The buzzword "tokenization" has been circulating through the ether for several years now. It is not only the crypto community that has recognized that the use of blockchain–based tokens makes a digital representation of almost all assets at least within the realm of possibility. In our legal practice, we have advised on a large number of such projects. With this article, we would like to provide an overview of which tokenization models are common in practice, which alternatives exist beyond that, and which legal as well as tax considerations need to be taken into account.
Bryan Hollmann, counsel at STADLER VÖLKEL explains in this video how tokenization of various assets is implemented in practice in Austria.Information Folder: For more detailed information on tokenization, order our information folder online. You can downlowad the PowerPoint Presentation here.
At the risk of carrying owls to Athens, we would like to briefly summarize what tokenization actually means for those readers who may be looking into it for the first time. In general, tokenization is the process of creating a digital representation of certain real assets on the blockchain. Often these are securities, means of payment, company or project participations, loans, precious metals or even shares in real estate.
Tokenization generally fulfills two different functions. On the one hand, the need for certain intermediaries is eliminated, which helps to save transaction costs. On the other hand, illiquid assets can be made easily tradable in this way.
| Functions of tokenization |
|---|
| 1. Reduction of necessary intermediaries |
| 2. Increased liquidity of assets |
The first function of tokenization thus concerns the reduction of necessary intermediaries. This is a particularly important aspect in the issuance of tokenized securities. Unlike traditional issues on the capital market, neither a paying agent bank, nor a depository, nor other intermediaries are required. The company raising capital issues the tokenized securities (or 'security tokens') directly to the investor. The investor holds the tokens in their own wallet.
The second function of tokenization relates to the possibility of making illiquid assets liquid, i.e., preparing them for simple and rapid trading. A physical gold bar or shares in an apartment building are more difficult to trade than a token, for example.
The limits of what is possible in tokenization are essentially determined by economic, tax and accounting considerations. Once it has been determined which asset is to be tokenized and tax and accounting issues have also been clarified, there is generally nothing to prevent implementation. Two things are required for this.
In a first step, the digital representation of the asset is created in technical terms: A smart contract is published on any blockchain, which produces and manages the desired number of tokens. In practice, the Ethereum blockchain is most frequently used for this purpose. The tokens created in this way will later digitally represent the desired asset.
The second step is to link this digital representation with the real asset. This second step – the interface between the digital and real worlds – is the real challenge. As a result, the holder of a token should be placed in such a position that they have a claim to the tokenized asset that can be enforced in the real world. The legal protection of the token holder must be given top priority in the structuring of the project if the current trend toward tokenization is to pave the way for long–term and sustainable development.
| Steps to tokenization |
|---|
| 1. Generation of the tokens on a blockchain |
| 2. Linking with the asset |
The legally secure link between digital token and real asset is therefore the core of tokenization. How this is implemented depends on the specific asset in question and the law under which the tokenization is carried out. So it makes a difference whether the law of Austria, or for example Liechtenstein, Germany, Switzerland, or another jurisdiction is chosen. Since our expertise is in Austrian law, we present the approaches under Austrian law.
If the right is a legal claim, as is the case with securities, means of payment or loans, the claim can usually be directly linked to the token. The ownership of the token is then necessary for the exercise of the claim. To transfer the legal claim, the token is transferred to another person on the blockchain. Whoever owns the token is the creditor of the security, payment or loan claim. This is achieved through corresponding clauses in the contractual agreement between the parties.
Model 1 : Direct transfer of a legal claim by transferring a token on the blockchain that represents the claim. (C: Company, A: Previous creditor of the Company, B: New creditor after taking possession or assignment of the claim via token transfer).
Whether existing debt can be tokenized depends on the prior agreement reached between the parties. If the debtor wishes to tokenize existing liabilities (i.e., its own debts), this generally requires the consent of all creditors. If, on the other hand, a creditor wishes to tokenize an existing claim, this may be possible under certain circumstances without the debtor's involvement.
If not only simple rights to receivables are to be tokenized, but a real ownership position, or if a stricter form is prescribed for the transfer of the right – e.g., if a written contract is required – then one must dig a little deeper into the legal bag of tricks. The tokenization of tangible objects such as stocks of goods, precious metals, shares in real estate or even participations in companies should be considered.
In these cases, it may be necessary to choose a trustee structure, whereby two different variants can be considered here as well – depending on the requirements. In the first variant (Model 2.A), a trustee (T) directly mediates the ownership position. The trustee owns, for example, physical gold bars for the token holders (A and B). In connection with an example of tokenization of real assets such as precious metals or apartment buildings, we will discuss this construction in more detail below.
