Tokens Archives - Foresight Valuation Group

The SEC – Impact Theory Settlement: Are NFTs Considered a Security?

Posted on September 7, 2023 6:59 pmModified on September 7, 2023 6:59 pmby Lynn Dudinsky

The SEC announced last week that it had reached a settlement with Impact Theory following the SEC’s first enforcement action against the sale of Non-Fungible Tokens (“NFTs”) which the SEC charged were unlicensed securities. The first step in attempting to understand the SEC’s position on this matter is to go back to the beginning where Impact Theory sold the NFTs that are the subject of this enforcement action. Between October and December of 2021, Impact Theory, a Los Angeles based media and entertainment startup, raised approximately $30 million worth of Ethereum through the sale of NFTs that Impact Theory named “Founder’s Keys”. Impact theory made certain statements related to the Founder’s Keys offering and the use of funds. These statements included that Impact Theory would deliver “tremendous value” to NFT purchasers and that they would use the proceeds for “development,” “bringing on more team,” and “creating more projects.” The SEC determined that Impact Theory was offering and sold these NFTs as investment contracts, and therefore they should be deemed as securities, based on the Howey test (see explanation below). Since the purchasers of these NFTs had a reasonable expectation of obtaining a future profit based on Impact Theory’s managerial and entrepreneurial efforts, they qualify as ‘securities’ under the Howey test.

Examples of statements that were made by Impact Theory in the run up to the sale of the NFTs include some of the following, which were selected by the SEC for inclusion in their public filing regarding the settlement of this matter:

Statement indicating that investors would profit from their purchases if Impact Theory was successful in their efforts
“If you’re paying 1.5 ETH, you’re going to get some massive amount more than that. So, no one is going to walk away saying, ‘Oh man, I don’t think I got value here.’ I’m freakishly bullish on that. I will do whatever it takes to make sure that this is true.”
“But yea, I will make sure that we do something that by any reasonable standard, people got a crushing, hilarious amount of value.”
“NFTs are the mechanism by which communities will be able to capture economic value from the growth of the company that they support.”

According to the SEC, the above statements, and others, led purchasers to believe that their purchases of the NFTs would enable the company to develop the various projects with the end result being the appreciation of value, over time, of their purchased NFTs. Ultimately, 13,921 NFTs were sold by Impact Theory to hundreds of investors, including investors in multiple US states. Additionally, these NFTs could be sold on the secondary market and Impact Theory would receive a 10% “royalty” on each secondary market sale. These secondary market sales generated nearly $1 million in royalty payments to Impact Theory.

Impact Theory entered into a settlement with the SEC that included approximately $6.1 million in disgorgement of profits and penalties, as well as the destruction of any NFTs in their possession and an update to the smart contract associated with the NFTs that would eliminate the 10% royalty on secondary market sales. While the facts of this case and the outcome are noteworthy due to it being the first time that the SEC has brought an enforcement action involving the sale of NFTs as unregistered securities, it is the potential impact of this action on the NFT market and the SEC’s broad interpretation of the Howey test that has the crypto community’s attention.

Under the Howey test, an ‘investment contract’ is any contract, transaction or scheme whereby a person (1) invests his/her money (2) in a common enterprise and (3) is led to expect profits (4) solely from the efforts of the promoter or a third party. Based on this definition, and its application to the Impact Theory NFTs, the logical conclusion is that many of NFTs being offered today would fall within the definition used to initiate an enforcement action against Impact Theory. A large percentage of NFTs purchased are not purchased for their collectible value but are instead purchased to provide some benefit to holders based on the efforts made by the company selling the NFTs. Those holder benefits are typically provided in the form of expectation of profits which can be derived from a multitude of options that are constantly changing.

Years ago, when profit driven NFTs began to be introduced into the market, those expectations of profits were through the marketing efforts of the NFT issuing company to continually drive up the value of the NFTs as well as collaborations that would provide NFT holders with access to partner NFTs for free or at a reduced price that would yield additional profits through the sale of those partner NFTs. The NFT and Crypto landscapes adapt extremely fast as one value driver trend peaks followed closely by the next value driver trend. Today, expectations of profit take the form of dividends from investment projects where the NFT sales are used to fund investment vehicles operated by entity selling the NFTs and each NFT represents a certain percentage of trading profits. Expectations of profit also take the form of higher yields from staking the NFT (as well as the connected cryptocurrency) where an NFT holder may receive 10% Annual Percentage Yield (“APY”) while the non-NFT holder is able to stake either underlying cryptocurrency for 5% APY. There are endless mechanisms through which current NFT issuers entice individuals to buy their NFTs based on the reputation or historical performance of the team selling the NFTs and these mechanisms change far faster than what is possible for the SEC to keep up with. A quick review of projects on Telegram or Discord will show the variety of mechanisms through which projects with no funding launch the sale of NFTs to fund the development of the project, which could range from creating a trading robot to launching a full video game, where there investor is taking the risk of early investment for the sole purpose of realizing profits in the future.

