By Robert Nanni
The concept of asset fractionalization has become increasingly popular as issuers, and market participants, seek to provide investors with new ways to access traditional asset classes. An exciting component of that growth has been a significant increase in fractional ownership platforms – with issuers bringing unique and sought-after opportunities to their investor base. The scope of this opportunity is only limited by the creativity of the issuers and the assets they can source.
Asset fractionalization is a surprisingly straightforward process. Here are the high-level steps required to fractionalize your assets and raise investor capital:
- First you must identify the assets to fractionalize i.e., art, precious metals, real estate, private equity or debt positions, etc.
- Second, you need to establish a holding company (SPV (Special Purpose Vehicle) - LLC/Corporation). This company will take ownership of the asset(s) above.
- Third, you must establish a security offering construct for the holding company and finalize offering documentation – this will vary by the exemption utilized to raise capital from investors (Reg D, Reg A+, Reg CF, etc.)
- Fourth, you must raise capital from investors (i.e., offer the holding company’s securities for sale)
- Your investors now own shares of the holding company with exposure to the underlying asset.
You have successfully fractionalized an asset!
While it is a remarkably simple five-step process, an issuer must ensure it is following all applicable regulations and requirements. It is strongly recommended that firms engage regulated entities and legal counsel to assist.
But do you still need to Tokenize?
Considering the definition and demonstration of fractionalization, it still begs the question, what role does tokenization play? With the rise of blockchain, many new market entrants incorrectly assume that tokenization is required to fractionalize. Because there is so much misleading information on the internet from providers who only deal with asset tokenization, it is not surprising that this is a common misconception. Tokenization is merely a representation of the shares issued and never a requirement. Moreover, a security token cannot behave like a cryptocurrency due to regulations. There are very few components of tokenization/blockchain that can be utilized when dealing with securities, and because of these minimal applications, many issuers will not consider tokenization until there are clear efficiencies from the SEC.
If an issuer chooses to tokenize, they must incorporate it into the process and, a final and sixth step would be completed by the issuer and their providers. To achieve fractionalization with tokenization, the issuer would be required to represent investors’ shares with a blockchain-based token/instrument.
Tokenization is typically the final stage in the process after an issuer has completed its capital raise. Some issuers may choose to create the tokens prior to selling the shares to investors. However, they will need to hold them in escrow until the capital raise is finished – the overall process does not change significantly.
The reality is that security tokenization not only adds an additional step, but it can also introduce a host of complexities and costs that are otherwise avoided should an issuer choose the direct fractionization route. These include, but are not limited to:
- Merging blockchain infrastructure within traditional regulated entities. Custody, clearance, settlement, and cap table management are just a few of the processes that must be performed by regulated entities. The use of blockchain does not allow an issuer to circumvent any of these processes. Short of any SEC (Securities and Exchange Commission) overhaul, organizations that perform these roles today, or new entrants to the market who are interested in blockchain technology, must develop their infrastructure to support tokenized issuances while continuing to follow standard practices as a regulated entity. Unfortunately, this can be extremely complex.
- Complying with laws and regulations. Tokenization does not remove the need to follow SEC (Securities and Exchange Commission) laws and regulations. Broker dealers and other regulated entities must continue to ensure that securities are issued and traded in a regulatorily compliant manner– this is accomplished today through their existing technology infrastructure. Blockchain and tokenization will simply be an additive feature and does not, by itself, replace any compliance technology that is already in existence. There are many firms that are already operational, issuing and trading alternative assets that do not require blockchain to govern securities and serve as a technology layer to achieve compliance.
- Managing the complexities of issuance exemptions. Certain issuance exemptions undergo various levels of SEC scrutiny. For example, the SEC (historically) has been reluctant to qualify many Reg A+ issuers seeking to represent ownership via blockchain tokens. It is likely that introducing the concept of tokenization will delay efforts to launch, which will increase an issuers time and costs to market.
- Navigating inconsistencies in policies and practices. Because tokenization is such a new concept, there is no one standard for how to do it. There are thousands of firms that can create smart contracts and “tokenize” equity/debt. As a result, multiple blockchain protocols are emerging from different companies. This fact makes it more complex when attempting to identify regulated entities that can support multiple technology layers to effectuate their business. If the SEC creates regulations that set forth common standards for security tokenization, we may see more standardization.
Asset Fractionalization without Tokenization is possible
Tokenization creates greater inefficiencies and costs in a process where it is otherwise unnecessary to fractionalize an asset. Tokenization is not required to fractionalize assets, or achieve greater liquidity, better price discovery, and democratization of alternative assets.
Templum is situated at the nexus of the highly progressive private market and the traditional public market, enabling the issuance and trading of alternative assets. Regardless of whether your firm moves to fractionalize alternative assets, the key to unlocking real benefits lives with next-generation financial infrastructure.