Tokenization: meaning and raising capital through IDOs and STOs

While we all now know at least broadly what cryptocurrencies are, the same cannot be said of tokens, yet it is in the concept of tokenization that the opportunities of the future for raising capital lie.

In fact, they can already be called "the opportunities of the present," since experiments in the field have already begun, but since these are complex concepts and in Italy we always arrive at new things a little slowly, let's start at the beginning to explain the basic elements for building awareness for the future.

We will find out what a token is, how it can be used, and why it may be the new frontier in crowdfunding.

Background: what is blockchain and how it works

Blockchain is also a concept now almost in common use, but it may be useful to review its meaning, because it is the indispensable context in which tokens move.

In practice, the blockchain translates into a digital ledger of data grouped into blocks, linked together in chronological order and encrypted. This ledger is supported by a distributed, decentralized computer network consisting of multiple "nodes" (servers) around the world that host and validate the data.

All of these features make the data entered on the blockchain secure, transparent and verified: it cannot be manipulated or modified because it is encrypted, it is accessible to all participants, and every data entry is verified and validated by all nodes in the network, which must give consent for any updates or changes.

Every transaction (economic or otherwise), contract, certificate, etc. entered on the blockchain is automatically validated because names, dates, objects remain recorded and immutable and verifiable at any time. This is why one of the effects of blockchain is disintermediation: no need for control and verification bodies such as notaries, banks, etc.

In summary, blockchain is a technology that enables the recording and sharing of information in a secure, transparent and decentralized way.

Tokens: what are they?

Tokens are digital objects that represent fungible resources (assets) within a specific system or circuit. The assets represented by a token can be economic values, rights to use or access services or content, rights to acquire a product, etc. Each token contains two pieces of information: the type of asset represented and the circuit where it can be used, spent or redeemed.

A useful parallel to understand the nature of tokens is that with food stamps or shopping vouchers: they have a specific value and can only be spent at certain participating circuits.

It might be natural to wonder what is the difference between cryptocurrencies and tokens, which, in some aspects, seem to overlap. It's very simple: cryptocurrencies have the same functions as traditional fiat currencies; in fact, they are the virtual representation of a currency with a defined and unique value. There are different cryptocurrencies, and they can be used for purchases and exchanges on the respective blockchain of each cryptocurrency. Bitcoin and Ethereum are perhaps the most well-known today.

Tokens, on the other hand, have no unique value because they all represent something different, determined by those who create and disseminate them. They can be bought with cryptocurrencies or traded with other tokens.

Tokens are created, exchanged and managed through smart contracts on the blockchain. The creation of a token consists, in effect, of writing in programming language the information about the asset to be represented: blockchains or brokerage platforms also offer this service. Smart contracts, on the other hand, are computer programs that define the rules and conditions for the issuance, transfer and use of tokens. Transactions involving tokens are then recorded on the blockchain, providing traceability and transparency of transactions.

Types of tokens

There are two main types of tokens:

• Utility Tokens are designed for a specific use, for example enabling access to services, features or content on a particular platform, and are not necessarily related to the company that issues them nor is there a third party entity that certifies their authenticity, value and validity. This makes them more risky in terms of scams, because the person who issues them has no duty to the person who buys them, and the transaction is based on trust alone.
• Security Tokens represent a form of investment or participation in an entity or project and are therefore closely related to the issuing company, which provides those who purchase them (investors) with voting rights, profit rights, or profit-sharing rights. In this case a third party, usually governmental, certifies the truthfulness and value of the representation.

Another type of token, which has become famous in the art world, is the NFT, which represents the ownership or provenance of a specific digital or real object, but is outside the scope of the discussion on capital raising.

Listing: how do you sell tokens?

The sale, or listing, of Utility Tokens can be done through three different procedures that have developed over the years:

• ICO, or Initial Coin Offering, is a practice that originated in 2013 and became widespread in 2017, whereby a company can privately issue and sell its tokens via smart contracts. The critical aspects of this mode are the wide room for fraudsters to maneuver, due to the total absence of third-party control, and the illiquidity of the token purchased, as there is no reference list value that makes it easy to resell.
• IEO, or Initial Exchange Offering, was created in 2019 to address the critical issues of ICOs with an exchange platform, that acts as an intermediary between token sellers and buyers, making entry selection of proposals to sell, overseeing exchanges, and providing a secondary market space with reliable quotes.
• IDO, or Initial Decentralized Exchange Offering, is a kind of synthesis of the previous two mechanisms, because it is based on an exchange that, however, acts only as a showcase, has no selection and verification role, so transactions are disintermediated.

Listing of Security Tokens, on the other hand, can only take place through a Security Token Offering, which is a strictly regulated procedure for placing investment instruments. The sale can only take place on platforms authorized by a central authority (in Italy, Consob) that certifies the value of the tokens issued. To make an STO, a company must follow protocols, pass audits and comply with certain requirements, as well as produce adequate and transparent disclosures to investors, who in turn must pass a suitability check.

How to raise capital with tokenization

Now that we know what tokens are we can take it a step further and understand how they can be useful for raising capital and how they intertwine with crowdfunding.

Let us start by pointing out that the most attractive tool for raising capital in these new ways are Security Tokens, because they are true investment tools and are more secure for both companies and buyers.

With a classic equity crowdfunding campaign you sell shares in your company to raise capital with which to finance yourself. With a Security Token Offering you can do a crowdfunding campaign to sell "tokens,, that is anything! Any tangible or intangible asset that can generate a progressive gain based on a specific parameter and can be attractive to the company's potential investors can become a token to be placed to raise capital. You multiply the opportunities for hooking, make your assets liquid, and do not have to sell shares in the company to engage investors.

A few examples for the sake of clarity: a token can represent the right to a predetermined percentage of revenue, the right to a certain amount of income for every tot. of new customers acquired, access to a free service for every tot. of revenue achieved, and so on. The possibilities are endless, as is the level of investor involvement. 

It is an opportunity in addition to the already many offered by alternative finance to reduce the dependence of companies, especially startups and SMEs, on bank credit, while also differentiating their relationships with investors. For now, the big hurdle is the complexity of the procedure and requirements, but it is a fast-evolving world.

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