You will be hard pressed to find any expert or authority in the field who will not agree that blockchain technology holds heretofore untapped potential yet to be capitalized upon. The future appears bright for the distributed ledger. A strong use case for cryptographic tech is its use as a new kind of registration or ownership vehicle of security interests in an enterprise or a particular securable segment of an enterprise. This process involves the development of a blockchain protocol for the asset, and the distribution of security tokens to investors instead of the commonly issued interests, shares, or units recorded on paper certificates or on the books of the offering entity. The process is believed to be less costly, more efficient, increase liquidity, and offer greater security than the current methods of security offerings.

What advantages and disadvantages does this relatively uncharted use of the blockchain have?

Stock equity ownership such as shares, units, or interests is similar to bond ownership except for the rights that attach to each security. For example a bond instrument entitles its holder to guaranteed first priority payments at the stated interest rate of the bond, and such a bond will fluctuate in value in proportion to the market forces of supply and demand with respect to the bond market and other potential investments.

Equity rights will fluctuate in value to a greater extent due to greater volatility inherent in the secondary equity markets. Equity securities may also entitle their owners to dividend payment which may be regular or specially declared. Equity holders have a lower priority right than bonds to receive payments and the return of their investment upon the issuer’s liquidation, but generally most of the larger creditors of any enterprise will be secured and it is likely all assets worth anything of significance will already have a higher priority lien on them or be depreciated for the most part, so don’t expect much from either type of security in a liquidation event.

Tokenization may be carried out with respect to any part of a company such as a certain division, a future project, accounts receivable, real estate development or holding income property, a new or current product, a joint venture, expansion into a new market, creditor repayment, or any business activity where financing is advantageous or necessary. Any issued token will apply to an ownership or financial interest in a particular venture or segment of a company. The flexibility here is that tokens may grant ownership interests to investors or simply the right to financial distributions, depending on the issuer’s goals. Note that these offerings will always be securities so registration or an exception (accredited investors only) will be required.

The tokens may then be secured by written contract or by smart contract. In case of tokens secured by some physical assets in the custody of 3rd parties the asset may be automatically auctioned off if the debt obligation is not timely made. With written agreements, once the payment obligation to investors is not made, a foreclosure derivative suit would be needed to seize and sell off an asset. With respect to an asset such as ‘accounts receivable’ or royalty payments, payments made to the issuer may in whole or in part be automatically redirected to pay investors in proportion to their holdings.

In some cases no security would be provided and therefore no recourse would be available to creditors except to wait for payment or file a lawsuit. Certainly such unsecured debt would carry the highest rate of interest to compensate investors for the increased risk. There is complete uncertainty as to how smart contract and tokenization issues would be dealt with by courts. An entirely new era of business litigation is about to be entered.

An additional benefit of electronic ownership interests would be a lock up period where the sale or transfer of such tokens may be restricted by the blockchain protocol, and if certain exceptions apply and a sale may occur, then the company could easily permit the transfer of specified tokens through its blockchain. After the lock-up period of 6-12 months expires for insiders or early investors, all trading of tokens may automatically be permitted on a secondary market.

A possible disadvantage of tokenization may occur due to the steep learning curve in obtaining, holding, and securing such tokens. For example older investors may not be aware of how to securely store the tokens, and if their software is maliciously hacked, then the total loss of the tokens if very possible. Furthermore, people may simply lose their tokens if kept without a backup, passwords are lost, improper estate planning, or if they simply don’t understand how important it is to properly store tokens.

Such issues may possibly be overcome by providing extensive instructions and perhaps even technical assistance with downloading the proper token wallets and providing storage instructions. This would certainly greatly increase costs to the issuer, particularly providing any technical support for investors, as may be necessary. If a 3rd party broker is involved, then clearly it would be responsible for the wallets, storage and security of any new tokens, similar to standard equities, but if an offering is private then all burdens fall on the investor, who may not be technically savvy enough to do everything correctly. Of course, technical expertise does not guarantee safety, as we see supposedly advanced exchanges, with their myriad security experts, getting hacked on a regular basis. Certainly, the issuer should not be held liable for any loss of tokens unless  such loss is directly the issuer’s fault.

Since token transactions cannot be reversed, short of a fork or the possession of private keys of a recipient, the risk of loss of tokens by investors due to hacking, physical misplacement, loss of passwords etc., remains substantial. It may be possible for ERC20 token issuers to maintain possession of each private key for each wallet issued to investors, thereby maintaining the power to replace lost or stolen tokens to their rightful owner with proper proof of ownership and registration of the full identity of each investor on the books of the issuer. The above would not apply to publicly traded tokens, of course, as wallets would be freely available to anyone, and there would be too many holders to track.

All tokens may be traded on secondary markets just as regular equities are traded on the Nasdaq or NYSE. The size of these markets may grow to unfathomable sizes and theoretically replace both the bond and stock markets, due to ease of transfer, (potentially) lower costs, (potentially better) security, and (possibly) decreased administrative costs. The new frontier of tokenizing company interests is certain to create a massive flow of capital into the tech and finance sectors, as well as a great deal of innovation from the legal standpoint to ensure that such transactions comply with securities laws and are enforceable as standard contracts. A great deal of new case law and regulations is certain to be generated.