Model 2.A : Trust structure where tokenized ownership is exercised by a trustee on behalf of token holders. (C: Company, T: Trustee, A: Previous owner, B: New owner after taking possession via token transfer).
In the second variant (Model 2.B), the trustee (T) only indirectly ensures that the company (C) can actually keep a certain promise. This variant is particularly relevant in the tokenization of efforts obligations (see also below). Indeed, as a rule, the participation of the shareholders (S) is necessary for the fulfillment of this promise. In such cases, the trustee is appointed as a shareholder of the company. This is particularly interesting in the case of corporate forms that do not have authorized capital.
Modell 2.B : Trust structure in which a trust shareholder (T) ensures that the Company (C) can fulfill promises relating to its own shares that would actually have to be fulfilled by the owners (S). By transferring the token from A to B, these so-called efforts obligations are transferred.
Caution: Not every legal system is the same. While Austrian law, for example, is well equipped for the types of tokenization presented, and Liechtenstein has even created its own law on asset tokenization, the legal situation in other countries may differ. In many cases, however, Austrian or even Liechtenstein law can be made applicable with a choice of law clause in order to take advantage of these favorable legal systems for oneself, even if the company is not domiciled in Austria or Liechtenstein.
Based on the legal constructs presented above, just about any asset can be tokenized. To offer an impression of the possibilities, we present some concrete examples below. Practical cases exist for all of these examples.
According to our observation, profit participation rights are currently the most popular instrument that is tokenized. Participation rights are used for corporate financing. A company raises capital from investors and in return promises a share in the profit and loss of the company as well as in the company value. A profit participation right can be repayable or non–repayable. Persons subscribing to profit participation rights thus have a position similar to that of shareholders in the company, except for the right to a say in the company's affairs. Their position is similar to that of limited partners in a limited partnership. The payment of the profit participation can be made in euros or a virtual currency, such as Ether. In such a case, the payment is made to those addresses on the Ethereum blockchain that are in possession of the tokens. Tokenization turns the capital participation right into a transferable security under EU law.
| 1. Raising capital | 2. Issue of security tokens | 3. Distributions in Euro / Ether |
|---|
The profit participation right is very popular due to its flexibility. It can be used for a wide variety of purposes. The funds raised can be shown in the company's balance sheet – depending on the structure – either as equity or as debt. If the company opts for the equity variant, this can strengthen its appearance vis–à–vis other potential providers of debt capital.
Profit participation rights are not the only common instrument. Other types of participation rights are also popular, such as revenue participation rights. These are similar to profit participation rights insofar as they both involve a promise by a company to make payments that are dependent on a specific measure. Whereas this measure for profit participation rights is the profit or loss of the company, in the case of revenue participation rights the reference point is specifically the revenue. Profit and loss can be influenced by the company to a certain extent, for example by bringing forward investments. This is not the case with sales, which can be emphasized to potential investors.
The revenue participation right can also be structured quite flexibly. It can be repayable or non–repayable. Certain minimum and maximum participation thresholds can be set, or the revenue share can be made dependent on other factors. Tokenization turns the revenue-sharing into a transferable security under EU law.
The qualified subordinated loan is the instrument that is currently most popular in the crowdfunding sector. In a subordinated loan, the company raises funds, usually promises an interest rate commensurate with the risk and repayment at the end of a fixed term. Qualified subordination means that the lenders may only demand payment after all other non–subordinated creditors. If promised interest payments or repayments cannot be made, insolvency proceedings do not have to be initiated due to qualified subordination. The subordinated loan also becomes transferable security under EU law through the process of tokenization.
The three tokenized instruments presented above have in common that they serve corporate financing and that they involve the issuance of debt instruments, i.e. ultimately promises by the capital-raising company. The main advantages of raising funds in this way are as follows:
When issuing tokenized debt instruments, capital is not lent by lenders, but the promised interest and repayments are sold as a product. Unlike a bank loan, the company determines the terms on which money is to be borrowed. This means that special financial and tax considerations can be taken into account when structuring the token terms and conditions.
First and foremost, the interest arrangements are of central importance. Interest can be fixed or variable; it can be paid on an ongoing basis or there can be no interest at all during the term of the instrument, with a higher repayment at the end of the term. In the case of variable interest, the interest rate can be linked to external parameters (EURIBOR, inflation index, commodity prices, exchange rates, etc.) or to internal indicators (EBIT, sales, internal indicators).
