STOs: The Dangers, Downsides, and Hidden Costs

Security token offerings (STOs) have been all the rage lately, but despite their popularity, they are not the salvation to tokenized funding offerings. Certainly, STOs have a place in the token offering world, but the rosy outlook toward STOs in the industry has made both investors and companies desperate for funding overlook their potential shortcomings and inherent risks.

Paying out Dividends

One of the highly touted benefits of STOs is that dividend payments are hard-coded into the token itself, guaranteeing fair payments for the token-holder. While this may be true in comparison to utility tokens where no rights are guaranteed the token holder, it leaves some added complexities.

Dividends based on earnings are highly subjective. My main career background is in accounting and I can tell you from experience that earnings can range from zero to infinity with a bit of fiddling. For example, in many jurisdictions, if you have utility tokens on your books that have not yet been redeemed or vested, these can be considered outstanding liabilities and marked to market to create a tax loss practically out of thin air.

The only way to hard code dividends is to have them based off the company’s gross revenue. This “cream off the top” method of income distribution is most easily done when companies transact in cryptocurrencies — either their own tokens — or in main payment coins like Bitcoin, Ether and Litecoin because portions of each transaction can be automatically credited to investor accouts using a simple algorithm. This certainly guarantees a dividend paid to investors, but does not work in the best interests of all startups.

Some startups can manage hard coding dividends well, especially when they have a simple model that does not require large continuing development costs. A good example of this is Monarch, that is building a wallet to hold all cryptocurrencies and pay fiat-based bills directly through this crypto wallet. They are hard coding 10% of gross revenues to be paid to investors, and they have a tokenomics model that is easily supportable on 90% of revenue. But the question then is, could they grow faster at a later stage with that extra 10% reinvested in marketing efforts?

The traditional investment logic goes that early-stage companies, especially those in the tech space, provide a better return on investment to retain their earnings and reinvest in growth of the company rather than paying dividends. This has always been one of the main arguments against a flat tax structure, that taxing based on revenue lowers the success rate of early-stage companies

Additionally STOs are tax-inefficient as the income from dividends is subject to double taxation: first at the corporate level and a second time at the individual level. Perhaps someday there will be legislation that gives security token dividends preferential tax treatment such as afforded to stock dividends, but the similarities in structure are not enough to suggest this treatment automatically Why then is there a pressure to have blockchain companies pay dividends?

Legal Headaches

The reason companies like Merrill Lynch get paid $50 million dollars to run an initial public offering (IPO) is not, like many allege, that they are the gatekeepers. Well, not entirely at least. Morgan Stanley is responsible for the numerous filings and legal disclosures that go into an IPO which are largely there to protect the company running a stock sale and its executives from potential legal liability if the company does not perform as projected.

In the “Wild West” of the crypto space, however, there is much less concern over legal protections. This is made apparent by the number of open SEC cases now that are prosecuting the mostly shady promoters of token sales back during the proverbial gold rush of 2017. Just like the ’17-ers thought that magically because they were calling an issue a coin they would have no liability, the promoters and many advisors now think magically by calling a token offering a security there will be no liability.

I hate to be the one to burst the bubble, but this is once again far from reality. I touched above on the implications related to hard coding earnings, but the issue runs deeper than that, namely, a slew of unanswered questions: What happens when the investors disagree with how earnings are distributed? Do the investors have a say in electing board members? Surely all these contingencies can be determined in advance and hard-coded into an STO, it’s just that people in this space seem to roll hard and loose, and I have yet to see a company running an STO that seems to be covering their assets.

Other countries have a more lenient view of the regulatory environment and STOs may be a better fit there. At Consensus in Singapore I heard Damien Pang, Head of Technology Infrastructure Office at the Monetary Authority of Singapore, break down two types of blockchain companies. The first type does not want to be regulated and the sandbox can allow them to assign status. The second wants regulation to legitimize the business. The Money Authority of Singapore has a hands-off policy:

“If there isn’t a need for a particular innovation to be regulated we would rather allow the innovation to prove their status.” Pang stated, then continued by summing up the ideology as: “Regulations will always lack innovations.”

Of course investor’s acceptance of innovative technologies flies high when times are good, and only when times turn bad do investors en masse cry “scam!” and file lawsuits to recover the funds they feel were unfairly ripped from their clutches. It is a thin line between creative geniuses innovating the world in ways previously unthinkable, and con-artists offering impossible gains through non-existent technology.

