Bringing foresight from IP strategies to risk management
Nobody knows more about buzz, or depends on it more, than the media and entertainment industry.
Yet amid the swirl of entertainment options, nothing seems buzzier in the industry right now than NFTs (non-fungible tokens). We see NFT “tutorials” from the likes of NBC’s SNL and Comedy Central’s South Park, and there are almost as many new NFTs as there are podcasts.
NFTs are sizzling hot, but is this market for real? Will it last? And most importantly, what do you need to do if you want to be successful in this space? Grant Thornton’s Digital Assets practice, immersed in the crypto world for nearly a decade, has been advising media companies and intellectual property (IP) owners looking to take the plunge — or even wade slowly — into the NFT pool.
It’s through this work that the firm has developed for IP owners a series of practical NFT market entry steps that Grant Thornton calls the “NFT Playbook.”
A review: Potential, success and risk
Let’s briefly level-set on what we’re talking about here. Markus Veith, Digital Asset practice leader with Grant Thornton, explained: “NFTs are fundamentally just another application of blockchain technology, which facilitates storing authenticated digital information across a network of computers. NFTs are blockchain-based ‘tokens’ like cryptocurrencies such as bitcoin, Ethereum and many more. The main difference between NFTs and other cryptocurrencies — as the ‘non-fungible’ label indicates — is their uniqueness. Most cryptocurrencies are interchangeable (or highly ‘fungible’), but each NFT has a unique identification and characteristic traits that mean it cannot be replaced by another blockchain-based token.”
This “uniqueness” helps explain the excitement within the media and entertainment world around NFTs. There’s only one Snoop Dogg, one iconic “The Godfather” film (okay, two, but definitely not three, films), one Call of Duty line of games, and one LeBron James. In the physical world, a rarified few own the rights to famous media brands. But NFTs present the tantalizing opportunity for individual fans to own a unique asset associated with beloved brands. In the immortal words of Britney Spears — or Seinfeld’s Frank Costanza — the question “You want a piece of me?” can be answered positively (and irrefutably) with NFTs.
“The main difference between NFTs and other cryptocurrencies — as the ‘non-fungible’ label indicates — is their uniqueness. Each NFT has a unique identification and characteristics that mean it cannot be replaced by another blockchain-based token.”
There is little doubt about the rapid transformation of this marketplace. Veith has been working with digital assets for nearly a decade, but he noted the stunning rise of NFT adoption in a relatively short time, especially when compared to the underlying blockchain technologies. According to NonFungible Corporation, a significant repository of NFT market research, NFT sales on the Ethereum blockchain amounted to just under $1 billion in the second quarter of 2021, an increase of 105 times the $9 million in sales in the second quarter of 2020. In a Variety special report on the NFT market, largely drawn from NonFungible Corporation data, entertainment-related collectibles are by far the largest source of these sales, accounting for more than four times as many sales as art-related NFTs. And these numbers don’t include sports sales, such as NBA Top Shot.
Although consumers can own a completely unique digital “piece” of almost anything now, questions abound. What exactly are these companies selling to the consumer? What is the value of these non-fungible tokens to the IP owner? Are NFTs a legitimate way to “crowdsource” new content production? And for companies that dive into NFTs, how do they ensure that their brands don’t get tarnished in the digital ecosystem? As with most technology adoption, the devil is in the operational details.
Just one white-hot example of media content NFTs is represented in the Bored Ape Yacht Club, controlled by a company called Yuga Labs. This is a collection of roughly 10,000 unique digital collectibles that now has a market cap of $3.5 billion. It’s easy to imagine taking these characters into animated TV series, motion pictures, fanboy podcasts and merchandise sales, with the development financing largely accessible from the sales of these NFTs. It sounds a lot like an old-fashioned studio, doesn’t it?
Grant Thornton NFT Playbook components
The content roadmap: Defining what you want to do in NFTs
In any trending area of media and entertainment, there is great temptation to jump on the train before you know your destination. The dangers of such an approach have been well-documented. Most major newspapers were so excited about the potential to expand their audiences via the internet that they distributed their content for free in the 1990s. Rather than complement traditional circulation and ad revenues, this move contributed to their demise. It took years before The New York Times, among others, established a digital paywall for their content. In another telling case, News Corp jumped into the not-yet-named social media world when it bought MySpace for $580 million in 2005; two years later its valuation had risen to $12 billion. But a mere four years after that, as Facebook began to dominate as a content-distribution platform, News Corp sold MySpace for $35 million. Such changes of fortune create corporate whiplash. As such, these cautionary tales provide useful lessons for thoughtful advanced planning before venturing into the NFT game.
