The Security Token Offering has quickly emerged as a legitimate investment tool in the crypto community and the wider world of finance by providing a regulated, compliant, alternative to the risky ICO (Initial Coin Offering).
Many in the crypto community see the STO as a much-needed bridge between the unbridled ICO and the tedious, time-consuming process for issuing a traditional stock IPO (Initial Public Offering).
As the STO gains momentum by blending the best of traditional and 21st Century blockchain financing, understanding valuation models for security tokens can provide many benefits for blockchain savvy startups and traditional corporations alike.
Before we dive into the security token valuation math, let’s get up to speed on this innovative and versatile financial instrument.
A Brief History of the ICO vs STO
ICOs have been designated by the US Securities and Exchange Commission (SEC) – in most cases – as “unregulated securities”. Plagued by a notorious reputation for failures and outright scamming, the Initial Coin Offering has lost its dominance in the brave new world of decentralized financing.
When numerous ICOs had to shut down and return capital to their investors, it became obvious that the totally unregulated ideals for decentralized financing are simply unsustainable. The STO quickly filled the resulting ICO void, with their number nearly doubling by Q4, 2019 while ICOs are down about 97% according to a recent report at Hackernoon.com.
Security Tokens: Going Forward With a Wise Step Back
STOs may arguably be the savior of decentralized financing. Amidst the blind and risky charge into the crypto future which ICOs represented, the STO is a wise step back to proven best financial practices. While some blockchain purists resent the idea of any third-party regulation whatsoever, the STO relies on the Howey Test to qualify as legitimate investment contracts (the Token Taxonomy Act has also been introduced, but not adopted).
Security tokens are backed by underlying assets, and bring to the table all the transparency and reassurance that traditional, SEC-registered securities provide to attract the highest class of accredited investors. Security token offerings also protect the issuer with available SEC exemptions from the Cease and Desist orders which shut down many ICOs.
So now that we know how valuable the STO is to investors and issuers as an investment and capital raising tool, just how do we go about determining the value of the security token itself?
The Math of Security Token Valuation: M=PQ/V?
In his informative article “How to Value a Security Token: Factors to Consider” angel investor and blockchain scientist Jesus Rodriguez points out that valuation models are the key to sustaining security tokens as a viable asset class in mainstream financing. Rodriguez suggests that the solution can be built on the foundation of existing models used for determining the valuation of utility tokens and other cryptocurrency assets. Rodriguez cites Crypto Assets author Chris Birniske’s equation of exchange model as a starting point for security token valuation, the formula M=PQ/V where:
M= the underlying asset base size
V= velocity of the asset (the ratio of revenue produced to asset value)
P= price of the asset
Q= quantity of the asset.
The “equation of exchange” model provides a clear picture of the driving factors that determine the price of a utility token, but Rodriguez notes that P, when applied to the world of security tokens, is affected by a host of “off-chain” factors which are much more complex.
There is no universal model for calculating the valuation of the different classes of security tokens with all of their subjective variables, but there some common sets of influential factors that can be used as a framework for any valuation analysis.
Frequency of trading and the number of tokens provisioned are two common crypto-factors that affect token value, but the innovative architecture of the security token brings a series of asset-based factors into the equation, the “off-chain” influences driven by traditional market conditions.
Asset-Based Factors For Security Token Valuation
1. Underlying Asset Value
Since security tokens are backed by underlying assets their value will respond to the value of those assets. If the token represents shares in a company, value can be expected to rise (or fall) proportionally with the company’s valuation.
As tokenization becomes more common commodities such as oil, wheat, and natural gas and their values on third-party exchanges will determine the value of the security tokens which digitize them. The same applies to tokenized hard assets, physical objects of tangible value such as manufacturing equipment, or even jewelry, art, and collectibles. Their valuation as determined by third-party assessors, tax environment, and insurability is a classic example of “off-chain” influence affecting the token value.
2. Dividends and Cash Flow Factors
A security token doesn’t necessarily require physical objects of value as the underlying asset. Tokenized real estate leases are an example of cash-generating assets in the form of debt instruments. Token holders can anticipate regularly paid dividends generated by rental payments which definitely has an impact on token value. Obviously, the higher the dividend, the higher the value of the token.
3. Risk, Reward, and Security Token Value
This may be the most important factor to overcome for blockchain startups and entrepreneurs seeking capital with an STO. Any perception of intrinsic risk on the investor side is sure to affect token value, especially if the token represents equity in a minimally collateralized company with a sparse inventory of hard assets.
Excessive risk is the influencer which brought about the downfall of the ICO. On the other hand, when the risk/reward factor is optimized an STO can raise incredible amounts of capital in a remarkably short time. BCAP, (Blockchain Capital) the firm who started the current trend with the first security token offering in 2017, had already established a sterling reputation since its founding in 2013 for lucrative investments in notable companies such as Ethereum, BitGo, and Coinbase to name just a few. BCAP was able to raise $10 million in just 6 hours capitalizing literally on their record of success.
4. Liquidity and Fractional Ownership to Enhance Token Value
Instant settlement and fractional ownership are two of the biggest advantages of tokenizing assets. Tokenizing physical assets opens the door to fractional ownership in hard-to-divide assets such as real estate, but blockchain technology isn’t stopping there. Fractional asset ownership is finding roles in everything from precious metals to sports team ownership and even big-budget film and entertainment projects. A wider range of ownership creates a larger market for the token with a lower cost of entry and more liquidity options for token holders, all of which enhance security token value.
At TokenRaise, we can offer the experience and guidance to instill the trust and confidence you need to enhance the value of your blockchain project. We offer the full range of consulting services to help you navigate the lucrative but complex world of decentralized blockchain financing from full certification, token development, and smart contracts to marketing support. We can connect you with our extensive network of investors when you’re looking to raise funds through an STO with full support from concept to launch so don’t hesitate to get started with TokenRaise today.