Cost Benefits of Tokenization vs. Traditional Private Placement (updated for 2020)
By Horizon & Entoro
Key discussion points:
- How Entoro’s offerings analysis shows savings may be 40% less expensive using tokenization versus a traditional method of raising capital
- What the true tangible and intangible benefits digital securities have over traditional private placement
- How existing capital market participants are integrating blockchain technology to support the new age of securities
We believe the introduction of digital securities offerings (DSOs) into the financial services sector will not only stabilize the investment landscape, but will radically disrupt Wall Street’s old-school ways. Forward-thinking technology players are excited that software decentralization will be the disruption catalyst; however, that can only hold true if the intrinsic and extrinsic benefits outweigh the cost. Put simply, do DSOs save time and money? Entoro, having yet to see an analytical review, decided to tackle it themselves.
Based on Entoro’s analysis, the DSO may just rule the securities world and enable us to create faster and more cost-effective financial instruments. The table below captures Entoro’s attempt to summarize the relevant costs of tokenization compared to traditional methods of capital raising.
Like all financial compare and contrast studies, there is an intellectual debate of the assumptions. In comparing digital securities offerings and traditional private placement costs using paper, there could be countless factors that significantly change the outcome of any simple analysis. Entoro’s analysis shows the savings may be 40% less expensive using tokenization versus a traditional method of raising capital, and believes there is an unlimited number of structures, costs and benefits to be perfectly precise. However, the purpose of this analysis is not to state a final answer, but to ignite debate.
Any discussion around the purpose of tokenization and digital financial instruments must ultimately benefit all stakeholders by decreasing expense, being easier to use, standardizing format, increasing compliance and reducing friction for investors globally.
Barring that, we are still at the beginning of this securities evolution, but great strides have been made in 2019 and beginning of 2020 with regards to the digital securities infrastructure, technology, and market participants mobilizing to meet these conditions.
Below is a list of the tangible and intangible benefits of tokenization.
- Legal — Are legal costs going to save you money on day one? No, but will it save the issuer and investors $3.3 million over five years on a $50.0 million private placement? Yes! And that’s what matters. Even if the answer was $1.0 million in savings, tokenization is worth it.
- Blockchain technology— The infrastructure necessary to seamlessly and compliantly conduct a DSO from issuance through secondary trading is here. Companies like Horizon which integrates Know Your Customer (KYC), anti-money laundering (AML), and custody solutions directly into a digital securities offering fuel market growth and adoption.
- Automated compliance — Money spent on regulatory compliance can be saved using smart contracts and transparent record keeping that the blockchain offers. Lockup periods, investor count, and other rules and regulations can be embedded in or alongside digital securities, allowing them to follow, enforce, and adapt to various jurisdictions automatically. In the instances presented in the table above, Entoro predicts this could save a company ~$200,000 over five years. However, this amount could rise as compliance management continues to become more costly. Note: This assumption presumes that record keeping, audit standards, and methods of reporting are stored on the blockchain with integrated automation software such as Horizon’s suite of products.
- Time — The amount of time senior executives spend in oversight and handling the administrative tasks related to their investors’ securities can be extremely costly. If 30 hours per month were cumulatively spent on this oversight, at an annual salary of $400,000, the cost adds up to $440,000 over a five-year period. However, if those same assets were issued, held, and transferred leveraging the efficiency of the blockchain, it could reduce the time they spend on: a) legal counsel, b) investor communications, and c) compliance processes.
- Administrative Costs — Administrative costs of shareholder conflicts and other miscellaneous issues can save the company ~$50,000 in time and legal fees, records stored on the blockchain are immutable. There can be conflicts if the data entered stored or transmitted using the blockchain is in error. Garbage-in/garbage-out still presents a risk; however, blockchain should minimize that risk.
- Up-to-date shareholder listings & cap table management — Putting securities on the blockchain allows for accurate management of shareholder lists. Not only is ownership recorded in real-time, but all transaction records from investor onboarding, KYC/AML checks, and secondary trades can be timestamped with a tamper-proof record stored on the blockchain for everyone to see.