These issues are why two of the SEC Commissioners dissented to the application of the Howey test to the Impact Theory NFT sales. These Commissioners outlined 9 pending questions that they believe the SEC should have addressed and offered guidance long ago when NFTs started proliferating. A discussion of those 9 questions will be discussed in a later blog, but at a high level they address questions that go to the core of the SEC’s view of NFTs with the goal being for the SEC to issue guidance rather than enforce without guidance. While it is unlikely that a decentralized ecosystem with participants around the globe will adhere to the guidance provided by the SEC, projects that seek to raise millions through a US registered entity will greatly benefit from such a guidance. These projects that seek to adhere to rules and regulations will drive the next wave of blockchain innovation and it is imperative that the SEC provide a framework for this innovation to occur.

Digital Intangibles: How NFTs Transform the World of Art and Sports Memorabilia

Posted on April 2, 2021 5:59 pmModified on April 2, 2021 5:59 pmby Lynn Dudinsky

The utilization of blockchain within the digital art environment is a new and rapidly growing application of the technology to enable ownership and authentication of intangible works of art. Historically, physical pieces of art could be bought, sold and authenticated based on the documentation that accompanies the work (known as provenance). The authentication process relies on documents such as artist signatures, ownership records, signed certificates of authenticity, exhibition stickers and other forms that link the piece of art to the artist. While it was possible for another artist to make a replica of a particular painting and try to sell it as an original, the lack of provenance would make it apparent to a buyer that the piece of art was not an original and the price would reflect the art as being a replica. Setting aside replicas, with physical pieces of art, there is typically only one version of the original work and because it is a tangible object, the owner can physically hold the piece of art and once it has been authenticated the owner is assured of the uniqueness and value above any replica. With ownership authenticated, the piece of art may still be displayed publicly in museums and found online in various forms without devaluing the original piece of art.

For digital art, the physical component is absent and the work is typically found online and available for anyone to view and copy. While this ecosystem has extended the reach of digital artists to anyone with internet, it has also complicated the management of rights and ownership as well as the value. Since a piece of digital art can be easily copied, the perceived value has remained low. Blockchain technology has provided a solution to this problem due to the immutable nature of the data stored on a blockchain. The data stored on a blockchain has the ability to provide the provenance for digital art that has historically eluded the industry and depressed the value of original digital art. This data and the process of storing it on a blockchain to create the provenance necessary to authenticate the original piece of digital art happens through the process of tokenizing the art to make a Non-Fungible Token (“NFT”).

An NFT is unique digital object that represents the digital asset or a particular right in the underlying asset. When a particular piece of digital art is tokenized with an NFT, the data (artist information, signature, purchaser history, etc.) is stored on the blockchain. Because the blockchain is both immutable and open source, anyone can view the digital provenance of a particular NFT. While this also means that anyone can view the piece of digital art, as is the case with most high-value tangible art, true ownership of the art is stored on the blockchain which, in theory, should create a strong market for authenticated ownership that parallels that of tangible pieces of art.

Recent headlines have hinted at this theoretical market for digital art in the form of NFTs becoming a reality. Christie’s Auction House recently sold an NFT for $69,346,250. This sale represented the first major auction house to offer a purely digital work with a unique NFT as well as the first to accept payment in the form of cryptocurrency. The piece of art was created by Mike Winkelmann (also known as “Beeple”) and was a collage of digital works of art he created and posted daily for 13-and-a-half years. Other examples include Twitter co-founder Jack Dorsey selling his first tweet as an NFT for over $2.9 million. NFT marketplaces are in the process of raising significant VC funding, particularly in the area of sports. According to the Wall Street Journal, the market for NFTs grew to at least $338 million in 2020, from around $41 million in 2018. In March 2021, Dapper Labs Inc., maker of NBA Top Shot, has raised $305 million from investors including NBA legends and other athletes and celebrities. NBA Top Shot is a site where basketball fans can own a digital copy of a video highlight such as a dunk or game-winning shot.

It is too early to determine if this new market for NFTs will be a short-lived bubble or if we are seeing the early stages of a growing NFT market where collectors will eventually no longer see a distinction between tangible and intangible works. One early indication that the value of owning tangible and intangible art may be converging can be seen in the story of one tech investor who was outbid for the Beeple NFT; this art collector returned to Christie’s to see if any other NFTs were available. While Christie’s had no NFTs to offer, the auction house informed him of an upcoming lot of tangible art, and he ultimately purchased a collection that included artworks by Pablo Picasso and Andy Warhol. Given the rapid rise in prices paid and media exposure of NFT, it is likely a trend that will continue. However, due to the unique nature of art and purchasers of art, the NFT market may simply result in a small number of digital artists receiving high prices for their work with others struggling to find a buyer for their work, just as we see in the world of tangible pieces of art.