The repayment arrangement is equally flexible. Repayment can either be made in regular installments (e.g., per quarter or year), or there can be no repayment during the term. In this case, the instrument is usually repaid in full at the end of the term. If repayments are to be made during the term, the respective amount can also be structured differently. As explained above, instruments can also be issued that are not repayable at all.
Because of the flexibility in the design of payments, tokenized instruments can also serve as a tool for (partial) risk hedging in addition to financing. In some cases the potential is obvious, in other cases it requires a detailed examination.
Example 1: Company A's earnings are significantly dependent on the price of steel. The company bears the risk of rising raw material costs. The interest could be structured in such a way that the interest increases when steel prices fall and decreases when steel prices rise.
Example 2: A customer of Company B wants to conclude a major contract in Saudi Riyal. The company thus bears the exchange rate risk. The repayment of the instrument could be structured in such a way that it can be made in Riyal at a certain rate.
Example 3: Company C finances the construction of a residential building and would like to finance the construction and maintenance costs from the rental income. The company bears the long–term refinancing risk. The instrument could be designed with a long term and the interest and repayment could be linked to the inflation index (also provided for in the rental agreements).
Since the stricter capital adequacy requirements came into force, banks generally require a high level of collateralization when granting loans. The granting of a lien on real estate and pledging of operating assets and receivables are common practice. This deprives companies of the freedom to manage these assets.
Borrowing with the above-discussed (and also other) instruments usually takes place without the provision of collateral. However, it is also possible to order collateral and in this way obtain a more favorable interest rate on the market.
Tokenization of efforts obligations (Verwendungszusage) is the latest development of tokenized instruments. In this context, efforts obligations are promises by a company to obtain performance from a third party. The company promises to expend its own efforts to get a third party to perform. Efforts obligations are most often used when the company makes a promise that can only be fulfilled by someone else. In the context of corporate financing, efforts obligations can be structured in various ways. Examples from practice include:
Promises made at the expense of third parties cannot, of course, effectively bind these third parties. This always requires the consent of the obligated person. In order to give weight to the company's promise, it must therefore ensure that the third party actually performs what has been promised, even if the third party may not wish to do so. In the examples presented above, the obligation of the company must therefore be transferred to its owner.
In practice, this is carried out in two different ways. Either the company's articles of association are amended to include appropriate clauses ensuring that the company's owners must fulfill these promises made by the company. Or a trustee takes over the company shares and in this way ensures that the promises made are fulfilled after a corresponding request by the company (see Model 2.B above for tokenization).
Shares in limited liability companies have been "immobilized" on purpose (at least in Austria). In order to transfer shares in a limited liability company, an assignment agreement must be concluded in the form of a notarial deed. Even the mere offer to transfer must already be made in the form of a notarial deed in order to be effective. If this formal requirement is not complied with, the offer or transfer is void.
Because of these formal requirements, the share in a GmbH cannot be tokenized directly. However, the previously mentioned efforts obligation can be used. A transfer obligation, together with an efforts obligation concerning the profit and, if necessary, a promise regarding co-determination rights, can be effectively tokenized. These promises can be transferred without any formalities. Compliance with the obligations can be ensured by the company itself using the trust model B. In this way, the company can effectively make promises regarding its own shares, even if it does not have already authorized capital (as may be the case with stock corporations, for example).
In Austria, only registered shares may be issued by unlisted stock corporations. The names of the shareholders are to be entered in a share register. Tokenization brings the share register onto the blockchain. Transfers of shares are made by notifying the company, which records the transfer in the share register on the blockchain.
Bearer shares may also be issued in the case of listed stock corporations. In this case, however, the shares may only be securitized in the form of a global certificate. This global certificate must be deposited with a central securities depository. In order to enable the tokenization of bearer shares, it is therefore still up to the legislator (at least in Austria). However, a stock corporation could also issue tokenized efforts obligations with regard to its own authorized capital. This would be comparable to the model presented above for the tokenization of efforts obligations with regard to GmbH shares, but in this case (provided authorized capital is available) the appointment of a trustee could be omitted.
Not only promises (claims) or entire objects such as companies can be accessible to tokenization. In particular, interest in the tokenization of real goods such as precious metals, precious stones or even shares in apartment buildings has been growing increasingly recently. The focus is not on the idea of financing, but on the desire to transform these relatively illiquid resources into easily tradable goods.
The linking of the real world with the tokenized representation usually succeeds with trust variant A. A trustee is appointed to take custody of the tokenized real goods. The trustee initially warrants that the tokenized goods actually exist. The further relationship between trustee and token holder can be structured differently. For example, the trustee can act as an intermediary for real (co-)ownership positions for the respective token holder, as is the case with securities deposits on the traditional capital market. However, it is also possible to grant the trustee only a succession claim under the law of obligations. Which variant is preferred depends on the circumstances of the individual case.
