual claims such as a profit participation.

Does an STO always need a prospectus?

Not always. For public offerings it is the rule. For smaller offerings and for offerings only to qualified investors, that is, professional investors such as banks and insurers, there are exemptions, in part with an obligation to provide a securities information sheet.

Are security tokens easier to sell than bonds?

Not necessarily. The technical transfer is simple, but a sale requires a buyer and an authorised trading venue.

The Roemer Capital view

In the funding rounds that Roemer Capital prepares, investors acquire shares in a GmbH, and these are precisely the rights that a security token cannot represent. For a technology company at Series A to C, an STO is therefore seldom the suitable structure. Roemer Capital treats it as a form of debt or mezzanine financing and compares it with the other instruments by cost, term and effect on the capital structure.

If tokenised profit participation rights or bonds already exist, Roemer Capital includes their claims in the capital structure and the distribution of proceeds before investors or buyers ask about them.