As new articles on airdrops are published and companies continue to use the tactic as a means to jumpstart their business, whether as a simple marketing giveaway or a means to gain traction with network effects, it is clear by now airdrops are here to stay.
The fundamentals of airdrops are clear: in order to kickstart their community, many crypto companies have used an airdrop model to get their tokens into the hands of potential users. An airdrop, in short, is when a company gives away tokens for free and “drops” them into thousands of digital wallets at once with no apparent charge. In order to receive those tokens, consumers generally have to give some form of contact information, whether in the form of joining a Telegram chat or completing a signup form online.
Why would a company want to do an airdrop? Shouldn’t these tokens have value? Why are companies giving away, in some cases, an estimated tens of millions of dollars worth in value? Of course, an airdrop isn’t truly free for the consumer. Companies today will pay several dollars to get contact information for potential users, so the companies receive value in return for this giveaway. Having tens of thousands of people in one chat that you control is a valuable asset.
However, there are other big reasons for airdrops besides that. The most important are:
- Some of the protocol companies doing airdrops need a strong token user base in order to create the network effects for the ecosystem to function in the first place. An airdrop can jumpstart that ecosystem.
- An airdrop greatly increases the number of token holders, which greatly increases the liquidity of that token on the secondary market. The more token holders there are, the more likely you will find buyers and sellers of those tokens. This catches the eye of the crypto exchanges. If the goal is to get listed on an exchange, then many companies see airdrops as a shortcut.
- And in terms of giving away “tens of millions of dollars” worth of tokens, crypto remains a frothy industry. Valuation hasn’t settled into a reasonable range yet, and many companies still have astronomical valuations and raise astronomical amounts of capital through an ICO when they don’t even have a proven market fit yet. The supposed value of the tokens being given away is a valuation of the token’s worth and future returns, not an actual sum of money being given away.
In the first case, in which we are talking about a proper utility token, the airdrop is putting the tokens into the user’s hands that allow the network to function, giving consumers the gas or the keys to unlock the network.
How best to do get these tokens into actual users is an ongoing question. Recently there has been discussion of creating “Smartdrops.” The thesis of this airdrop 2.0 is this: don’t just give away the tokens to anyone, target the airdrop to those who deserve it the most, or in other words, those who are most likely to use the token being dropped. The goal is to get more information about the consumer before sending tokens into their wallet. Is the token intended for developer use? Make sure the token gets sent to developers. Is it for artists? Target artists, and so forth. It’s a more sophisticated and targeted take on airdrops than blasting your token into the hands of hundreds of thousands of people, but it does not address the regulatory issues companies will face in the US if they move forward with an airdrop. More on that in a minute.
The above airdrop, or smartdrop, scenario applies to only a small fraction of token companies. In the US, the majority of ICOs to date have been securities in the eyes of the SEC. This is because the tokens don’t yet have utility. Rather, investors are purchasing or trading the tokens purely on speculation — this is a classic hallmark of a security. In order for an airdrop to be legal in this first scenario, the utility tokens would have to have a proven use case, nor should they be traded on the secondary market, as this is another hallmark of a security.
The premium of (and problems with) liquidity
Let’s take a look at the second airdrop reason, in which the company’s goal is to boost liquidity in their token. Liquidity matters to companies because it matters to investors. Investors like liquidity because it means they can trade their investment at will. They have a better chance of profit, and perhaps more importantly, there is a shorter time horizon to receive returns on their investment.
If you think about traditional investments in private companies, investors’ money is generally locked up for anywhere between 5 to 10 years. With the liquidity of crypto tokens, investors can get their money back (perhaps more, perhaps less) in the same day if they chose to. Investors are willing to pay more for that liquidity because they perceive less risk within the shorter time span.
You may have noticed that my language suddenly shifted heavily into “investors” “investments” and “returns.” In the case of liquidity, that is what we are now talking about as the utility is being ignored by the owner, if it exists at all, and instead market-listed tokens are merely speculation vehicles. That makes universally all tokens on exchanges securities, except for a few with proven currencies or utilities (Bitcoin and Ethereum among that short list).
