How to Tokenize Your Cap Table to Raise Money (+ Advantages & Disadvantages)

What about offering your Cap Table as Security Tokens? There’s an emerging trend of tokenizing entire companies instead of raising money through angel investors and VCs. This is reminiscent of the ICOs of the past, but we’re talking STOs now. While ICOs were akin to the Wild Wild West, the whole point of Security Tokens is to be as compliant with the law as humanly possible. With this, comes customer protection and a lack of regulatory risk. Precisely the two main vulnerabilities that ICOs had.

Let’s be honest, even though ICOs sold Utility Tokens, they were selling securities and not utilities from the get-go. To tokenize their Cap Table properly, issuers had to comply with local securities regulations and register with the relevant authorities. For the most part, they didn’t, and that’s one of the main reasons the ICO bubble burst. 

Is this time different, or are we kidding ourselves? Can Security Tokens become the new way for companies to raise money and for retail to invest in the future?

That’s what we’re here to find out.

However, to avoid confusion, let’s check Investopedia’s definition of Cap Table first: 

“In general, the capitalization table is an intricate breakdown of a company’s shareholders’ equity. Cap tables often include all of a company’s equity ownership capital, such as common equity shares, preferred equity shares, warrants, and convertible equity.”

In this article’s case, we’re discussing the tokenization of entire companies to raise money.

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Cap Table tokenization and network effects

Let’s be honest (once again), most small and middle-sized businesses will never have access to VC money. And even for big enterprises, the road to take a company public is an uphill battle that can take years to accomplish and require substantial investments to get there. Enter Security Tokens, the best possibility the world has to democratize and modernize both of those processes.

In the case of Cap Table tokenization, both the company and the investors directly benefit from the tokens gaining value. That means, both the company and the investors’ interests are completely aligned. It also means that early adopters have an obvious incentive to promote and support the business. Which generates a virtuous cycle of network effects that no other business model can rival.

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How to tokenize your Cap Table

Let’s cut to the chase, this is what you probably came for. Make sure to read the rest of the article, though. Tokenizing your company’s Cap Table is a complicated process that comes with advantages and disadvantages. Also, read Smartblock’s comprehensive guide to real estate Security Tokens. Those are slightly different from Cap Table Security Tokens, but the lessons stand for both types.

• Legal comes first: For a Security Token to exist, it has to comply with the regulations of the jurisdiction it’s issued on. Solve that problem first and the rest will follow. Don’t even think about anything else until your STO is fully compliant with the law.

• Pick your blockchain: Choose wisely, this is a make-or-break step. You may use a Security Token-specific blockchains like Ravencoin, Ethereum or Polygon or a platform like INX. Those require much less coding since they developed tools to make the process as easy as possible. Alternatively, you can use any smart contract-enabled blockchain like Ethereum, Binance Smart Chain, or Cardano. In those, your programming team will have to do all of the coding for the smart contract. This gives you freedom and flexibility, but coding requirements are steeper.  

• Define tokenomics: Before writing a single line of code, put on paper all of your Security Token’s characteristics. In this case, since we’re talking about a company’s Cap Table, focus on specifying what the tokens represent, what rights they grant, and how will the profits be distributed.

• Program your smart contract: to gain trust, your contract needs to be auditable. Not only by security companies like Consensys MythX that will look for vulnerabilities, but also by the investors who will check them to make sure that the specified tokenomics are present in the code. A simple mistake in the smart contract could be devastating for any project, so triple-check everything and then check again.

• Deploy the code in the blockchain: When your team is 100% sure that the smart contract holds up, it’s time to pay for the listing and deploy it on the blockchain. It’ll be there forever.

• Promote your Security Token: There are thousands of tokens out there, but not many of them represent a company’s Cap Table. You are striking first and you’re offering a valuable and convenient investment, but, how are people going to know? Smartblocks published a general guide to promote Security Tokens that serves as a starting point. Innovate in this area and success will follow.

The case for Security Tokens over stocks or shares

There are many advantages to STOs. Since the blockchain is a public, distributed ledger, Security Tokens are completely auditable in a simple way. That’s not only true for issuers and investors. Regulators and relevant authorities also have access to this unalterable and trustworthy ledger, which provides most of the information they need. 

The tokens are digital, so transaction costs can be quite low, and the marketplace for them is open 24/7. That opens the most valuable property of all, tokenizing your Cap Table brings liquidity, and it brings it fast. In general, equity is far from liquid, and it remains that way for a long time after the original buy. 

Also, take into account that the digital nature of Security tokens enables fractional ownership. This is also relevant to the liquidity question since the lower entry bar theoretically opens the door to retail investors. There’s also the programmatic nature of Security Tokens, which allows for those investors to automatically receive profits and revenue if that’s what the smart contract says.

In general, Security Tokens live in a digital realm where processes are trusted and sped up. Traditionally, securities required an ungodly number of man-hours and manual work. Not to mention, lawyers, fees, and investor calls.

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The case against tokenizing your Cap Table

As usually happens, there are also many disadvantages to STOs. First and foremost, current regulations can get in the way of progress. Even though Security Tokens open up the theoretical possibility of the democratization of the investment process, security law in the US closes that door by requiring Accredited Investor credentials to participate (However, there is a Reg A, Tier2 exemption) . The world where retail gets access to investment opportunities only available to the upper classes is still far away, and yet so close.

The other major issue concerns crypto companies’ lack of access to corporate bank accounts. This problem, which exists ever since Satoshi Nakamoto created the first cryptocurrency, has come to the forefront. The main banks of the world claim that they don’t understand the industry well enough to take a risk and deal with crypto companies. And the so-called crypto banks that emerged to fill that role are currently facing a crisis like no other. It’s like investor Mike Bucella told CNBC, “Near-term, crypto banking in North America is a tough place. However there is a long tail of challenger banks that may take up that slack.”

Then, there are the philosophical problems. Decentralization is paramount to the crypto space, and in the case of tokenizing Cap Tables, reporting percentage of ownership is desired. So, is a Security Token decentralized if a party owns, let’s say 25% of the tokens? 

Privacy is a technical problem. Is it desirable for investors that all of the transactions are available to anybody with a blockchain explorer and some time on their hands? Is this public access something they’ll have to learn to live with? Or can we keep some data private while still getting all of the advantages that a blockchain brings?

Last but not least, there is the issue of ownership rights. While Security Tokens usually represent ownership of a valuable asset, in the case of companies, investors don’t get board seats and voting rights as stockholders do. Is this going to be a problem or an opportunity?

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Cap Table tokenization in conjunction with traditional funding

In 2019, Verlato CEO Dave Hendricks told The Block:

“These are companies that are less early, because the problem in this industry has been that people have been trying to tokenize companies that are too early in their lifecycle. It's not the right time to do that. What we see as a great market for tokenizing are venture-funded companies that are three, five, seven years old that [want] to get liquidity.”

Is it possible that Cap Table tokenizing is more useful for already funded companies that are well into their business life? Last year the president of 3iQ Digital Assets, Chris Matta, told TechCrunch about “a hybrid cap table that has a core list of traditional equity holders along with some investors who are in a token conversion agreement that will grant them token allotments once the token tied to the company is launched. “These business models focus on the token but use the equity as a transition structure.”

Maybe the two ways of doing things are not in competition with each other and can work in tandem instead.