- Distributions & payments — Right now, for a traditional security, if a company needs to issue a dividend, they go through transfer agents, who would typically mail a check to investors. The process can be slow and inefficient. Using blockchain technology paired with Horizon’s CustodyWare solution enables a registered transfer agent to issue dividends to shareholders instantaneously with the click of a button.
Along with the tangible costs and benefits, there are numerous intangible benefits to motivate an issuer to want to digitize their offering.
- Removing friction — For traditional securities issuance, a big obstacle is the time, money, and energy put into a mostly manual and paper-based system. Conducting a digital securities offering paired with blockchain technology digitizes the entire process to remove friction and dramatically speed up the process. For example issuing digital securities using Horizon’s Ethereum-based KYC smartphone app digitizes the entire investor onboarding and data collection process. Everything from in-app wallet creation to a US Broker-Dealer Subscription Booklet to investor accreditation is integrated to further streamline the investment process.
- Liquidity —The potential for liquidity is increased with secondary market trading after one year as opposed to waiting for a multi-year exit which is typical in a traditional private placement, depending on relevant laws. Also on a regulated secondary marketplace, investors have the ability to trade globally, 24/7, with T+0 settlements through a much more efficient and transparent process.
- Transparency— With public blockchain technology, the investment process becomes much more transparent. All transaction records from the onboarding process through the transfer of securities can be stored on the blockchain, in Horizon’s case the Ethereum public blockchain. These public records protect both the investor and issuer. For investors, they can be assured their data wasn’t tampered with at different stages of the offering. For issuers, shareholder management and immutable transaction reporting is available for internal checks or any regulatory oversight that may occur.
- Security — Provides regulatory certainty, increased due diligence, legal review, quality documentation and peace-of-mind that the offering has multiple levels and layers of review.
- Fractionalization —Although real-world assets can already be fractionalized, the current method can be inefficient. Digital securities allow for a more streamlined fractionalization process for the assets and the revenues they generate.
- Brand Awareness — This is not a direct result of digital securities but most digital securities offerings to date have been conducted using Rule 506(c) of Regulation D/ Regulation S/ and in August the first two Regulation A+ digital securities offerings, BlockStack and YouNow have been qualified. These capital raising vehicles allow for companies to market their offering directly to investors online which opens the door for both a company’s fans and broader investor audience to participate.
Market participants adapting to new age of securities
Because of changes in guidance and understanding of the regulatory framework since the start of 2019, certain market participants are proving critical in order to conduct a truly compliant digital securities offering while reaping all the benefits mentioned above.
One key market participant originally thought to be replaced by a smart contract’s ability to program certain features is the transfer agent. If you’d like to learn about a transfer agent’s role and the many reasons they’re necessary in today’s digital securities marketplace, Horizon offers an in-depth explanation in a previous blog you can find here.
Briefly, transfer agents are required in most Regulation A+ offerings and while not explicitly required in a Regulation D offering, utilizing a transfer agent in a Reg D offering sets up an issuer’s digital securities for compliant and efficient secondary trading. After any relevant holding period, digital securities can be seamlessly moved from custody to “street-name” for secondary-trading on a US SEC-regulated ATS.
In summary, we believe the hard costs of undertaking a digitized securities offering are currently lower than traditional ways. From Entoro’s analysis the cost difference over a five-year period may be 40% less, more than compelling to move to a digital format for private placement securities. As tokenization continues to be the driving force behind capital formation, we believe the cost and additional benefits will replace today’s current methods.
Blockchain technology has demonstrated its ability to greatly improve the ways in which we issue, trade and manage securities. The benefits will continue to become more prevalent as the market matures. This doesn’t mean that we have to, or should, completely absolve all former processes that exist in today’s capital markets. Instead, we can combine the two to create effective, efficient, and user-friendly solutions for the next generation of securities.
Entoro is a global investment bank that elevates traditional banking services with the efficiency of modern technology. Connect with us here and on twitter @EntoroCapital.
Horizon offers a suite of blockchain software solutions from issuance through secondary trading. Connect with us here and on twitter @HorizonFintex.