Token Distribution: A Guide

When an organization wants to embark on a crypto project, it’s usually enabled by a token. A token is a digital asset residing on a blockchain under the control of an owner. Tokens can have different properties and use cases. They can be fungible and used as cryptocurrencies or non-fungible and linked to other assets. Tokens can also have utility within the blockchain’s operation or governance.

Understanding token distribution is important for builders in web3 who may be planning a distribution of their own. Product managers and others involved in the building process need to know about the different ways to structure token offerings and the legal ramifications to consider. Potential participants in web3 projects also need to understand token distribution so they can be careful about scams. This guide covers the essentials of token distribution for each group in turn. We’ll begin by describing what token distribution is.

What is token distribution?

Token distribution is the process of handing out tokens. Many decisions about a token offer need to be made prior to distribution day: how many tokens will be offered, what rights will token holders acquire, its value, and much more.

Why are new tokens often used in web3 projects rather than existing cryptocurrencies? Where cryptocurrencies are primarily used for buying and selling, tokens can have additional functionality. For example, tokens may grant voting rights in an organization, enable access to exclusive communities, or something else specific to the project.

Tokenomics: the economics of tokens

The economics of a token offer are known as tokenomics. Tokenomics plays a key role in making the token offer a success.

Who will be able to receive or purchase your token? What utility will this token have that might make it desirable to recipients or investors? Why might the tokens increase in value in the future? Consider how you will make this token distribution an enticing offer.

Most importantly, you need to decide how many coins will be made available. If supply exceeds demand, token prices will be low. Too few tokens may result in underfunding.

Keep the goals of your token distribution in mind. What are you trying to accomplish? Most token offers have one of two main goals: Raising money or building community buy-in for the project.

Types of token distribution

At base, there are two types of token distributions: paid and free. Within each of these approaches there are different ways to structure the token offer.

Free

Free token distribution is usually a way to incentivize participants to spend time on the project. The following possibilities are not mutually exclusive.

Rewards

Tokens may be offered as a reward, triggered by specific actions users take to help with the project. These might include promoting the project in social media, winning a game, or using the project for a week, etc.

Airdrop

An airdrop delivers tokens to the wallets of an entire group, usually in a single day. There is no requirement that tokens be given to all the users of the project. The project decides which group of users will receive tokens based on different factors.

Lockdrop

Here, token recipients pledge not to spend a set amount of their crypto on another blockchain for a defined time period. This willingness to endure a lockup period indicates enthusiasm for the new project and qualifies them to receive the airdropped token.

Paid

Paid token distribution is about raising money to fund web3 projects. Ways to structure these offers include:

Venture capital

Professional investors in a project acquire tokens–and an ownership stake in a project–by purchasing the tokens at an agreed-upon price.

Public sale

The project offers tokens to the general public at a set price. This may take the form of an initial coin offering (ICO) on a public marketplace or an initial exchange offering (IEO), through an established cryptocurrency exchange. Alternatively, the organization may manage its own offer through an initial DEX offering (IDO).

Private sale

An exclusive group of individuals are offered an opportunity to purchase tokens, often before they’ll be publicly available. For instance, only a particular group of investors might be offered the opportunity initially, or only project founders.

Who gets tokens?

In planning a token distribution, one of the big decisions is what percentage of the tokens will be offered to which types of users. It’s common for the token distribution to include a set-aside of tokens for future community rewards, tokens allocated for project founders, and tokens earmarked for investors. This is what happened in the initial token distributions for Flow and Solana.

Before distribution day, a cap table or pie chart should be created that specifies these percentages. This gives everyone involved valuable information. Founders will see how much power they’ll retain through their token ownership, how much might be handed out as future free rewards, and how much is available to outside investors.

Initial token distribution

Typically, a large chunk of the available tokens are given out in the initial offer–but not all. The organization will need to decide what proportion of the total tokens minted will be distributed in the first round and what proportion will be retained by founders. This is similar to a privately held company that decides to sell a portion of its shares on the stock market in an IPO.

