Going down the rabbit hole: an introduction to tokenised equity

For founders and investors. If you are a founder weighing up whether to tokenise your equity, or an investor trying to work out what you would actually be buying, this is the place to start. From a legal perspective, it covers: how tokenised equity works, what changes, what does not, and where the rules are heading.

Tokenisation is a concept often met with much hype and little knowledge. At its core it is simple. A cryptoasset token is just shorthand for data held on-chain, meaning on a blockchain. If that token represents an external asset, then the asset is “tokenised”, in the sense that the token stands in for it. The same approach works across a range of different real world assets, and the tokens that do this job are usually called RWA, or real world asset, tokens.

How a tokenised share is built

Applying this to equity, most tokenised equity structures take a very similar approach. A company issues the shares to be tokenised, and those shares are held in regulated custody or in a trust structure. Tokens are then issued and contractually linked to the shares held in that structure. So if the shares pay a dividend, there may be a contractual obligation to pass the dividend on to the token holders.

The effect is that the shares themselves are unaffected by the existence of the token. The token does not directly change the company’s articles or its share classes. In fact the tokenisation vehicle can be run entirely independently of the company, which means a company’s shares can be tokenised outside the control of the company whose shares are being tokenised.

One aspect of the share does change. The legal owner of the share becomes the company operating the trust in which it is held. This affects the cap table, and in many ways simplifies it, because there is generally a single legal owner acting on behalf of many token holders, rather than each holder needing to be recorded as an owner of equity in the company. The token holders hold a claim to the underlying share, often called a “beneficial interest”, but that claim is not as strong as the direct, or “legal”, owner’s.

For an investor, this is the line to read twice. A token can give you real economic exposure to a share without making you the registered shareholder, so it matters that you understand exactly what your beneficial interest does, and does not, entitle you to.

Why a tokenised share is usually a security

Because a tokenised share is, on its face, a cryptoasset that gives rights connected to an underlying share, it is generally treated as a type of security. This is reinforced by the fact that “rights to or interests in investments”, such as shares, are themselves categorised as securities. Where the token simply represents all of the ownership rights in the underlying share, many jurisdictions, including the EU, regulate it in the same way as shares generally.

That is not always the case. In the UK at present, tokenised shares have to comply with both the cryptoasset and the securities frameworks at once. So it is important that any tokenisation project is clear about the regulatory reality of the jurisdiction it sits in. Different jurisdictions carry different set-up costs, and those costs have to be weighed against the size of the market each one opens up. At the macro level the direction of travel is clear. Regulators want to make trading tokenised equity a viable alternative to traditional equity, and on that note the UK will, during the coming year, phase out the requirement to comply with the cryptoasset framework as an extra obligation on top of the securities framework.

What tokenisation makes possible

Simply tokenising a share already brings advantages in terms of trade. Think of automation, trading beyond the fixed hours of traditional stock markets, more flexible funding models such as stablecoins, and faster settlement. But on its own this underuses the value of tokenisation.

A tokenised share does not have to carry every right that the underlying share carries. A token might give holders the right to dividends paid on the share, while leaving out the voting rights a direct holder would otherwise have. This allows a more nuanced approach, splitting out the value of the different parts of a share. It also means that buyers of tokenised equity have to be careful that they know exactly what they are buying.

Shares can also be fractionalised and combined. Fractionalising lets a buyer own part of a share, which can be cheaper than a whole share and makes ownership more accessible.

Combining lets a buyer hold a single token that represents, for example, ten companies in one industry, so they take a position on the sector rather than on any single company within it. Particular care is needed here. The basket has to operate on a non-discretionary basis, otherwise the whole structure risks being treated as a collective investment scheme, meaning a fund. A fund is far more expensive to operate than a simple tokenised equity model, and depending on its nature may reach a smaller market.

The models that try to dodge the rules

For completeness, some models try to structure tokenisation so that the share falls outside the definition of a security. These generally alter the nature of the investment fundamentally, and often introduce a high level of commercial risk, for example by seeking to provide a fixed yield. Their regulatory advantage has greatly diminished in any case, because so-called “unregulated” cryptoassets are in fact becoming increasingly regulated. The likely result is that such models fall out of fashion.

Where this is heading

The overall trend, therefore, is towards greater and easier adoption of tokenised equity as a capital raising mechanism, helped by the genuine advantages it offers over a traditional equity raise. As with any form of adoption, the road will have bumps. Those who navigate them well will be the winners in the new world. 

Legal View is contributed by gunnercooke LLP. This article is provided for general information only and does not constitute legal, financial, or investment advice. The regulatory treatment of tokenised assets and digital securities varies by jurisdiction and continues to evolve. Readers should seek independent professional advice before making any financial, legal, or regulatory decisions.