Carrots and Coins: The 2018 IP Valuation Year in Review:

Posted on January 30, 2019 5:24 pmModified on February 13, 2019 8:14 pmby Efrat Kasznik

A lot has been written on the impact of the new leadership at the USPTO on the value of patents. Since his appointment in early 2018, Director Andrei Iancu has managed to introduce new initiatives that increase transparency and uniformity in how the USPTO and the courts interpret patent claims and validity challenges, reforms that are largely considered to have a positive impact on the value of patents. Some market followers who keep track of the venerable “pendulum”, which signals the patent climate de-jour, were quick to note that the pendulum started swinging ever so slightly back in favor of patents (as evidenced by some renewed interest in the patent marketplace).

From an IP valuation perspective, one should take a broader view at the factors impacting the value of IP Assets, patents as well as other assets. While patents are legal rights that are profoundly impacted by case law and the USPTO examination policy, focusing on legislative and judicial developments in the US alone constitute a very narrow lens by which to evaluate IP portfolios and the value they bring to the companies that hold them.

Below are some of the main trends in that we have seen in 2018, based on the IP portfolios and transactions that came through the door in our IP valuation practice:

Over the last year, we have seen a clear increase in the weight of foreign assets in the IP portfolios presented to us; it used to be the case that the vast majority of assets were US assets, with a few counterparts that served more as a placeholder and less as a driver of economic value. Over the last couple of years, we have seen more and more patent portfolios used to support funding, strategic collaborations, international expansion or the sale of a company, where the major corpus of assets were foreign assets. More specifically, we have seen German, Korean, Chinese and Japanese assets anchoring an entire portfolio with very little and sometime no US counterparts at all. This is a telling sign of the increasing state of enforcement in foreign markets, as well as the increasing economic activity in foreign markets, which are usually the two reasons driving patenting decisions. I will stop short of also saying that this is a sign of the weakness of the US patent market, because I don’t believe that to be the case. Patenting decisions are made years in advance of the patent actually showing up. I also don’t believe that to be a ‘zero sum game’, i.e., if foreign IP assets drive more value, it doesn’t mean the US assets are worth less, but rather the entire pie is probably worth more.

Another trend that we are seeing emerge is the return of “carrot licensing”, which is a term used to reference licensing activity that is driven by technology transfer, as opposed to licensing driven by enforcement (also known as “stick” licensing). This form of licensing is more closely associated with emerging technologies, where the licensor is interested in creating markets for new products using an idea protected either by trade secrets or by patents. With enforcement models taking a back seat for a variety of legal and judicial reasons, particularly in the US, we are seeing more and more licensing activities involving new technologies and the IP rights protecting them. While enforcement is looking into infringement in mature markets, technology transfer is looking to carve new markets. This is a clear indication not only of the decline in the value of patents as “naked assets”, but it also indicated the increase of trade secrets as a form of IP protection that can be monetized together or apart from patents. We worked with a few European companies looking to expand worldwide using IP licensing as their main business model, seeing that IP licensing allows expansion into new regions without bearing the marketing, manufacturing and distribution cost associated with the complementary business assets needed to bring new technology to market.

There is a wave of innovation in the area of biotechnology, leverging on novel methods for molecular diagnostics and other technologies enabled by advances in genetic sequencing and gene editing, as well as the convergence of science with big data analytics and artificial intelligence (AI). Many of these technologies are initially developed by startup companies, that end up licensing to, or being acquired by, larger players. In such acquisitions or collaborations, we have seen IP rights – patents in particular – play a key role in determining the price and terms of the deal. IP assets in these areas are very valuable, and they gain their value from a technology transfer and new market perspective. As a matter of fact, IP assets in biotech and other life sciences companies are so valuable that they often survive the company even if the startup goes bankrupt for lack of funding, particularly if regulatory (FDA) approvals have been secured and other product milestones have been met.

Over the last couple of years, we have seen the emergence of new digital assets: databases, cryptocurrency, and other types of assets that made their way from the digital world into the business world. The valuation profession is slow to keep up with these assets, and as a result we have to be very creative in how we value them, as no guidelines, comparable transactions or other points of reference exist. One interesting case we have worked on this year involves the valuation of a digital token for a token-presale (a token is an asset used in a Blockchain environment to facilitate transactions on the network). From a valuation perspective, valuing tokens and cryptocurrency in general poses a challenge, as the very nature of the asset is not clearly defined: is it a security, a commodity or a currency? Should the asset, and therefore the valuation thereof, be regulated by the SEC? Many of these valuations are done for tax reporting purposes, however there is no clear policy by the IRS on some of these assets and the regulations are evolving, which makes the valuation exercise somewhat of a moving target.

In conclusion, our experience in 2018 indicated that patents are only one component of the modern company’s IP portfolio. There are other types of intangible assets, including new categories of assets we haven’t seen before, that are emerging in the new digital economy, posing new valuation challenges but adding more sources of value for companies. Additionally, new technological advances are creating fertile ground for technology transfer and open innovation, processes that depend on IP rights and which give IP Assets great value.