Token Valuation 101: Why you need a valuation when using tokens as compensation

At Magna, we’ve been working with dozens of Web3 Founders over the past year, and we get similar questions all the time about token valuations. Why do I need to get one? When? And what do I need to know about it?

So, to make things easy, we decided to list out the 10 most common questions we received regarding token valuation that we tackle in this blog post. We'll cover:

  1. What is a Token Valuation?
  2. Why is a token valuation needed?
  3. When is a token valuation needed?
  4. What are the factors that go into a token valuation?
  5. How often should a project revisit its token valuation?
  6. When do projects usually get their first token valuation?
  7. Do you need a token valuation if the token hasn’t been minted yet?
  8. Should you get an equity valuation separate from your token valuation?
  9. What if the token is trading on an exchange, is a token valuation still needed?
  10. Who should you get a token valuation from?

We’ll also be holding a Token Valuation Webinar with our friends at Teknos Associates. Fill out this form to get an update when that is scheduled. We'll be giving an overview of all things token valuation-related and answering all of your questions live.

And without further ado, let’s get to it!

This article is provided for informational purposes only and is not intended to be construed as legal, financial, or tax advice. Readers should not rely solely on the information presented herein and should consult with their own legal, financial, or tax professionals regarding their specific situations. The author(s) and publisher make no representations or warranties concerning the accuracy or completeness of the information contained in this article. Reliance on any information provided in this article is solely at your own risk.

What is a token valuation?

A Token Valuation is a determination made of the value of a particular token. This valuation is usually carried out by an independent third party appraiser, a token valuation firm that specializes in the valuation of digital assets. 

This valuation firm will determine a fair market value for the total supply of tokens that are planned to be issued (called the Fully Diluted Valuation) as well as a value for each individual token.

A Valuation Report is typically written that outlines the rationale for how the valuation was determined. 

As an example, for a token contract with a total supply of 1 Billion tokens and a Fully Diluted Valuation of $1B, the value of each individual token would be $1.

Why is a token valuation needed?

Token valuations are essential since they help companies stay compliant with tax and financial reporting regulations.

If you’re thinking about using tokens for employee compensation (as payroll or bonuses) or deferred compensation (as vesting tokens, future token interests, restricted token units, or token options), you need to think about getting a token valuation.

To be more precise, at the time of each major taxable event involving your tokens (whether at the time of grant, vest, or option exercise), a determination of the Fair Market Value (or FMV) of the tokens is needed to determine the value that is subject to tax by the IRS.

There are other regulatory needs for token valuations including to determine adherence to volume limitations on grants or sales, for accounting purposes, and for gift and estate purposes, but taxes on token compensation are particularly top of mind for companies distributing tokens as well as employees receiving them.

One important thing to note here: Tax concerns usually come into play for US tax residents, which includes people that are living in the US or US citizens globally that have US-sourced income.

When is a token valuation needed?

As mentioned above, a token valuation that is current and valid is necessary at each key taxable milestone related to token compensation or deferred token compensation to ensure that any income or capital gains/losses can be correctly accounted for.

The exact taxable events depend on the structure of the compensation, but here are a couple of examples of times when a valid token valuation is needed:

  • When tokens vest: By default (without an 83(b) election), tokens are taxed on their Fair Market Value (FMV) at the time of vesting.
  • When granting vesting tokens: If an 83(b) election is filed, the recipient is taxed up-front at the time of grant instead of at the time of vesting.
    An 83(b) election is usually preferred if the token valuation is low at the time of grant and is expected to increase. Stay tuned for a separate post about 83(b) elections.
  • When granting token options: In most cases, token options need to have a valid strike price, determined at the time of grant, that is not below the FMV.
  • When exercising token options: Token Options are usually NSOs (Non-qualified stock options), and taxed at the time of exercise on the spread between the exercise price and their FMV at the time of exercise.
  • When tokens are paid as a bonus or through a token payroll: Those tokens are subject to tax based on the FMV at the time of the payment.
  • When Restricted Token Units are settled: When RTUs vest, the company can delay settlement. Income is recognized at the time of settlement equal to the FMV of the settled tokens.
  • When Future Token Interests are issued or vest: Depending on how FTIs are structured, an FMV is needed to determine the value at the time of grant or vesting (depending on whether an 83(b) was filed).

What are the factors that go into a token valuation?

Or said differently: how can someone define the value of my token?

Token valuations are usually commissioned from third party experts that use sophisticated methodologies to arrive at a Fair Market Value for the tokens.

