Tokenized Equity

Venture capital funds tokenize their limited partnership (LP) interests. This allows smaller investors to access venture capital portfolios, automates capital calls and distributions, and provides transparency into fund holdings and performance. The Securities and Exchange Commission (SEC) regulates these offerings under existing securities laws.

Tokenized equity involves the digital representation of a legal claim to an underlying asset, such as company stock or a private fund interest, on a distributed ledger. This is achieved by linking a security token to a legal agreement, often via a smart contract, which encodes ownership rights and compliance rules. The process requires a licensed intermediary to ensure regulatory adherence, typically under frameworks like Regulation D or Regulation S in the U.S.

• Liquidity & Accessibility: Enables fractional ownership and secondary market trading for traditionally illiquid assets like private equity or real estate.
• Operational Efficiency: Automates processes like dividend distributions, shareholder voting, and cap table management through smart contracts, reducing administrative costs.
• Transparency & Immutability: Provides a clear, auditable record of ownership and transaction history on the blockchain.
• Global Reach: Allows for borderless investment, though subject to jurisdictional securities laws and KYC/AML requirements.

Tokenized equity operates within established securities regulations. Key frameworks include:

• Regulation D (506c): For private placements to accredited investors in the U.S.
• Regulation S: For offerings to non-U.S. investors.
• Regulation A+: For public offerings up to $75M, allowing participation from non-accredited investors.
• Security Token Offerings (STOs): The compliant fundraising method for tokenized securities, distinct from unregulated ICOs. Jurisdictions like Switzerland (FINMA) and the EU (MiCA) have developed specific guidelines.

• Private Company Shares: Startups and growth companies issuing digital stock to raise capital.
• Venture Capital & Private Equity Funds: Tokenizing fund interests to provide liquidity to Limited Partners (LPs).
• Real Estate Investment Trusts (REITs): Fractionalizing ownership in property portfolios.
• Tokenized Public Stocks: Platforms offering blockchain-based representations of publicly traded equities (e.g., Tesla, Apple) for efficient settlement, though these are often synthetic derivatives, not direct equity claims.

The ecosystem relies on specialized infrastructure:

• Issuance Platforms: Securitize, tZERO, and Polymath provide end-to-end solutions for token creation and compliance.
• Trading Venues: Licensed Alternative Trading Systems (ATS) like tZERO ATS and INX facilitate secondary trading.
• Custodians: Regulated entities like Anchorage Digital and BitGo provide secure custody for security tokens.
• Blockchain Protocols: Protocols like Ethereum (with ERC-1400/3643 standards) and Polkadot are commonly used for their smart contract capabilities.

• Regulatory Fragmentation: Navigating differing securities laws across jurisdictions remains complex.
• Interoperability: Lack of standardization between different issuance platforms and trading systems.
• Legal Enforceability: Ensuring on-chain token ownership is unequivocally recognized under traditional law.
• Market Liquidity: While improved, secondary markets are still developing depth compared to traditional exchanges.
• Technological Risk: Dependence on the underlying blockchain's security and scalability.

In the U.S., the Howey Test determines if an asset is a security. Most tokenized equity qualifies, making it a security token. This triggers stringent requirements:

• Registration with the SEC or an exemption (e.g., Regulation D, Regulation A+, Regulation S).
• Mandatory disclosures and investor accreditation checks.
• Compliance with transfer restrictions and custody rules. Failure to comply results in severe legal penalties.

Holding tokenized securities requires secure custody solutions that meet regulatory standards. Key considerations include:

• On-chain vs. Off-chain: Legal ownership may be recorded off-chain (a traditional cap table) with the token as a beneficial interest claim.
• Qualified Custodians: Regulations often require assets to be held by a qualified custodian (e.g., a regulated trust company).
• Private Key Management: Loss of keys means loss of the asset. Institutional-grade multi-signature wallets and hardware security modules (HSMs) are essential.

Regulations vary drastically by jurisdiction, creating a complex landscape for issuers and investors.

• EU: Governed by MiCA (Markets in Crypto-Assets) and traditional financial instruments directives like MiFID II.
• Switzerland: Uses the DLT Act, providing a clear framework for tokenized securities.
• Singapore: Regulated under the Securities and Futures Act by the MAS.
• Key Challenge: A token issued in a compliant jurisdiction may be a security in another, affecting secondary market trading.

Trading tokenized equity on secondary markets (Alternative Trading Systems - ATS) introduces additional layers of regulation.

• Licensed Trading Venues: Platforms must be registered as a broker-dealer and often an ATS with the SEC/FINRA in the U.S.
• Anti-Money Laundering (AML): Platforms must implement KYC (Know Your Customer) and AML checks on all traders.
• Investor Eligibility: Enforcement of transfer restrictions and accredited investor status is required at the point of trade, not just issuance.

The technological layer introduces risks beyond traditional finance.

• Smart Contract Vulnerabilities: Bugs or exploits in the token contract can lead to irreversible loss or unauthorized issuance.
• Oracle Reliability: Contracts relying on oracles for price feeds or corporate action data (dividends) are vulnerable to manipulation or failure.
• Governance & Upgradability: Mechanisms for corporate actions (stock splits, dividends) and contract upgrades must be legally enforceable and secure against governance attacks.

Tokenization adds complexity to traditional tax treatment.

• Taxable Events: Each token transfer or trade may create a capital gains event for the seller.
• Dividend Distribution: Automated dividend payments via smart contract must be reported to tax authorities.
• Form 1099 & International Reporting: Issuers and platforms may have obligations to issue Form 1099 (U.S.) or comply with CRS (Common Reporting Standard) globally.
• Cost Basis Tracking: The immutable ledger can simplify audit trails but requires integration with accounting systems.

A smart contract is self-executing code deployed on a blockchain that automates the terms of an agreement. For tokenized equity, smart contracts are critical for:

• Token Standards: Implementing interfaces like ERC-1400 for security tokens.
• Automated Compliance: Enforcing investor accreditation and transfer restrictions.
• Corporate Actions: Distributing dividends, facilitating votes, and managing cap tables programmatically.

Secondary market liquidity refers to the ability to buy and sell tokenized equity on regulated trading platforms after the initial issuance. This is a primary value proposition over traditional private equity. Key elements include:

• Alternative Trading Systems (ATS): SEC-regulated platforms like tZERO and INX that list security tokens.
• Increased Accessibility: Enables fractional ownership and broader investor participation.
• 24/7 Trading: Potential for continuous settlement, unlike traditional markets.

Cap table management involves tracking the ownership capitalization of a company. Tokenized equity transforms this process through on-chain cap tables, where ownership is recorded immutably on the blockchain. Benefits include:

• Real-Time Transparency: Instant visibility into shareholder registry and token distribution.
• Automated Updates: Equity events like new funding rounds or employee option exercises are automatically reflected.
• Reduced Administrative Overhead: Eliminates manual errors and simplifies audit and compliance processes.