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Digital Security Offering – 6 Things to Know Before You Create a DSO

Cryptocurrency’s ongoing transition from underground to mainstream has resulted in a number of important changes in the way virtual currencies and all related activities are treated. Perhaps one of the most critical changes has been the migration away from ICOs and toward DSOs. While this migration is positive in many ways, it carries with it a host of new considerations – especially for emerging projects and businesses that undertake DSOs. Exploring and illuminating those considerations is the purpose of this article.

In this article, we’ll cover the 6 most important things you need to know before you create a DSO.

1. The Main Purpose of DSOs

If you’re already considering creating a DSO – or in the process – then you likely have a good idea of what their main purpose is. It is true, however, that people can tend to get swept up in hypes and trends; in the same way that some people create NFTs with no real purpose except that they feel they should jump on the bandwagon, there are certainly some businesses and projects that create DSOs that are doomed to fail because they’re essentially aimless. So let’s avoid that.

The acronym DSO stands for Digital Security Offering. DSOs are also known as STOs – Security Token Offerings. DSO and STO are simply two different ways of referring to the same thing.

The main purpose of DSOs is fundraising. DSOs are essentially online events in which projects and businesses sell digital securities (aka security tokens) to early investors in exchange for capital. Ostensibly, funds raised during DSOs are to be used for further development and growth.

With this main purpose in mind, we can explore the idea that DSOs are wise for some projects and unwise for others. The main questions to ask yourself to decide whether or not you should create a DSO include:

  • “Do I need to raise funds right now?
  • “Would it be worth it to sell shares of my project/business for capital right now?”
  • “If my DSO is successful and I raise funds, what will I use those funds for?”

Before you create your DSO, make sure that you’re absolutely clear in your purpose.

2. DSOs are Not ICOs

Before DSOs became popular in the cryptocurrency space, ICOs were the preferred method of crowdfunding. Unlike DSOs, ICOs were unregulated. While many ICOs were successful and mutually beneficial for the projects that launched them as well as their investors, many other ICOs were catastrophic failures. Unfortunately, there were plenty of scams masquerading as ICOs, too.

There are two main differences that distinguish DSOs and ICOs:

  • ICOs issue “utility tokens” while DSOs issue “security tokens.” (Whether or not a token is classified as a security is dependent on the “Howey Test.” More on this in #5.)
  • DSOs are subject to far more regulations than ICOs.

Actually, the first difference causes the second difference, in a way. Because of the fact that the tokens offered during DSOs are classified as “securities,” DSOs are beholden to the same regulatory frameworks that govern all securities, which leads us to #3.

3. Creating a DSO Requires Regulatory Compliance

Before you create a DSO, you must be absolutely sure that you are fully in compliance with appropriate regulatory frameworks. Failure to comply can result in investigations and hefty fines, at minimum. Quite simply, it’s something you want to avoid.

The “appropriate regulatory frameworks” alluded to in the last paragraph are dependent on the location of your business or project; we’ll get to that in #4. For the purposes of familiarizing ourselves with what compliance can look like, though,  let’s consider a hypothetical DSO beholden to regulations in the USA.

The agency responsible for regulations concerning DSOs in the United States is the Securities and Exchange Commission (the SEC, for short). According to regulations put forth by the SEC, businesses and projects creating DSOs operating out of the United States must do one of two things:

  • Register digital security tokens with the SEC directly.
    OR
  • Claim an exemption from registration.
    • Exemptions from registration are found in The Securities Act of 1933. Exemptions that DSOs often claim include:
      • Regulation A+
      • Regulation CF
      • Regulation D
      • Regulation S

It should be noted that most DSOs opt to claim one of the available exemptions rather than register their tokens with the SEC. Registering with the SEC can be costly, both financially and in terms of the amount of time it takes.

Another important note to make at this time is that the above snippet of information is limited in scope for the purposes of this article. If you are, indeed, looking to create a DSO that will necessitate compliance with regulations in the USA, you should understand that doing so may be complicated. For this reason, it’s highly recommended that you seek the counsel of a qualified attorney.

4. Regulatory Frameworks Largely Depend on Geographic Location

In order to shed a bit of light on what certain regulatory frameworks might look like, we used the frameworks imposed by the SEC in the United States as an example in #3. Now, however, we must acknowledge that regulations for DSOs will vary significantly based on location. To illustrate this point a bit, we’ll list some of the agencies and frameworks that govern DSOs in a few different countries.

  • USA: DSOs must comply with regulations put forth by the SEC (as explained in #3).
  • Canada: DSOs must be approved by the Canadian Securities Administrators (CSA, for short).
  • Australia: The relevant agency for securities (and therefore DSOs) is called the Australian Securities and Investment Commission (ASIC, for short).
  • Hong Kong: Securities and Futures Commission (SFC) supply relevant regulations for DSOs.

Of course, the short list above simply serves to demonstrate the fact that regulations for DSOs are dependent on the relevant country. Before you create your DSO, you’ll need to familiarize yourself with the regulations that DSOs need to comply with in your country.

5. The “Howey Test”

NOTE: The “Howey Test” is applicable in the United States, specifically.

As mentioned earlier, one of the key differences between ICOs and DSOs is that ICOs sell utility tokens while DSOs sell security tokens. In fact, it was the classification of “utility tokens” that allowed many ICOs to engage in unscrupulous behavior. Since utility tokens do not necessarily represent any sort of ownership, many projects sold essentially useless tokens with false promises of future use cases.

Security tokens, on the other hand, are digitized assets by definition. With the SEC now regulating DSOs, any token classified as a security token and will therefore require appropriate compliance.

If you’re unsure of whether or not the tokens you plan to sell in your DSO are technically security tokens, you can refer to the Howey Test. The Howey Test consists of four criteria. If your token meets the criteria, it is an “investment contract” according to the Howey Test, which means it is a security token and will require compliance with the SEC. The criteria, as obtained (and simplified) from the official SEC website, are:

  1. The Investment of Money. Are your tokens to be sold or simply given away? If they’re sold, that sale represents an investment of money from your purchasers.
  2. Common Enterprise. Common enterprise refers to a shared goal between the issuers of tokens and their investors. DSOs satisfy this criterion because both the projects selling tokens and the people that buy them benefit from the project’s success.
  3. Reasonable Expectation of Profits.  This criterion is met when investors expect (and especially when they are promised) that the project will gain value over time.
  4. Derived from the Effort of Others. As long as the gain in value over time comes from the effort of the project and not its investors, this last criterion is met.

6. DSOs Have an Excellent Success Rate!

If all of the regulations that must be understood and complied with appear daunting, it’s completely understandable. The fact is that DSOs require more careful planning and consideration than ICOs. However, the success rate (so far) of DSOs is much higher than the success rate of ICOs. With this in mind, if you’ve got a solid project and a good plan for your DSO, it might be a great idea to go forward with it.

One report in particular states that DSOs enjoy a success rate of 99%! While this figure seems astronomically high, even if the true success rate is lower, it is still considerably higher than the success rate for ICOs, which some sources report is only 10%. While these success rates do not offer any iron-clad explanation for this huge discrepancy, it’s reasonable to surmise that the extra steps in planning and legitimizing for DSOs act as a hurdle which poorly thought out or unscrupulous projects simply can’t jump over.

Obviously these figures should encourage you! If you do decide to go forward with creating your DSO, history has shown us that your chances for a good outcome are very high.

At the same time, however, don’t let optimism cause complacence. One way you can help yourself and your project is to hire a skilled and knowledgeable attorney to guide you through the more complicated regulatory phases of creating your DSO.

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