The Fundamentals of Token Valuation
Token valuation is a critical piece of the puzzle for many Web3 and blockchain-based entities. Understanding token valuation is essential for ensuring regulatory compliance as well as navigating the complexities of blockchain ecosystems and potentially even attracting investor interest.
What Is Token Valuation?
Token valuation is the process of determining the economic value of a digital token, providing a snapshot of its worth at any point in time. This involves assessing various factors, such as the token's utility, market demand, and liquidity or tradability in the market. Token valuation is critical for pricing tokens accurately for regulatory compliance and ensuring investors and stakeholders understand the token's fair market value. The valuation of a token can fluctuate over time as market conditions and business milestones influence it.
Why Is Token Valuation Important for Businesses and Investors?
For businesses, token valuations ensure compliance with regulations and help facilitate planning. For investors, token valuations provide critical insights for a variety of purposes, which include marking investments to market for financial reporting pursuant to ASC 820. An accurate valuation may also enhance credibility, facilitate informed investment decisions, and foster trust between the token issuer and potential stakeholders.
It is essential to have a token valuation for taxation and accounting purposes. Proper valuation ensures that the company remains compliant with tax reporting and financial reporting standards and avoids potential penalties for misreporting the token's value.
What Is the Token’s Function?
Understanding a token's function is key to accurate valuation. Tokens may serve various purposes within a blockchain ecosystem:
Utility Tokens: These grant access to a platform’s services or products within a blockchain ecosystem (e.g., Ether for Ethereum's smart contracts). They often function similarly to pre-orders or concert tickets, offering future access rather than immediate ownership. Unlike traditional financial assets, utility tokens may be traded but their market presence may limit trade at fair prices. Utility tokens differ from security tokens, which represent ownership or investment. Utility tokens are used for accessing network services or functionalities, not for ownership stakes. They can be used for transaction fees, premium services, certain governance functions, and more. Examples include Ethereum’s gas token and Binance Coin.
Governance Tokens: Governance tokens are cryptocurrencies that enable holders to vote on decisions and proposals related to blockchain projects, particularly in decentralized finance (DeFi) and decentralized autonomous organizations (DAOs). These tokens help decentralize decision-making and influence the direction of projects. Each token typically represents one vote, but methods can vary. Holders can use these tokens to approve or reject changes, propose new initiatives, and participate in governance. Utility tokens may provide governance rights as well, but governance tokens do not typically provide additional utility over and above governance functions.
Security Tokens: A security token functions like a traditional financial security, such as a stock or bond. These represent ownership in an underlying asset, such as equity in a company. They are regulated under securities laws, requiring compliance with registration and disclosure rules. Security tokens can offer investors potential capital gains, dividends, or other income forms, making them financial assets.
NFTs: These tokens are unique and often represent ownership of digital or physical assets such as art, music, or real estate. NFTs are very limited based on the low number of items created (usually one of a kind) and have identifiers to prove their authenticity and uniqueness. This is in contrast to the various fungible tokens listed above that have considerable supplies of tokens, often in the hundreds of millions or billions. In theory, scarcity of NFTs is what drives their value.
The function of a token influences its demand and perceived value, which in turn impacts its market price. A token with valuable uses and widespread adoption will typically command a higher value than one with limited use or uncertain demand.
Key Factors that Impact Token Valuation
When determining token valuation, a few key factors impact the process, starting with the availability of a market price. If the token has undergone any sales—whether to outside investors or through established agreements—these transactions typically provide the clearest indicator of value. In such cases, pricing from these sales establishes the starting point when determining the token's valuation and additional adjustments may be required from there based on a variety of other factors including changes in market conditions, trading volume, etc.
Dealing with publicly traded tokens is different than dealing with tokens that are not yet publicly traded. Appraisal expert Julia Staines says, “We always start with the market price for publicly traded tokens. Taking that price, we may be able to apply some discounts for slippage or lack of marketability. The market approach is considered the most reliable indication of value for a publicly traded token.”
There seems to be confusion in the industry about when a discount for lack of marketability applies. This discount lowers the value of a token or security if it can't be sold due to market restrictions, which most commonly occurs during lockup periods. It applies only when the token is owned but can't be traded. Applying a discount for lack of marketability based on vesting schedules (vs. lockups) is not appropriate as the tokens are not owned until vested.
In situations where there is no market price, other approaches including a cost approach may be appropriate, especially in the very early stages of a project when there are limited data points.
In addition, the type of token —whether utility, governance, security, or another type—may influence valuation. Security tokens, for example, often require more rigorous compliance efforts, which can affect both their perceived value and the cost of issuing them.
When to Get a Token Valuation
Determining the right time for a token valuation depends on various factors like the project stage, market conditions, and regulatory obligations. A timely and thoughtful pre-launch valuation is crucial for compliance purposes. We recommend getting a valuation as soon as possible to ensure compliance with critical regulations are met, particularly when making an IRC 83(b) election. After a token sale, valuations for gift and estate tax planning purposes or charitable contributions may be critical in order to ensure compliance with relevant IRC provisions. Additionally, during periods of market volatility, reassessing the token’s value to reflect market shifts is crucial to maintaining its accuracy. Lastly, as business models evolve or new developments arise, updating a token’s valuation may be necessary. For example, if a company changes its token’s use case, a new valuation can reflect its revised function and market potential.
Best Practices for Getting a Token Valuation
To obtain an accurate and credible token valuation, following best practices is essential. Engaging a professional valuation service provider with expertise in Web3 companies and token issuances ensures a reliable and defensible token valuation. It is also important to consult with your legal team to confirm that the valuation timing and scope aligns with regulatory requirements and minimizes legal risks. Keep in mind that token valuations are typically valid for a limited time due to market fluctuations and other dynamic factors. “The timing is so important. A token valuation is only valid for a relatively short period of time. So if we finalize the valuation but you haven't connected with your legal team yet, and they don't have any of the paperwork drafted up for the token grants to be issued, then that disconnect could sometimes lead you to be outside of the window—to which you may need to go through the process again,” says Staines. “Of course, we work with our clients to properly plan so that the valuation is timely and relevant.”
In Conclusion
Token valuations play a crucial role for both blockchain companies and their stakeholders, ensuring regulatory compliance and providing transparency in an evolving market. By adhering to best practices, seeking expert guidance, and staying up-to-date with market changes, businesses can maintain accurate and defensible valuations. A proactive approach helps avoid legal complications and builds trust with investors, enabling long-term success in the Web3 ecosystem.