by Torsten Szabolcs Sandor

In the last year, asset tokenization emerged as one of the leading use cases for blockchain technology. When I first wrote about it in 2018, it was an exciting but distant possibility. Today, (almost) anyone can buy tokenized real estate in, say, Detroit, and the biggest banks are experimenting with issuing securities on the blockchain. In this article, we introduce a general model of asset tokenization, including the legal side.

The core idea behind tokenizing any asset is simple: investors buy tokens representing partial ownership. More often than not, these are productive assets (real estate, intellectual property, royalty rights, etc.), and the proceeds are paid out to the investors:

We will use this simple diagram and expand on it to build a general model. First, let’s add a management company. Most assets would require some management: in case of a real estate, you need someone to find tenants, collect the rent, and do maintenance work; in case of intellectual property, someone needs to manage licenses and make sure the IP is enforced.

The management company receives compensation for these services, but who is paying them? Something is missing from the model: the legal layer.

We say we “tokenize an asset,” but that’s not quite possible. How would that work, for example, with real estate? Imagine two hundred investors own a single house. Theoretically, you could list all of them on the ownership records, but this is highly impractical and defeats the purpose of using a blockchain. It is even more complicated to establish partial ownership of an intangible asset like intellectual property or royalty rights.

What is missing from the equation is a limited liability company. You can’t tokenize an asset directly — but you can tokenize a company! The LLC owns the asset, and the token holders own the LLC. The tokens don’t directly represent the ownership of the asset but the ownership of a company:

Adding an LLC into the model answers the management question, but it introduces several legal problems.

First, what type of company can have tokenized ownership? Tokenization on the blockchain is a new concept, and regulation simply has not caught up yet. Luckily, company tokenization is possible in jurisdictions where the laws are so broadly defined and permissive even this new use case fits into the existing framework. The most prominent examples are Wyoming and Delaware in the US. Both are very business-friendly, and both allow tokenized company ownership.

Let’s recap what we have in the model so far: a Wyoming LLC owns an asset and sells ownership in the company using tokens on the blockchain. So far, so good!

Unfortunately, this is where the second legal complexity comes in: KYC. If you are a regular reader of our blog, you might be aware that some US states, like Wyoming, don’t require companies to prove the identities of their owners. Indeed, you can start a company as “Frank Sinatra” or “Satoshi Nakamoto.”

However, in practice, you need to perform KYC checks on every investor buying the token because of two reasons. First, while the Wyoming company registry does not care about the owners’ true identity, banks do. If the company wants to have a fiat bank account, KYC becomes unavoidable. If the second reason makes you utterly confused, welcome to the United States, the land of the free for non-US citizens. KYC on the investors is needed because the token will be considered a security in the US, which US citizens are not allowed to buy unless they are accredited investors. You’ve heard it right. Does this mean, for example, that American citizens can’t buy fractional ownership in a Detroit real estate owned by a Delaware company? Yes, it does. And no, it does not make sense.

An offering to mainstream, non-accredited investors would require a public offering, which comes with very high disclosure requirements and is a burdensome process. This is why most offerings will be limited to accredited investors (wealthy individuals or households) under what is known as a Regulation D offering. Such “Reg D” can be combined with a Reg S offering outside of the US. However, bear in mind that the rules of the country where the buyer is based do apply, irrespective where the token is issued from. For instance, offering a US-issued security token to Singaporean investors will need to meet the Singapore accredited investor requirements.

“Whitelisting” you investor base, which includes knowing who they are, will be a first step in any offering. Luckily, there is technology that can help automate the process.

This is how our model looks like after introducing KYC:

Let’s take a closer look at the tokens themselves. What type of tokens are we talking about? Would something simple like ERC-20 work here?

Partly yes, but mostly no. It is beneficial if the tokens the company issues are adhering to some common standards, so they can be stored in any wallet and transacted through the blockchain using standard operations. These tokens should implement the ERC20 interface (or any other token standard on other platforms like FA1.2 or FA2 on Tezos), but the governing smart contract needs to be heavily modified.

Remember, these tokens should never be held by someone without KYC. We need a whitelist stored by the contract that prevents transferring the tokens to any non-approved address. We also need a way to freeze addresses and reissue tokens to a new address (in case an investor loses the private keys), and a governance mechanism to make sure this power is exercised responsibly. Lastly, we need a method to distribute the proceeds, typically using a stablecoin, either baked into the main contract or branched out to a side contract.

The result is a token that whilst customized still interfaces with the existing ecosystem. For example, an asset token could be used as collateral in a Collateralized Debt Position, or sold on a decentralized exchange (but only to another KYCd investor).

We are almost ready with our model. What we have so far works well if we want to tokenize a limited number of assets, but it is not scalable. Setting up a separate LLC for each asset is inefficient and creates a lot of overhead. This is one use case in which a Series LLC is very useful, and our OtoCo product allows users to spin up such LLCs quickly and entirely on-chain.

If you want to tokenize two dozen real estate properties, these LLCs will be very similar, using the same operating agreement, et cetera. It makes sense to set them up as Series LLCs, a unique type of company available in half a dozen US states.

A Series LLC is a fully-fledged company with a unique name, membership structure, bank account, and separate books. It exists under a Master LLC, but at the same time, it is entirely firewalled from the Master’s finances, ownership, and liabilities. The most significant advantage of a Series LLC is the reduced incorporation cost and speed. Forming an LLC costs hundreds of dollars, while a Series LLC can be incorporated in no time, and practically for free (and soon entirely for free with OtoCo, except for a small gas fee).

In the last 12 months, we’ve been developing OtoCo, a product that lets anyone spin up a Series LLC for free in seconds. Because the setup of the Series LLC is contractually between the Series and the Master, formation can be instant, hence we like to refer to them as “hypercompanies”. We supply a generic operating agreement that covers a wide variety of use cases. It will be possible in the future to use a specific template, e.g., for real estate tokenization.

We aim for OtoCo to become a platform for companies who want to mass-tokenize assets, complete with Series LLC incorporation, plugins for external KYC providers, token management (minting, distributing, etc.), and distribution of profits. You can form a test LLC on the Kovan testnet today.

In conclusion, this is the general model of asset tokenization we propose, and what we plan to implement:

Variants of the general model can be used for a wide range of use cases, for example:

  • Wrapping a hypercompany around a patent or IP.
  • Holding a DeFi smart contract in an hypercompany, so operational risks are covered under limited liability.
  • Fractionalizing a piece of art held by the LLC; when it sells, proceeds get distributed via smart contract to all wallet holders.
  • Tokenizing future revenue streams, such as royalties from music, or fractionalizing an income stream from a back catalogue. Imagine you can buy a token as a Beatles fan that gives you fractional exposure to all worldwide revenue from every Beatles song still played today!

Blockchain’s killer app may well be capital formation and shared title. An instant on-chain legal wrapper that can raise funds and hold title to an asset is arguably one of the primitives of the decentralized space. Expect great things!