This creates a problem. If I want to raise capital and I sell my token to 100 investors, that market isn’t big enough to create liquidity for those tokens. I need to get my tokens into the hands of tens of thousands of investors in order to create that secondary marketplace. This means involving both accredited and non-accredited investors (accredited investors are considered “sophisticated investors” by the government in a test of wealth, not actual intelligence — a problem for another article). Accreditation is a binary test, in which an investor is accredited if they prove that they have made more than $200k annually in the past two years or have $1M in assets outside of the primary residence.
If I want to sell securities to non-accredited investors, I can’t just give them to the investor in an airdrop, there are laws in the US that regulate the ways in which non-accredited investors can buy and sell securities. But what if I give away the securities for free?
In 1999, the SEC issued a press release on just this topic when early web companies gave free stock away online. In that release, SEC Enforcement Director Richard Walker said, “free stock is really a misnomer…while cash did not change hands, the company that issued the stock received valuable benefits. Under these circumstances, the securities laws entitle investors to full and fair disclosure, which they did not receive.”
The press release continues, “the investors were required to sign up with the issuers’ web sites and disclose valuable personal information in order to obtain shares.” Sound similar to airdrop signups? While free stock may not be identical to free tokens, remember that in the SEC’s eyes, more often than not, they are both securities, so the same laws apply.
So what are my options if I’m an entrepreneur and want to do an airdrop?
One option is to leave the US out of the matter entirely. Take, for example. Dfinity, which is promising to have one of the largest airdrops ever by giving away tokens to tens of thousands of investors. Dfinity is requiring users to give personal information, such as name, address, and ID before giving them their tokens in an airdrop (though it’s worth noting that the tokens are delayed until a future date when the platform is ready; Dfinity is planning for later this year).
If you are a US citizen, you are out of luck because Dfinity has restricted their airdrop to non-American citizens “due to regulatory uncertainty” in the US. In plainer English, this means that they don’t want to deal with going through the process of hiring a securities lawyer to analyze their token and potentially follow the rules of airdropping securities to non-accredited investors.
How to Airdrop Within Regulation
The good news for US companies is that it is possible to do an airdrop even if the SEC, or more likely your securities lawyer, says your tokens are securities and not utilities. With the JOBS Act (Jumpstart Our Businesses) and Regulation Crowdfunding, a company can legally airdrop or smartdrop tokens to tens of thousands of investors as long as the value of those tokens is less than $1.07M in value.
However, some entrepreneurs would point out: how do you know the value of those tokens and how much you are really airdropping until the tokens hit exchanges? It doesn’t need to be a perfect science, but you could find identify a value that could work. For example, if you did a presale of the token, where each token was valued at $5. In the general sale using Regulation Crowdfunding, those tokens could be priced at $10 per token, with an increase of price to coincide with the increase in liquidity. Thus, under Regulation Crowdfunding, you could airdrop 107,000 tokens, priced at $10 each.
If you needed to airdrop a greater value of tokens, companies could use Regulation A+, which increases the limit to $50M (in both Regulation Crowdfunding and Regulation A+, these cap limits are annual limits, so the next year you could airdrop the same amount again).
Many crypto entrepreneurs are avoiding the US because of the laws in place by the SEC, the CFTC, and the Treasury. There is discussion of brain drain, that the best talent in crypto will leave and move to Malta, to the Grand Cayman Islands, to Gibraltar. There is discussion of the US being left behind in crypto development
People are quick to forget that every country has securities laws in place. China halted ICOs altogether last year. Japan is regulating its crypto exchanges. Foreign regulators are watching the developments in this space very carefully even if they haven’t come forward and commented on it publicly yet.
The fact that foreign regulators haven’t spoken on airdrops doesn’t mean they won’t at some point in the future. When that day comes, entrepreneurs will be looking for an alternative way of doing airdrops that pleases regulators. Turns out, a solution has been right there before them the whole time.
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