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Uncertainty In The Valuation Of Non-Fungible Tokens

NFT concept, man standing with VR goggles looking for digital art to buy online.

The Non-Fungible Token (NFT) Market is soaring and many more people are creating, buying, selling and swapping NFTs. There are many challenges in this new market and one of the biggest challenges is the valuation of NFTs.

Valuation of NFTs is one big unknown. There are no cases on how an NFT should be valued, and its closest analogy, that of valuation of Art, is rather murky. What is clear is that an NFT requires a new methodology for valuation, and a better means of managing the digital asset associated with the NFT to maintain that value.

For tax purposes, the value of an NFT is its Fair Market Value, or FMV. Fair market value is the price at which the NFT would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. This value may include the digital image associated with the NFT, based on the smart contract of the NFT, as well as rights on the display and reproduction of the real world subject of the image which is based on the contractual obligations between the seller and the buyer of the NFT.

Fair Market Value relies heavily upon the concept of the “most relevant market”- that is, the market in which such item is most commonly sold to the public. While auction sale might be deemed the “most relevant market” in some circumstances, the specific nature of each NFT, and the online marketplace (OpenSea, for example) it is listed on, will be used to determine “most relevant market”.

The analogy is how artwork is valued. A print published just last year is unlikely to have found its way into the auction market. The same will be true for an NFT which is unique and has yet to be auctioned. So, in this case, the “most relevant market”  is the asking price for the NFT.

The newsletter Bankless has the following as factors to consider in valuation of NFTs:

It is important to the buyer that the underlying blockchain stays secure. Ethereum, which is presently the most secure smart contract platform that exists, can contribute to the NFT’s value over time.

On-chain is defined as the  direct incorporation of the metadata into the smart contract which represents the tokens,  while off-chain representation means hosting the metadata separately, due to storage limitations of the Ethereum blockchain.

On-chain metadata makes an NFT more valuable; in part because the metadata is incorporated into the token, allowing the NFT to last forever (or as long as Ethereum exists); and, in part because on-chain tokens have to meet certain Ethereum standards, giving them a liquidity premium and making trading easier.

When determining whether the NFT is on-chain or off-chain, the key question is where the NFT is hosted, that is what Digital Asset Management System (DAMS) is used.

Since NFTs are so new, an NFT created before 2020 may be considered a “digital artifact” that possesses greater value.

The broader marketability and recognition of a celebrity artist will affect the value of their NFT over that of another, less well known artist. Certain NFT creators in the sports industry have realized this and partnered with notable artists to produce digital-first, one-of-a-kind content. These NFTs are attractive to buyers as exclusive and distinct from the types of physical objects available to buy.

Certain NFT platforms like SuperRare only support unique, single-edition digital artworks. Some marketplaces also break their NFT offerings down by scarcity, for example, NBA’s Top Shot puts its NFTs in “common,” “rare,” “legendary,” and “ultimate” tiers. Those listed in a higher tier possess a significantly greater value than their counterparts in the “common” tier.

Authenticity goes hand-in-hand with scarcity—for example, the Uffizi Gallery in Florence has created an NFT of a Botticelli they own, which is more valuable than an NFT created from a tourist’s iPhone image. However, verifying the authenticity of a seller on the internet, and managing the Intellectual Property associated with an NFT remains difficult, if not impossible without access to a DAMS.

Scarcity also is a large factor in the valuation of gaming NFTs, since such NTFs can only be acquired in very specific ways.

The release pace, or how many of these NFTs the creator minted overall, effect the value of the NFT. A project that offers unlimited mints of an NFT at a nominal price is generally not as enticing as buying an NFT from an artist who’s committed to minting a limited edition of 25 NFTs.

Richness relates to additional features of an NFT. An audio component can add value as it could: 1) feature a known artist, or 2) create an addictive loop for the viewers. An NFT that combines a digital asset with access to a real world asset or experience also has greater value. This occurred recently when the Golden State Warriors auctioned off NFTs of their previous championship rings and included a tangible benefit for the buyer, which could have been a VIP basketball game experience or an imitation physical version of the ring with custom name engraving. One of these NFTs sold for over $800,000.

On the experience side, the purchaser of a New Jersey Devils NFT also received an opportunity to watch a 2021-22 season game in the New Jersey Devils Alumni Suite with a Devils’ legend from one of the championship years. This NFT sold for $3,000; whereas, some of the digital-only NFTs on the site are selling for only $100.28.

An approach that some creators are using to increase value is destroying the original work, either upon agreement at the time of the NFT’s transfer to a buyer, or before the sale even occurs. Perhaps the most well-known destruction event was the planned auction of a Basquiat NFT in late April.  The auction sponsor DAYstrom advertised that the sale would include all related IP and copyright in perpetuity, and that the highest bidder could choose to “deconstruct” (i.e. destroy) the physical drawing if they wished. The auction did not end up happening, as Basquiat’s estate pulled the NFT from OpenSea and clarified that the estate will retain the drawing’s license and rights.

Destruction may confer status on the NFT as an exclusive digital asset; however, once an NFT is minted on the internet, destruction of the original does not prevent anyone from viewing, downloading, sharing, and copying the image, unless the IP rights have enforceable restrictions.

Origin Protocol recently auctioned off the “Charlie Bit My Finger” video as an NFT, once the most-viewed video on YouTube. Origin stated that it planned to remove the original video from YouTube so that the content could be memorialized on the blockchain. YouTube has yet to take the clip down, but the video now has “Waiting on NFT decision” added to the title.

Instead of destroying the original work or giving the buyer the option to destroy it, the creator can always make an NFT of the physical object and leave the object intact. One space in which this occurs is the art world: for example, art historian Ben Lewis created an NFT of Salvator Mundi by Leonardo da Vinci, with some slight modifications, without destroying da Vinci’s original work. It appears that the NFT is still listed on OpenSea and has not yet been sold. Similarly, as mentioned above, the Golden State Warriors became the first professional team to launch an NFT collection, which included the Warriors’ six NBA Championship Rings digitally reproduced as NFTs. The initial sales occurred in early May and did not involve destruction of the original championship rings.

The creator could add an offer to contractually restrict display of the original. The buyer would then have a potential breach of contract and copyright infringement claims against the creator, if the creator were to publicly display or use the work. Again, the issue with this is how to manage the IP rights of the digital image associated with the display, or even sale, of the original.

As the NFT Market roars along, expect that valuation will become more, not less confusing. Valuation is critical, however, because so much of the tax impact of buying, selling, trading and gifting NFTs will depend on what the correct valuation is, either for determining cost basis, for determining the relative value of NFTs that are exchanged, the value of a charitable contribution and the value of a gift or estate. It will also be important how the NFT is handled in the underlying DAMS, and what methodology the IRS, and ultimately the Courts, adopts. Getting out ahead on both issues will be critically important as the NF market continues to grow.