The so–called voucher model should not go unmentioned. This first established itself as a suitable instrument in the course of the ICO wave in 2017. And although the ICO boom is long over, the voucher model still has its justification in certain areas. In this instrument, the company promises to exchange a token for a certain service in the future. The funds collected are used to finance the company. Depending on how the voucher is structured, it can be used to manage accounting and tax consequences. The voucher property can be linked to the other instruments presented above, so that a token can simultaneously have aspects of, for example, a profit participation right, an efforts obligation and a voucher.
The first step on the way to successful tokenization is always to consider which goals are to be achieved with it. The types of tokenization presented above can have very different tax effects and also effects on the company's balance sheet, depending on the specific design. These effects can be used specifically for the company. If, for example, loss carryforwards are to be utilized, an instrument can be chosen that leads to an income in the company. If the equity capitalization is to be strengthened without an income tax burden, this can be realized with tokenized profit participation rights, for example. The possible tax burden with sales and corporate income taxes must always be kept in mind, especially in the case of non-repayable instruments. To avoid unexpectedly triggering a tax liability, we therefore recommend involving a tax advisor or auditor in the structuring at an early stage.
The tokenized instrument should be structured depending on the aforementioned tax and accounting considerations. To that end, either the corresponding security token conditions are worked out or other necessary contracts are drawn up. If necessary, the company's articles of association will be amended. If required, the trusteeship will be set up.
The preparation of the necessary contracts, and if necessary, the amendment of the articles of association are the first steps. The second step in many cases is the sale of the tokenized assets in a public offering. In this process, capital-raising company offers the tokenized securities or investments to the general public for subscription.
For this purpose, the company usually creates a dedicated landing page for handling the issue on its website. The landing page is initially intended to ensure that only persons to whom the offer is addressed are given access to it. Interested investors thereby confirm, for example, that they are from the EU. In addition, the landing page primarily serves to provide investors with information. It contains those documents and records that are required by law to be given to interested investors. Finally, the landing page can be used to map the subscription process: In this case, interested investors subscribe to the securities directly with the issuer.
The documents and information to be included on the landing page essentially depend on the minimum subscription amount per investor and the total amount of funds that the company wishes to raise. If the minimum subscription amount per investor is at least EUR 100,000, then as a rule no further information is required apart from the terms and conditions of the security token and a subscription form.
If, on the other hand, the minimum subscription amount per investor is less than EUR 100,000, for example, if a subscription is to be possible for just a few hundred euros, more information is usually required on the landing page. What exactly is required depends on the total volume:
| Volume < EUR 250,000 | Volume < EUR 5 Million * | Volume >= EUR 5 Million |
|---|---|---|
| For very small placements, a general risk disclosure with the key characteristics of the instrument is sufficient. | For small placements, an information sheet is sufficient. | For larger placements, a capital market prospectus must be drawn up in accordance with the EU Prospectus Regulation and approved by a regulator in the EEA (FMA, BaFin, CSSF, etc.) |
* More precisely: placements of less than EUR 5 million over a period of 7 years, whereby less than EUR 2 million may be raised in a 12-month calculation period.
The drawing up of a capital market prospectus is time-consuming. Companies should allow for a lead time of at least three months. The advantage is that an offering can be made in several EEA member states without having to worry about national law. If, on the other hand, a capital market prospectus is not prepared and the offer is to be made in several countries, the respective national regulations must be observed. Who provides support in practice? Looking at the multi–layered possibilities of tokenization presented above, it becomes apparent that the title of this article is far less sensational than it first appears. In fact, a wide range of assets can be tokenized and thus made tradable. As a financing instrument for young companies, the issuance of security tokens is just as suitable as for established medium-sized companies or industrial giants. Tokenization requires technical, tax and legal know-how. In addition, we are often asked in our legal practice who actually takes care of the distribution of tokenized assets. A good overview of who can be considered as a contact in all these areas is provided for Austria by the Blockchain Landscape Austria 2021. We have already provided legal support for a large number of tokenization projects in the past. We would be happy to support you with your project as well.
Oliver Völkel Bryan Hollmann Stadler Völkel Rechtsanwälte As Austrian lawyers, we deal in this article with the practice and the legal situation in Austria. The legal situation in other countries may differ. Furthermore, this article is only intended to provide an initial overview. It cannot replace individual legal advice. More precisely: placements of less than EUR 5 million over a period of 7 years, whereby less than EUR 2 million may be raised in a 12-month calculation period.