ICO caps, auctions, and limits

There are many ways ICOs can be structured. These include:

• Capped auction–The number of tokens to be sold is limited, thereby also limiting how much funding can be raised. Buyers state their target price and spending limit, with lower-priced bidders potentially receiving fewer tokens than requested if there are too many higher-priced bidders.
• Capped first come first serve–A limited number of tokens are available, with an initial discount on early blocks to encourage buy-in. Once the initial set of discounted tokens are exhausted, sales continue at a higher price until all the tokens are sold. This has been the most common ICO format recently.
• Capped with redistribution–Both the price and number of tokens are preset, with buyers indicating their desired purchasing budget. If demand exceeds supply, extra funds are reimbursed and buyers may receive fewer tokens than they requested.
• Capped with parcel limit–A defined quantity of tokens at a preset price are offered, but with a limit on how many tokens any individual buyer may purchase. This move is designed to prevent buyers from becoming whales who amass outsize stakes and substantial control over the project.
• Uncapped auction–Both the number of tokens and their price are unlimited. Buyers bid for the price and number of tokens they want, with highest bidders receiving tokens first. Lower bidders may be shut out, if the supply is exhausted before their bid price is reached.
• Uncapped–Both the number of tokens and amount any individual buyer can purchase are unlimited, as is the amount that could potentially be raised.

You can see that each of these structures has its pros and cons. With unlimited supply, it may be hard to convince buyers your token will become valuable–but with limited supply, the amount you can raise is also limited. Your organization will need to weigh the options and decide on the best course for your particular project.

Future token distributions

If a project’s distribution plan was fully fleshed out, they would know the circumstances under which they may make additional distributions. They might be triggered by project participants engaging in activities that earn reward tokens, or the anticipated need for another round of planned fundraising.

Legal ramifications of token distribution

Each type of token offer has legal implications that must be carefully considered.

For instance, ICOs may require creation of a white paper or pitchbook, and registering of securities with authorities. To enable a private sale of a token that’s not yet been created, a SAFT (Simple Agreement for Future Tokens) is required in some countries.

Anti-Money Laundering (AML) or Know Your Customer (KYC) regulations will often come into play, as regulators seek to prevent criminals from money laundering via crypto. You’ll also want to avoid making any claims about future returns or increased value for your token.

Your organization should retain qualified legal counsel to advise you on how to structure your token distribution to avoid any legal problems. Penalties can be steep: for instance, Block.One was fined $24 million by the SEC after a 2017 token distribution that raised the equivalent of over $4 billion. The agency alleges that the structure of Block.One’s offer constituted sale of unregistered securities.

How to avoid token distribution scams

What if you’re not a builder in web3 and you have no intention of designing a token distribution of your own? You may still be interested in participating in web3 projects that distribute tokens. In that case, you need to be careful about scams, which have plagued token distribution in recent years. One 2018 analysis conducted for Bloomberg showed that nearly 80 percent of all ICOs involved fraud.

More recently, in 2022 the Journal of Financial Risk and Management reported that of over 5,000 ICOs they studied, nearly 100 were confirmed scams, and another 479 had at least one fraud accusation lodged against them. That means over 11 percent were identified as possible scam ICOs.

How can you avoid being the victim of an ICO scam? Here are some red flags to watch for from the SEC. The agency is so concerned about ICO fraud that it set up a fake ICO website to educate consumers. Their HoweyCoins.com site contains all of the warning signs:

• Claims of high, guaranteed returns
• Celebrity endorsements
• Unverified claims that the ICO is “SEC compliant”
• They accept credit cards
• Statements that the issuer will help you earn with planned “pump and dump” maneuvers

One study from Chainalysis revealed nearly one-quarter of 2022’s more than 40,000 token launches showed evidence of pump-and-dump manipulation. The founders should be people you trust not to simply disappear with the funds raised, as some ICO organizers have. Some tokens may be considered securities that must be registered with the SEC–read the organization’s white paper carefully, and check directly with the SEC to see if compliance documents are actually on file.

Airdrops of free tokens to your wallet are also ripe for fraud. Fake airdrops usually require you to visit a malicious website and enter your secret recovery phrase or private key to claim the token. This information is then used to drain your wallet.

Even established, credible coins may be involved in fake airdrops. This happened in February 2023, when an imposter airdropped fake AGI tokens (which had actually been rebranded to AGIX) while posing as issuer SingularityNET via a fake Twitter account.

Remember:

• Never interact with tokens airdropped from any person or organization you don’t know.
• Don’t share secret recovery phrases or private keys–they shouldn’t be required to claim a legitimate token.
• Always make sure you transact directly with the token issuer and aren’t on any other site.
• Time pressure is a red flag–don’t fall victim to FOMO.
• Watch for requirements that don’t make sense–for instance, the fake AGI airdrop asked users to bind their wallet to both the Ethereum and Cardano blockchains, a maneuver that can’t actually be accomplished with a single smart contract.

In general, when it comes to token distribution, do your own research.