Veith delineated what he referred to as two early models for how IP owners are constructing their entry into the NFT market. The first is what the Grant Thornton team calls the “Lamborghini” targeted approach. Earlier this year, the Italian luxury car manufacturer released a limited set of five NFTs in a project they call “Space Time Memory.” This high-end artistic venture consists of five different glossy photographic illustrations of a Lamborghini Aventador Ultimae breaking up in space with Earth as a backdrop. The NFTs can be accessed only from a QR code on physical carbon “keys” that were previously sent to the International Space Station. Even if the NFT market proves a bubble, Lamborghini is hedging its bet here, presuming that these rare physical artifacts will retain some tangible value on their own.
Veith identified a second, more varied, mass-market approach to NFTs as the “Theme Park” strategy. In this scenario, the IP owner (or its licensee partners) set up a walled garden, whereby consumers can purchase a variety of NFTs and sample a mix of experiences and merchandise linked to those unique digital assets. DC Comics, home to superheroes such as Batman, Superman and Wonder Woman (and now part of Warner Bros. Discovery) jumped into NFTs in this fashion last year. The company promotes its films, sells digital and physical merchandise, and offers behind-the-scenes superfan experiences through DC FanDome. Its next planned offering is 200,000 Batman-related “Bat Cowl” NFTs to be sold for $300 apiece. The quick math on this nets $60 million into DC Comics’ coffers, which has to be an intriguing proposition for Warner Bros. Discovery, considering that only a handful of films per year earn that much. But will consumers deem these NFTs “worth it”? The “real” value of these new tokens will lie in the eye of the NFT holder.
“For every company, the calculus for entering the NFT market will be different. Most importantly, where do your strategic goals lie on the continuum between driving maximum revenues and prioritizing brand reputation and long-term asset building?”
Howard Homonoff, Grant Thornton senior advisor in U.S. Media and Entertainment, said: “For every company, the calculus for entering the NFT market will be different. What assets do you have to exploit? What physical assets and live experiences could be linked to these NFTs? Do your properties fit market demands? In benchmarking your competitors, which are having success and why? And most importantly, where do your strategic goals lie on the continuum between driving maximum revenues and prioritizing brand reputation and long-term asset building?”
Cataloging an inventory of IP rights: Understanding what you can do in the NFT market
No amount of strategic planning can help if a company doesn’t have the rights to exploit IP in an NFT environment. Every IP owner needs to ensure it has the most up-to-date picture of its owned and/or licensed IP rights. Until recently, it was common practice — even at established film studios — to pore through stacks of documents to ensure ownership before developing a strategy for exploiting their content library online. Industry leaders need an understanding of these rights, and they must be confident they have the most accurate picture.
Understandably, a company would start with those entire works it controls whether in film, TV, recorded sound, or script libraries. But the largest potential of NFTs may be as derivative works, exploiting the subparts of a larger work. Accordingly, leaders need to examine whether the company has the rights to all associated images of a work. Did you buy those rights out from the creative artists involved? A company may control a film or TV series but may not control characters licensed from elsewhere. Do you have rights to the names, images, and likenesses of all on-screen talent? Do you have rights to the underlying music of another work? Are you able to use images of commercial products in your work? Are the trademarks actually under your control? What geographic restrictions relate to your ability to exploit this IP?
And you’ve also got to know who your partners are in any given rights-exploitation gambit. Even if you have the sole right to make these decisions, you need a comprehensive picture of your financial participants (and what they are owed), in terms of gross receipts and profits, as well as auditing and reporting obligations to those participants. Companies don’t want to find themselves in a litigation quagmire because they failed to account for the rights of actors, directors, producers, or content licensors, or because they misunderstood how their IP is being used within a given set of NFTs to begin with.
“As leaders examine their financial operations, they need to learn what NFT (and crypto) assets the company has. You’ve got to account for these assets on your books. NFTs are digital assets, but the need to account for them is there all the same.”
Retrofitting your business infrastructure: Running a real business
As exotic and extraordinary as the NFT market seems to be today, in the end, leaders must approach it as a business with familiar financial and operational infrastructure needs. David Zaiken, Grant Thornton’s Media and Entertainment International Tax Services leader, said, “As leaders examine their financial operations, they need to learn what NFT (and crypto) assets the company has.” Zaiken also compared the NFT market to the very analog dress business: “Whether you manufactured dresses and are holding inventory or just purchased them at wholesale, you’ve got to account for these assets on your books. NFTs are digital assets, but the need to account for them is there all the same.” They also need to assess existing processes and perhaps establish new processes to update that inventory regularly and accurately. Additionally, Marc Skaletsky, leader in Media and Entertainment Tax Services, pointed out: “There is a desperate need to catalogue and identify each individual NFT transaction and bucket of rights for global and specific jurisdictional tax considerations.”
