What’s the Difference Between Utility Tokens and Security Tokens for Businesses?

Since then, as blockchain tokenization has shifted from an experimental fundraising approach to a serious consideration for many startups and established firms, which utilize the issue of tokens as a mechanism of raising funds, incentivizing user behavior, decentralizing existing platform ecosystems, and creating new digital marketplaces, a key question has centered on the difference between a utility token and a security token. It's not just semantic, it determines how a token can be sold, who can buy it, how it can be traded, and what obligations a business must take on under law.

In addition, companies failing to make the token classification can subject themselves to regulatory enforcement actions, token holder refunds, reputational damage and in some cases the shutting down of their business. However, if businesses can successfully identify the token classification and design for it, tokenized networks can enable functionality and use cases that other forms cannot, from compliant capital formation to ecosystem-level incentives. This article discusses the difference between utility tokens and security tokens, the economic function of token offerings, their regulation, and potential use cases for real-world tokens..

Defining Utility Tokens: Access, Function, and Network Participation

Utility tokens are tokens which are used to provide access to a product or service on a blockchain-based platform and are described in terms of use, rather than ownership or a share of profits. In general a utility token is a digital key/voucher, enabling its holder to interact with the platform, and potentially allowing it to pay for services on the platform or participate in governance or validation activities.

From a business perspective, utility tokens should be viewed as a coordination mechanism that aligns the interests of end-users with those of other external stakeholders, including developers, validators, and service providers. For example, a decentralized storage network may require users to spend tokens for using the storage network, and provide the storage providers with tokens. This would give a value to the tokens based on the supply and demand for the service as opposed to dividends or profit sharing.

A well-known example is the ETH token of the Ethereum network. Ethereum uses its in-network currency ETH to pay transaction fees on the network, and to pay validators that process transactions. ETH may become more valuable but its primary use is as fuel for the Ethereum network. This is a hallmark of a strong utility-token design.

Defining Security Tokens: Investment Contracts on the Blockchain

Security tokens, in contrast, are investment interests that take the form of digital representations of customary equity or debt, revenue-sharing agreements, or profit participation rights. In effect, it is an investment contract that has been deployed on a blockchain architecture, rather than a customary securities registry like a purchase ledger.

Security tokens are backed by an issuer's or underlying assets, and their holders are generally entitled to the profits the company or a third party generates through their efforts. Thus, the defining economic feature may not be the token's usage but the expectation of profit.

Security tokens may represent an ownership interest in an underlying asset, much like other security types:

• Equity ownership in a startup
• A claim on future profits or revenues
• Ownership of a fraction of real estate or commodities
• Tokenized bonds with periodic interest payments

Although blockchain technology creates a more efficient, transparent and programmable environment for these kinds of relationships, it does not change the underlying economic relationship between the issuer and the investor, therefore, security tokens are considered securities by regulators.

The Economic Purpose: Consumption vs. Capital Formation

The key difference between utility and security tokens is that utility tokens are designed to be used or consumed by their holders, while security tokens are designed for investment.

In practice, the motivation for issuing utility tokens is often to bootstrap the business's ecosystem and incentivize distribution, with tokens being distributed to early adopters to start network effects and internal markets. Revenue may exist, but it is not typically generated by the promise of returns from holding tokens.

Security tokens, in contrast, are built with a purpose of capital formation. They are issued by businesses as a way to collect money from investors who are betting on the company while not being the users (spending their time/energy) of the product.

This is important because these factors affect token price, the ability of users to find and use the platform and whether the token will be used as expected. A security token must be a compelling investment with disclosure and governance rights and an exit strategy.

Regulatory Interpretation: How Authorities Draw the Line

Even if a business tries to call their tokens a "utility token", regulators typically analyze whether these tokens meet the legal definition of a security using several test cases that are well established in the United States and elsewhere.

The most widely used test is the Howey Test, based on a definition from a 1946 ruling by the U.S. Supreme Court that a transaction is a security if it fulfills:

1. An investment of money
2. In a common enterprise
3. Having a reasonable expectation of profits
4. Influenced by the work of others.

Given that any sale of such a token will satisfy the above characteristics, a regulator may still treat the token as a security in cases where the prefunctional network results in the token buyers expecting a return based on the developer's efforts, even if the token was not meant to be a security.

Business Use Cases for Utility Tokens

When built as intended, utility tokens can provide a fundamental innovation to the economic nature of certain businesses by enabling decentralization, peer-to-peer relationships, or an alternative mode of coordination not available through customary business forms.

