Valuation Considerations for Non-Fungible Tokens or NFTs

Valuation Considerations for Non-Fungible Tokens or NFTs

 What is a non-fungible token? Recently, the media has seemed to catch on to the new(ish) invention – NFTs. Even the recent episode of Saturday Night Live (SNL) has featured an entertaining segment explaining the nature of NFTs to the rhythmic beat of the Eminem song. NFT stands for the non-fungible tokens; it is a unique, non-interchangeable digital asset backed by blockchain ledger technology. Non-fungible characteristic of these tokens or assets refers to the unique or scarce and non-replicable nature of this digital-crypto assets compared to, for example to a Bitcoin or a $1 bill, where each unit of the asset is interchangeable and is the same. Examples of NFTs range widely from digital art, domain names, games, and collectibles to rare audio and video recordings. NFTs are created (i.e., minted) on a blockchain, such as Ethereum, which authenticates the ownership and the NFT asset (i.e., where it comes from, where it originates, and who is the owner). In a physical world, a tangible example would be Mona Lisa's painting by Leonardo Da Vinci. Although there are many replicas, there is only one original Mona Lisa in the world, and this piece of art is unique, creative, and indivisible.

Similarly, NFTs are creative works of art that, for the most part, do not allow for fractional ownership. Some NFTs can be very expensive, with a price tag of millions of dollars. One example of the sold NFT is a digital crypto kitty (Dragon Kitty) art sold for 600 ETH (Ethereum currency), roughly equivalent to USD 170,000. Certain domains such as "exchange.eth" can be worth more than $500,000.  

Some trace the origins of the NFTs back to 2012-2013 when colored, small denominations of bitcoins were created. These coins represented different assets with different uses, ranging from collectibles to access tokens. These colored coins were "unique and identifiable from regular bitcoin transactions." In 2014, Robert Dermody, Adam Krellenstein, and Evan Wagner founded a peer-to-peer financial platform, Counterparty, which was built on top of the bitcoin blockchain. In 2015 and onward, trading cards and memes became prevalent. Various video games popularized the creation of digital assets to be stored on blockchain technology; these included swords, shields, and even digital parcels of real estate. Crypto kitties became famous in 2017, launched by the Vancouver-based company Axiom Zen. According to the Digital Trends article: "CryptoKitties is a game centered around breedable, collectible, and oh-so-adorable creatures [called] CryptoKitties! Each cat is one-of-a-kind and 100% owned by you; it cannot be replicated, taken away, or destroyed." In 2021, NFTs have gained more momentum and have started to permeate the mainstream economy in some unexpected ways. The NFTs are poised to create a brand-new aspect of the digital economy.

From the valuation perspective, the NFTs represent a digital asset that can be licensed for various purposes. However, that's not all. The NFTs can also be used in lending, specifically, collateralized lending and in the realm of investing, as part of de-centralized finance (known as "DeFi"). The NFT can allow the borrower to use digital tokens (assets) as collateral to borrow money against it. One of the DeFi borrowing and lending platforms, Aave, enables borrowers to borrow as much as 75% of the collateral amount. Challenges arise when it comes to assessing the fair market value of this type of asset due to limited liquidity. To illustrate, imagine someone buys a crypto kitty for 10 ETH (assume equivalent to USD 3,500), later this NFT is used as collateral, and the borrower draws 1,750 DAI (1 Dai = 0.000479 ETH), given a 50% Loan-to-Value ratio. If no one buys the subject crypto kitty, the market for this item would be illiquid or even non-existent. The only assumption that can be made is that the subject crypto kitty is worth the amount for which it was the last sold, i.e., 10 ETH, which is not a very re-assuring assumption as the value of NFT is volatile and is constantly changing.

There are certain peer-to-peer marketplaces that allow for NFT collateralized loans, where the lender can choose a particular NFT that they can accept as collateral. In this scenario, the NFT would be held in the escrow account. If the borrower were to default on its loan, the NFT would be transferred to the lender. Other uses of NFTs relate to structuring complex financial products in the insurance, bonds, and options marketplaces. For example, YInsure facilitates NFT usage in the insurance space, where each insurance contract is represented as an NFT and is traded on the secondary exchange such as Rarible. To date, approximately $100 million of NFTs have been traded. It is one of the fastest-growing niches in the crypto marketplace.