These methodologies usually take into account various factors such as:

  • Stage of development
  • Functionality and usage of the token
  • The value of the token’s utility in use
  • Trading activity (including as market price, trading volume, depth of liquidity, price volatility)
  • Primary or secondary sales
  • Comparable token valuations
  • Lockups or other transfer restrictions
  • Economic interests the tokens provide

These factors are often detailed in a token valuation report that explain how the firm arrived at the particular valuation

Companies will usually proactively grant vesting tokens early on in the token’s life, when it is worth very little and before there has been any trading activity or major launch that could cause the token’s value to increase significantly.

Another Pro Tip

When determining the valuation of a employee token grants, valuation firms might take into account the lockups on those tokens to be able to justify a lower value for them relative to investor tokens (Which may have lesser restrictions) or tokens in the open market (which may have no restrictions).

How often should a project revisit its token valuation?

Because the above token valuation factors can change over time, token valuation reports will usually include a note that the valuation is valid up until a certain date or until a material event occurs. 

Due to the fast-moving nature of the digital assets space, token valuations are usually only valid for a few weeks or months after the initial valuation report is issued (in contrast to equity 409A valuations, which are typically valid for 12 months).

This is typically in the form of a guarantee where firms will stand behind their valuation and defend it if it is later questioned by regulators, but only if the valuation is used within that window of validity.

When do projects usually get their first token valuation?

Projects usually first commission a token valuation when they are getting ready to grant vesting tokens to founders and early employees.

Commonly, projects will mint a token, do nothing with it (i.e. no trading activity or token sales, they just sit in custody), and then commission a token valuation when the token is worth little-to-nothing.

This allows for a favorable Fair Market Value determination whereupon a founder can usually file an 83(b), pay a relatively low tax bill, and enjoy the appreciation in the value of the tokens as they vest without paying taxes until subsequent sales.

Do you need a token valuation if the token hasn’t been minted yet?

Token Valuations are usually done to assign a fair market value to tokens that have already been minted. Most of the taxable events listed above require a fair market value assigned to the underlying tokens. 

There are however novel legal structures that can allow companies to grant deferred token compensation. One such example is the Future Token Interest (FTI), a structure that grants vesting interests in tokens that have not yet been minted. Some law firms structure FTIs in a way that they argue is compatible with 83(b) elections so that founders can commission a token valuation, grant FTIs, file an 83(b) election, and recognize the tax based on the value of the FTIs at the time of grant.

Should you separate your equity valuation and your token valuation?

It is usually wise to get a token valuation that is separate from a valuation of the project’s equity. Why, you might ask?

Because projects often launch tokens years into their existence, during which time their equity may have appreciated due to equity funding rounds or increased company revenue.

See, when the token is minted, the value of the token itself is often close to zero.

Indeed, it at this point, immediately after minting, the token often:

  • Has no direct sales
  • Is subject to lockups
  • Has no trading activity
  • Gives holders no economic rights
  • Hasn’t yet demonstrated a value in the market

Getting an independent token valuation that takes these factors into account will arrive at a favorable valuation of the token for the early token grant recipients.

What if the token is trading on an exchange, is a token valuation still needed?

Even if a token is actively trading, the fair market value of the token may be deemed to be lower than the market price because of low liquidity or transfer restrictions that apply to particular vesting/locked tokens.

If a project is trading with significant depth of liquidity and a majority of tokens released on the market, with direct stablecoin trading pairs, it may perhaps forgo a token valuation and instead use the spot price or a trailing multi-day/week/month average price for fair market value determinations (depending on the advice of its accountants and lawyers!)

Who should I get a token valuation from?

There are many highly competent firms out there – just make sure they specialize in valuations of digital assets.

We have often introduced our clients to Teknos Associates, and have also heard good things about Redwood Valuation. Both firms specialize in digital asset valuations, are widely used by crypto startups, and are well-recommended by law firms.

Another Pro Tip

Speak with your lawyer — since law firms usually have valuation firms that they recommend that are familiar with the particular legal structures used by that law firm.

Closing Thoughts

And here you have them, all the answers to the most frequently asked questions regarding token valuation.

If you're interested in our Token Valuation webinar, fill out this form to register your interest and updates when it is scheduled.

If you still have further questions, make sure to shoot us a DM on Twitter, or an email to hello@magna.so. And if you have feedback or thoughts on this article let us know and we're happy to make additions or updates!

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