Examples of business use cases:

• Tokens are used for payments to services and platforms, as opposed to issuer-centric payment processors such as Visa and Mastercard..
• Incentive alignment: Network users get rewarded with tokens for creating value for the network, e.g. creating content, validating.
• Governance: Token holders vote on protocol upgrades or policy decisions, distributing decision-making authority.
• Network bootstrapping: Preemptive distribution of tokens to build usage and liquidity prior to launch.

An example of a native token is Binance Coin (BNB), which was initially created to be used as a trading discount on the Binance crypto exchange and has since been used for payments, staking, and token sales within the Binance ecosystem.

Business Use Cases for Security Tokens

Security tokens are most appealing to companies seeking compliance and efficient methods of raising capital or tokenizing existing assets, especially in highly regulated industries or markets with illiquid assets.

Key applications include:

• For startups, tokenized equity or revenue sharing enables easier cross-border financing.
• Asset tokenization may increase liquidity in the market for real estate, private equity, and art.
• Debt issuance: Companies can issue tokenized bonds with interest paid automatically.
• Secondary markets: Security tokens can be traded on regulated exchanges, providing liquidity to investors.

As one example, a number of real estate firms have issued security tokens that fractionalize ownership in commercial properties to allow for smaller investors to buy previously inaccessible commercial assets.

Compliance, Risk, and Strategic Decision-Making for Businesses

Compliance Obligations: A Diverging Burden

Utility and security tokens impose radically different obligations on the issuer's business: the latter, falling under existing securities law, typically requires registration or an exemption, as well as disclosures to the investor, compliance with anti-fraud laws, and active reporting requirements in many jurisdictions.

These requirements are costly but codify investor protections, stabilize protections between investors, and improve issuer reputation and institutional access to capital. For more mature businesses the trade-offs are acceptable.

Utility tokens with genuine utility do not have to satisfy most of the requirements above but will still be regulated. Regulation will apply to consumer protection, anti-money laundering, tax, and advertising, among other areas. There is legal uncertainty regarding regulation that will apply to tokens that are difficult to distinguish from financial instruments..

Risk Profiles: Regulatory, Market, and Operational Considerations

Tokens are subject to regulatory risk. Enforcement action is taken against early token projects if tokens are sold with no functional use and speculative demand arises before the use case exists. Business also must consider the volatility of token prices leading to potential adverse effects on the economics of the platform.

Security tokens are often more regulated than fungible tokens, and their liquidity is generally limited to regulated trading platforms. They generally carry risks of wide-ranging KYC and investor accreditation. These risks are largely predictable, and manageable within existing legal and regulatory frameworks.

Strategic Design Choices: When to Choose Which Model

Token issuance must be based on business rationale, not regulatory arbitrage. Key planned questions include:

• Is the token needed by the product, or is it mainly a tool for fundraising?
• Are the majority of token holders users or passive investors?
• Can the platform keep running even without speculation?
• Is your business ready for continuing securities compliance?

A hybrid of these approaches is legally complicated; some companies only issue tokens once their product is live, making it less likely that the tokens would be classified as securities. Other projects may start with a security token framework, seeking to be regulatory compliant and trustworthy.

Conclusion

Where the line between utility tokens and security tokens is drawn is largely dependent on intent, not a matter of technology or law. The most effective utility tokens are those whose purpose is baked in to the product itself and that are most strongly integrated with usage, coordination, and participation in a live network. In practice, they depend on actual demand for the service, and careful development to prevent the market becoming a speculative bubble. In the case of success they can enable new forms of digital business, which would be infeasible with the current infrastructure.

Security tokens are the next evolution of capital raising, taking existing investments and translating them to programmable, transparent infrastructure with more efficient issuance, compliance, and settlement (and the same investor protections and rights). Companies seeking to raise capital, deliver liquidity to their investors, or organize their investors' participation will find security tokens a clearer and more sustainable solution.

For business leaders, the most salient lesson is that choice of token cannot (and should not) drive business strategy and that trying to backfit a structure for raising funds into utility token architecture may lead to regulatory and credibility problems. Furthermore, the issuance of security tokens when a functional token would suffice is likely to limit growth and demand. The most successful tokenized businesses align economic purpose, legal structure, and product design with the token from day one.

As the regulatory environment for digital assets matures and market participants grow more advanced, the gap between experimentation and implementation will narrow, and firms that embrace this discipline and accountability in differentiating utility tokens from non-utility (security) tokens will be better positioned to create enduring business value, earn stakeholder trust and compete successfully in the emerging tokenized economy.