According to the valuation theory, there are three main valuation approaches: an income approach, an asset approach, and a market approach. All three approaches can be relied upon as the appropriate means to determine the fair market value of the subject NFT or the NFT-holding entity, although not without some special considerations. There is a great deal of subjectivity and volatility surrounding the valuation of NFT assets and-or NFT-holding enterprises. Let us take a closer look at possible valuation methodologies.

In terms of the income approach, to value an NFT, the appraiser will have to consider the earning capacity of the NFT-asset (i.e., economic benefits or cash flows). Such cash flows can be in the form of licensing, royalty payments, for example. In this scenario, the valuation professional's task would be to estimate the appropriate proxy royalty rate. The relief-from-royalty method can be used to arrive at the fair market value of the subject NFT. A relief-from-royalty method is an income-based approach, where the value is derived based on savings from not having to pay a licensing/royalty fee as a result of ownership of the subject asset. For example, if an artist created an NFT music album, the appraiser would estimate the revenue stream associated with the subject asset and apply the appropriate royalty rate to calculate royalty savings using the relief-from-royalty technique. As an illustration, according to Ethereum.org, the original owners of EulerBeats earn an 8% royalty every time the NFT is sold. Once the royalty savings are calculated, they are adjusted to an after-tax basis and discounted to present value. The discount rate should take into account the inherent risk associated with this type of asset. Most likely, the level of risk related to this asset will be greater than the entity as a whole. The sum of present value after-tax royalty savings would represent the fair market value of the subject NFT. As more M&A transactions take place, business valuation professionals may have to allocate the purchase price to NFT asset(s). for financial reporting purposes.

With respect to the asset approach, we can consider the ownership of NFT or NFTs as asset-holding, non-operating portfolios. The fair market value of the individual NFT assets can be approximated based on the current, listed, comparable NFT asset classes on several NFT marketplaces (exchanges). If the NFTs are held in an entity, the balance sheet items, assets, and liabilities are adjusted to their fair market values. We then subtract from the adjusted total asset balance total liabilities (adjusted to their fair market values) and determine the adjusted net asset value (NAV) for the subject entity. For an asset-holding company, the asset approach sets the floor, as an entity typically could not be worth less than the value of its underlying net assets.

Finally, when it comes to applying the market approach, we can consider the guideline public company method. When using the guideline public company method, the appraiser typically selects comparable public companies and determines the appropriate valuation multiples to apply to the appraisal subject. The selected multiples may include, for example, enterprise value-to-revenue, enterprise value-to-EBITDA, and so on. Although there are not many publicly traded players in the NFT field, several companies have entered this space. These include Takung Art (NYSE: TKAT), Funko (NASDAQ: FNKO), and Liquid Media (NASDAQ: YVR), among several others. With respect to the transaction multiples method, it would be challenging to find privately-held companies that have been sold based on their SIC or NAICS codes (as published by DealStats and other similar databases). Therefore, this technique is unlikely to be used in the near future. Eventually, more companies enter this space. In turn, business brokers, who typically report data to various transactional databases, will start to facilitate the buying and selling process for companies that specialize in NFTs. The resulting transaction multiples, such as price-to-sale, price-to-seller's discretionary earnings, or price-to-EBITDA, can be determined and applied to the subject entity's financial characteristics.

Lastly, it should be noted that a modern-day company may own an NFT as an investment or a non-operating asset. Therefore, an appraiser should review the subject company's balance sheet and determine whether any adjustment would be appropriate. If the NFT represents a non-operating asset, the company's equity value can be adjusted accordingly.

The field of business valuations has not seen a wave of valuation engagements related to NFTs. It could perhaps turn out to be another tulip bubble craze. Whether NFTs are viewed as speculative modern-art play, one thing is clear; the underlying blockchain technology is here to stay.