Backup Withholding

U.S. companies that pay investment gains to non-U.S. persons are required to either withhold 30% of any payments received as backup withholding that is remitted to the IRS, or retain evidence of why this is not required via tax treaties. This means if you have a U.S.-based STO and any foreign investors buy your tokens, you will be required to handle this withholding for them. Otherwise the company is on the hook for the 30%!

In this instance, your answer might be to not have a U.S.-based STO and to incorporate in a foreign country. However, U.S. investors will be potentially subject to the tax reporting requirements of beneficial ownership of a foreign corporation (Form 5471), or the passive foreign investment company rules. Either way this can get messy for U.S. owners, and penalties for not filing form 5471 when required is a minimum of $10,000! Again I see potential company liability if the investors are not given the information needed and informed of their requirements.

Collecting the necessary information to administer all of this is not impossible, it could be done by exchanges transacting in STOs as part of the know-your customer (KYC) qualifications, meaning the identity verification process performed when an exchange onboards a user. I just have yet to see any STO platforms who are planning for these issues, and as of now there are no security token exchanges operating to see how they will address this in practice.

Additionally, there is the recurring cost of providing these reporting statements and other company-related communications to token holders. After running an IPO companies will on average pay between $1 million and $1.9 million in annual costs related to their stock and administration of shareholder documents. While the cost per individual investor is not as high as when issuing publicly traded stock, because tokens are divisible into small fractions the number of potential investors is relatively limitless. This could lead to a very high administrative burden for a small company that does not have the staff or budget to manage this.

Security Risks

The people I mostly hear preaching the benefits of STOs are not developers. When viewed from a development standpoint there are not yet great ways to accomplish the objectives of companies running STOs. Smart contract architecture is capable of hard coding the rights of token holders; that was part of the original plan for Ethereum as described in the whitepaper on the section discussing Decentralized Autonomous Organizations (DAOs).

The trouble though is the Turing-complete smart contracts from Ethereum can execute many different types of functions and this flexibility adds complexity that creates additional risk from hackers. This was proven when tokenized venture fund “The DAO” was hacked, with $50m stolen! To prevent permanent loss of these funds Ethereum was forked from a timestamp before the hack, a decision that is still controversial.

There are many times when companies in the blockchain space cut corners when it comes to securing smart contracts. With the shortage of knowledgeable developers it is only too easy to replicate code bugs, and without a third-party process of auditing smart contracts the are often only discovered by being hacked. However, few companies go through with smart contract audits after seeing the price tag. But this is running a tremendous risk, especially after a peer-reviewed research paper from academics in Singapore was released last March that showed 89% of the sample was vulnerable to attack!

Seeing how the industry has addressed these other security vulnerabilities, and the desperate search for funds that companies in seed stages or companies that have raised using utility tokens that are running out of runway will likely fall into soon, this will exacerbate the need to push offerings fast rather than doing things correctly. Thus it is not a matter of if but when the first STO gets hacked.

The Investor Side

All these risks are on the company side for the most part; only security vulnerabilities, and potentially some tax issues, are truly a potential detriment for investors. With that in mind I would say the benefits of liquidity to resell the tokens on a secondary exchange outweighs these risks in the minds of most investors. This is especially true in comparison to crowdfunding equity sales, where a little piece of paper a five year old could have printed is all you get in exchange for your hard earned money. That and a promise of a share in future gains if they ever occur.

This is why I am bullish on STOs in general as I think they serve a very important place in the future of the investment world, I just think there are still a number of issues that need to be addressed before every company switches to issuing security tokens, as many of the crackpot advisors in this industry are now recommending to anyone who will listen. Let us work on solving these issues through technology and regulations that simplify the reporting requirements for small companies, and focus on the benefits STOs can provide to small investors and seed-stage companies.

About Crystal Stranger

Crystal Stranger, EA, author of The Small Business Tax Guide, has more than 15 years of tax experience, with a focus in international tax. She has been writing about Cryptocurrency tax and regulatory issues since 2014. Wanting to help her tax clients who struggled with regulatory compliance, she founded PeaCounts, a blockchain accounting software company building a revolutionary new payroll system using the token PEA. This new, transparent payroll will promote fair wages and eliminate the need for black market labor. You can follow her crypto adventures on Twitter.