This section shall provide you with background information about Tokenized Equity and Alethena’s solution of Tokenized Shares.
Tokenized equity constitutes a framework where each token represents a share in the underlying company.
It represents a legal relationship in which the holders of tokens are endowed with enforceable rights (voting and/or dividend rights) by holding the corresponding tokens. Tokenized shares thus bridge the gap between the existing law doctrine and the progressive blockchain technology.
Tokenized Equity Terms
Tokenholders are de jure shareholders of the underlying company, which implies that a token represents a share in the company (while the principle remains unchanged, this legal relationship may also be governed by a different exchange relation, i.e. one token represents two shares), hence tokenized equity. Holders of tokens are endowed with enforceable rights, that is, voting and dividend rights, by holding the corresponding tokens.
Why tokenized shares and not tokenized equity? Many publications and articles predominantly use the term tokenized equity, however, strictly speaking this is not entirely correct. Since the term shareholder’s equity commonly refers to a company’s net amount of total assets and total liabilities listed on the balance sheet. In the tokenization process, only the share capital, which is part of the shareholders equity, gets tokenized. Given its common use, we will henceforth refer to the framework as Tokenized Equity and to the ownership in the company as share.
- Token Ownership in a blockchain project. Not associated with enforceable capital rights (dividends) and voting rights (although the former and latter may be contractually agreed upon, they are not binding and their materialisation at discretion of the board of directors of the company in ownership of the project).
- Share Fractional ownership in the underlying company. Entails enforceable capital rights (dividends) and may entail voting rights (i.e. preferred shares).
- (Underlying) Company The company whose shares are being tokenized.
- Tokenholder Natural person or legal entity in possession of the token.
- Shareholder Natural person or legal entity in possession of the equity.
- Dividend Distribution of a company’s earnings to its shareholders.
- Voting Right Shareholder’s right to vote on corporate matters.
- Tokenized Shares Framework where each token represents a share in the underlying company.
The fundamental principle of tokenized equity is constituted/shaped by a re-interpretation of the current legal doctrine by well-known scholars in Switzerland (von der Crone, H.C., Kessler F. J., and Angstmann, L, 2018, Token in der Blockchain – privatrechtliche Aspekte der Distributed Ledger Technologie, Schweizerische Juristen-Zeitung), which now makes it possible to offer fully tokenized equity with enforceable dividend and voting rights (in Switzerland).
In essence, registered share tokens qualify as uncertified securities (as defined by Art. 973c CO or extra-legal). Given uncertified securities are pure obligatory rights, in principle, this allows for an application of the common rules of the Swiss Code of Obligations (as opposed to the law on securities). Therefore, this makes possible both the integration of tokens into shares and the transfer of these tokens.
From a legal perspective, the solution of fully tokenized equity is quite comprehensive:
- First, the legal qualification of share tokens needs to be considered. These tokens qualify as uncertified securities. These securities confer only civil law rights and no financial market laws are being touched.
- Second, the connection between tokens and shares needs to be established. This causes a restriction on the power of disposition since the tokens need to be transferred in order to transfer the rights associated with the shares. This restriction needs to be empowered in the (Eidgenössisches Amt für das Handelsregister (EHRA)-approved) bylaws.
- Third, the transfer of the tokens itself is regulated in the sense of uncertified securities. The corporation gives implicit approval of the transfer of tokens, which takes place without specific form requirements and this enables the transfer of rights.
What is important to note here, is that the shares are legally bound to the tokens. Thus, transferring the token is similar to handing over a physical share certificate: the possession of the share is transferred along with it.
Once in possession of said tokens, the buyer must register himself with his real name in the shareholder registry of the company, which is a legal duty. Without registration, the shareholder is neither entitled to receive dividends nor can he/she make use of his/her voting rights (but he/she can still sell the share to a next shareholder).
Each share is represented by a token on a blockchain and transferring shares is accomplished by transferring the token directly. In this sense, the token really replaces a physical (paper) share.
A smart contract is a computer program that runs on a decentralized network. This means that every node on the network (for example a miner of Ethereum) runs a copy of the code locally. In a healthy network, no single player can make malicious changes unanimously.
A common use case of smart contracts is keeping track of assets. Concretely, the smart contract contains mapping of owners and assets. The ERC20 standard defines a specific implementation of this idea.
Due to the pseudonymous nature of most blockchains, owners must register with the company in order to exercise their full shareholder rights. The company can now monitor transactions happening on the blockchain and update the shareholder registry accordingly – this process can be fully automated.
It is important to note that shares can be transferred on the blockchain freely, even if none of the counterparties are registered. However, until the buyer registers with the company, they will not be able to exercise their shareholder rights.
