tZero STO

tZERO’s Security Token Offering (STO) Unpacked

by William Restis

published April 4, 2018

tZERO is conducting the first major Security Token Offering (STO). tZERO, like Polymath, is positioning itself as a leader in the movement to transition securities like stocks and bonds to the blockchain. tZERO’s niche in this space is trading. It owns controlling interests in broker-dealers, SEC registered trading platforms, and even an investment advisor. Picture Schwab, but all the stocks are tokenized, and all the back office settlement happens on the blockchain.

There is a lot riding on tZERO’s STO. While not technically the first, it is the first major company to do a broadly subscribed offering. It had input and scrutiny from U.S. regulators, and has the potential to set trends.

So what’s in it? Let’s take a look.

Terms of the tZERO STO

tZERO, Inc is a Utah corporation, that under the terms of the STO, will likely reincorporate in Delaware. It is doing an “exempt” offering of preferred stock to accredited and non-U.S. investors that will be issued as an ERC-20 compatible token.

There was a pre-sale to large investors that occurred between December 18, 2017 and February 28, 2018. tZERO priced the pre-sale tokens between $5-$8 each. The public STO is ongoing between March 1st and May 14, 2018, selling tokens at $10 per.

As far as I can tell, during the pre-sale, tZERO sold approximately 2 million tokens at $5 per, 6.02 million tokens at $6.67 per, and 6.25 million tokens at $8 per. That pre-sale generated $100 million in commitments.

The current stage of the STO is selling 15 million tokens for a raise of $150 million. tZERO’s Offering Details permit the company to sell another 5 million tokens for another $50 million, capping the offering at $300 million. Approximately 2.3 million tokens will be issued as compensation for advisory services to tZERO affiliates. Another 30 percent of tokens will be authorized but not issued, for a cap of 59 million tokens in all scenarios.

Investors can buy into the tZERO STO with $U.S., Bitcoin or Ether, and have withdrawal rights before the tokens are issued.

There is a one year lock-up period for U.S. residents, and tokens cannot be transferred unless tZERO designates an official exchange, or authorizes peer to peer trading.

Token holders have the right to receive a dividend of 10 percent of the Company’s gross profits if available in any given quarter. Gross profits are defined as gross revenue minus cost of goods. Dividends can be paid in $U.S., Bitcoin or Ether.

tZERO can redeem the tokens at their fair market value or $10 minimum. The tZERO tokens also get a $0.10 liquidation preference over common stock in the event of a sale, which amounts to 1-2% of the STO price per token. In a merger or consolidation, the tokens have no preference. And the tokens have no voting rights.

What I Don’t Like About the tZERO STO

$10 per token will probably be underwater for some time 

The first disappointing feature is that the STO is offering Series A Preferred Stock, not common equity. And it’s not your regular preferred stock, let’s call it preferred stock “light.”

The word “preferred” sounds fancy and special. Generally, the term “preferred” simply means that the shares are paid dividends first, at a preference to common stock. Usually, the preferred shares have a guaranteed dividend, where common shares do not. And usually, preferred shares can be converted to common shares.

But not in the tZERO offering. There are no rights to the company’s equity, by conversion to common or otherwise. And the dividends are not guaranteed, only discretionary.

In addition, token preference is not guaranteed, but can be subordinated in a subsequent offering. In other words, tZERO can issue another series of “senior” preferred shares that has a preference to the tokens.

The major problem however, seems to be the pricing on the tokens themselves. I wouldn’t pay $10 per token. At present, tZERO is not operating at a profit. At the end of 2017, the company had a net loss of $10.29 million, with an accumulated deficit of $27.5 million. It’s gross profit was $5 million.

Now I spent some time toying with net present value calculations of future cash flows, and only extreme growth scenarios give the tZERO STO a positive return at $10 per token. And its impossible to do the math at this point because we don’t know how many tokens will be competing for that 10% of gross profits. Obviously the less the offering is subscribed, the higher the returns and vice versa.

This is important because the tZERO STO is not the ICOs of 2017. This thing will probably not “moon.” Why? Because this isn’t crypto economics we’re dealing with. Traditional value calculations apply. In other words, the market will probably price the tZERO token much like a bond. And if we use those metrics, expect this thing to puke hard once it starts trading. Until tZERO’s gross profits have annual growth rates approaching 40% (depending on inflation), investors who buy at $10 per token will probably be underwater.

It’s a whole other set of math, but Overstock.com owns 81.0% of tZERO through an intermediate subsidiary. In addition, $50 million of the raise will be used to pay outstanding debt owed to Overstock, which has the right to be paid in tokens. tZERO revenues are going to percolate up to Overstock’s bottom line, so buying the limitations on the token may not be the best investment in tZERO’s business.

The Structure of the tZERO STO Is Not Investor Friendly

In order to purchase tZERO tokens, you have to execute a “Simple Agreement for Future Tokens,” or “SAFT.” Like a butterfly emerging from its chrysalis, the SAFT was conceived as a way to turn a security into a “utility token.” By segregating the fundraising – the SAFT contract – from token issuance, the securities offering would magically transform and lose the properties that make it a security. At least that’s the theory.

As I’ve said elsewhere, I’m not a fan of the SAFT structure. It elevates form over substance, and has never been tested in the courts. Frankly, I don’t think the SAFT is going to do what it promises: exempt tokens sold in ICOs from application of the U.S. securities laws.

But here, it is downright confusing. You see, tZERO is admitting their token is a security. Series A Preferred Stock to be exact. Thus, a SAFT agreement makes no sense.

Perhaps it is because the lawyers for this project got creative with the “Terms and Conditions” for the tZERO tokens. Under those Terms, token holders waive all claims against tZERO’s officers and directors in shareholder lawsuits. In general, Delaware law is very management friendly and limits shareholder rights more than almost any other state. So the need and propriety of these Terms are questionable at best. 

The tZERO STO Is Setting Bad Precedent

Let’s go back to what I said at the beginning of this blog post. The tZERO offering is important because it is among the first of its kind. Perhaps the board decided to conduct this offering as an experiment. After all, there is a lot that could go wrong with being the first major STO.

Maybe the board thought that they shouldn’t risk the Company’s capital on an offering that could fail for a number of reasons. So that’s why the shares are preferred. Maybe they are confident that tZERO will be generating a billion dollars in revenue 12 months out. In that case, the Offering is a screaming deal. Maybe they thought they needed additional protections from shareholder lawsuits because fundraising on the blockchain is the regulatory topic du jour.

However, I think overpricing the Offering and using creative legal maneuvering is a bad strategic move for tZERO and Overstock. Why? Because tZERO is in the security token business now. They expect to be trading security tokens as their primary business.

How is tZERO helping grow this business model by conducting such a crappy offering? How are they going to create a community around this type of token if the first one tanks? This should have been a sweetheart deal, with real value provided to investors. It should have been structured with no funny business, knowing that other offerings would likely follow its “template.”

Perhaps I am wrong and the demand for securities on the blockchain is so huge that tZERO’s STO will be a raging success. But it might have been a missed opportunity to set the stage an industry that is clamoring for guidance, and ready to make the move.

Be careful out there!

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