Consider these basic decision-making questions:
- If you are creating new NFTs for sale, do you have the right capabilities in-house and if not, who are the right partners?
- In the deal realm, whether purchasing a company with NFT assets or selling your own company, including an NFT portfolio, are you confident of how you’d value these assets in the context of that proposed transaction?
- If you are accurately recording your NFT assets, what kind of value are you assigning to them? And how do you go about assessing the fair value of these one-of-a-kind assets in a market that fluctuates as wildly as this one?
- Have you differentiated between the tax rules and the financial statement/accounting rules, including reporting?
- Most tax systems, including those in the U.S., do not yet require the asset owners to mark NFTs to market, but when that happens, would you know what you have?
- Beyond your tax obligations, what happens when the SEC steps in and demands that public companies report on these assets and transactions in their financial statements?
Proactively managing risk: Assessing vulnerabilities from financial, legal, reputational and regulatory standpoints
The risks associated with NFTs aren’t unfamiliar to complex and emerging media businesses, but even in early market development, NFTs bring unique risks to the fore. Companies can expose themselves to litigation, including class action suits, if they release NFTs in the market and don’t make clear to purchasers precisely what they’ll be purchasing. A company and its valuable IP brands run significant financial risks from being in business with poorly vetted partners and offering products whose brand usage is unauthorized.
Another aspect to be considered is reputational risk. A media and entertainment company that sold NFTs will continue to be associated with that token even if out of their control. Any misuse or illicit activity associated with it will cast a shadow on the company holding the IP rights.
“As media and entertainment organizations integrate digital assets into their IP portfolios, they should expect that they will need to demonstrate the efficacy of the controls they have to detect, minimize and report on fraud related to their NFT assets.”
Johnny Lee, Grant Thornton’s Forensic Technology & Digital Assets leader, noted, “The myth that cryptocurrency is nothing but a playground for criminals is demonstrably false.” At the same time, criminal fraud in misappropriation of corporate assets is an all-too-real possibility. Consequently, forensic specialists, such as Lee’s team, have developed frameworks to trace and recover digital assets, leading to meaningful results for organizations that are victims of fraud and digital asset theft. Lee explained: “As media and entertainment organizations integrate digital assets into their IP portfolios, they should expect that they will need to demonstrate the efficacy of the controls they have to detect, minimize and report on fraud related to their NFT assets.”
Assessing and managing each of the top risks associated with NFTs — legal, financial, reputational, and regulatory — converge when it comes to having proper financial controls in place. Such controls require a mix of the trained staff, auditable processes, and optimum technology. Even — perhaps especially — if a company isn’t directly operating an NFT business but simply licensing its portfolio for others to buy, sell, and trade on its behalf, leaders need to assure licensees that both contractual terms and business processes are in place to protect against unreasonable risk for the IP owner.
Cybersecurity risks likewise must remain top of mind in this space. Although it didn’t directly involve a theft of NFTs, there may be no starker example of the cyber risks in NFT and crypto than the recent case of Sky Mavis’ Axie Infinity. Described by one industry observer as a “Pokémon-style NFT battler,” the gaming platform has been viewed as “one of the biggest ‘success’ stories in the world of crypto gaming.” And Axie Infinity, through its tech partner Ronin Network, was the victim of a hacker’s theft of over $600 million in crypto assets. While blocking all hacking isn’t a reasonable expectation, any company, especially a public company, has the obligation to minimize its potential exposure to theft and to maximize its responsiveness.
As if this weren’t all complex enough, the regulatory landscape remains almost entirely unformed here. The Biden Administration just recently released an executive order on “Ensuring Responsible Development of Digital Assets,” but we await crucial details and clarity — whether NFTs are securities that must be registered with the SEC, which agencies will actually craft regulations, and what kinds of legal actions companies may initiate when seeking the enforcement of their rights. Such decisions will have a significant impact on the future trajectory of the NFT marketplace.
Media organization leaders already involved in the business of NFTs or considering becoming involved will set themselves up for success if they approach it with foresight. More specifically, leaders should focus on defining what they want to do with respect to NFTs, retrofitting their business infrastructure accordingly, and proactively managing legal, financial, reputational and regulatory risks.
For insights on NFT asset tracing and recovery, see “The formula for digital asset recovery.”
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