Dealing with lost private keys
Tokenized shares are held on accounts which can only be accessed with the correct cryptographic key. While systems exist that facilitate handling of keys, a situation where a private key is lost can still occur which means that the corresponding shares can never be transferred again.
To mitigate this risk, the company can decide to maintain a degree of central control over the shares (thus moving away slightly from the decentralized character). If this is not desired, the smart contract can be implemented in such a fashion that users can claim “lost” shares back after staking a collateral which will be lost in case of a malicious claim.
Distinction from Utility Tokens
Utility Tokens, Security Tokens, and Tokenized Equity share the fundamental aim of enabling investors to participate in a company’s growth and success. However, there are certain key differences with respect to how this is achieved, and which legal claims are involved.
- The Tokenized Equity framework equates shareholders and (security) tokenholders, thus endowing them with enforceable rights, i.e. claims, on the underlying company.
- Utility tokenholders are not endowed with any enforceable claims on the underlying company.
- As the term suggest, the utility of holding the token is derived from its usability in a particular ecosystem.
- Capital gains for tokenholders only result from an increase in the token demand and a corresponding increase in the token price.
Distinction from Security Tokens
- Within the Tokenized Equity framework, each (security) token de jure represents a registered share in the underlying company. Not only does this simplify the whole dividend and voting process considerably, but also guarantees that share (= token) prices fundamentally correlate with the enterprise value.
- Security tokenholders are not endowed with any enforceable claims on the underlying company.
- In many cases the underlying companies set up contractual dividend and voting agreements, however, the latter are not enforceable.
- If shares (of the underlying company) and security tokens coexist, the distribution of dividends to tokenholders is at the discretion of the shareholders (general assembly).
- If shares and security tokens coexist, the voting on agenda items is at the discretion of the board of directors of the underlying company, non-binding and not mandatory by law. Therefore, the board of directors can vote on a proposal for an online assembly of tokenholders but is not obliged to do so.
- If shares and security tokens coexist, there is no implicit (fundamental) correlation of the token price and the enterprise value.
Distinction from Equity
- The framework of Tokenized Equity merges the legal domains of shares and tokens to create a unified framework where tokenholders are de jure shareholders, enhancing tradability of shares, reducing transaction costs, and facilitating valuations.
- Equity of startups and small and medium-sized enterprises is not easily tradable as those companies have no access to an exchange market for their shares. Thus, the so-called liquidity premium (up to 25%) cannot be unlocked in a traditional Equity framework.
- Transferring shares is associated with high transaction costs (i.e. contracts, commercial register etc.).
- Valuations of startups and small and medium-sized companies are very difficult, given the lack of a proper market price for shares.
Position of the Shareholder/Tokenholder
The framework of tokenized equity endows the shareholder (and therefore also the tokenholder) with certain enforceable rights.
The shareholder can enforce the following:
- The right to receive the same per-share dividends (distribution of company’s profits) that other shareholders receive.
- The right to vote in the general assembly on the agenda items proposed by the board of directors of the company.
Aim of Tokenized Equity
The main aim of tokenized equity is:
- To merge the up until now separate legal domains of shares and tokens and create a unified framework where tokenholders are de jure shareholders, thus creating enhanced legal certainty.
- To endow shareholders/tokenholders with voting and dividend rights.
- To foster the professionalisation of the blockchain industry by endowing investors with legal claims on the underlying company.
Advantages of Tokenized Equity
- Share tokens qualify as uncertified securities according to Art. 973c of the Swiss Code of Obligations and therefore get enforceable token rights.
- Startups and small and medium-sized enterprises get the possibility of a tradable exchange market for their shares and can therefore unlock the so-called liquidity premium (up to 25% of market value)
Further advantages include:
- Tiny transaction fees
- Lowering of issuance fees
- Tokens may be eligible for global trading depending on their set-up
- Inclusion of professional investors such us venture capitalists and family offices
- Decreasing the reliance on lawyers in the long run
- More accurate and fair asset valuations in the venture capital and private equity market
- Document ownership of securities in a fully transparent way
Applicability in Jurisdictions other than Switzerland
In its current form, the legal framework of tokenized equity has been designed and tailored specifically to the Swiss legal system. However, the application in other jurisdictions, where certain legal aspects are given, should theoretically be possible.
Tax Aspects of Tokenized Equity
Tokenized equity is taxed in the same way as normal shares are. In Switzerland, this implies that capital gains are tax-free for natural persons, but dividends are subject to income tax. Furthermore, wealth tax is owed on the share capital.