We do not yet know if the world’s most expensive NFT is really worth $69.3 million, but venture capitalists are convinced that the technology behind non-fungible tokens is worth billions.

Dealmakers did not come to this conclusion overnight. In fact, it was about seven years in the making, which is an eternity in the world of venture capital. VCs have been tiptoeing around the space since the first non-fungible token was minted in 2014. They invested no more than $145 million combined in a single year through 2020, according to data from PitchBook. That all changed last year, when investment in NFT companies skyrocketed, topping $4.6 billion, or about 11 times more than the previous seven years combined. The gold-rush mentality has continued into 2022, with nearly $900 million more going into NFT-related companies in January, PitchBook reports.

“What’s coming to light is some important dynamics that will make NFTs a more permanent fixture,” says Jordan Nof, general partner at Tusk Ventures, which has backed NFT company Dibbs, an online marketplace for buying and selling sports cards and other digital collectibles. “This is a solution to a lot of problems that broaden ownership of assets and isn’t limited to individuals with high net worth.”

“What’s coming to light is some important dynamics that will make
NFTs a more permanent fixture”
Jordan Nof
Tusk Ventures

“It did feel as if the GameStop phenomenon kind of set the tone at the start of the year, and NFTs were there to pick up the slack in the back half as attention span faded from meme stocks and accelerated into digital assets,” says Ryan Vaswani, a PitchBook analyst who specializes in crypto.

Vaswani notes that a confluence of factors led to 2021 being a huge year for NFTs, including the maturation of infrastructure, growing interest among retail investors and internet culture. NFTs went from a niche technology to mainstream seemingly overnight. Brands not commonly associated with crypto, including Visa, Nike and Clinique, have released NFTs in the past few years.

Athletes such as Tom Brady and Lionel Messi and music artists such as Justin Bieber and Snoop Dogg have also jumped onto the NFT bandwagon, minting their own tokens or making high-dollar purchases of digital tokens.

Digital artworks are selling at a blistering pace. About 2.9 million NFT artworks were sold as of February 4, according to Crypto.io, which tracks digital art sales. The highest price paid so far is $69.3 million in March 2021 for a piece of digital art called Everydays: The First 500 Days, by Mike Winkelmann, who goes by the moniker Beeple.

The recent spike in investment is also probably due to a bit of the FOMO that you typically see among VCs when their brand name peers start investing in something new. Among the familiar names seen on recent deals are Accel, Andreessen Horowitz, IDG Capital, Intel Capital, Kleiner Perkins, Lightspeed Venture Partners, Sequoia Capital China and Y Combinator.

Mainstream VCs took a while to warm up to non-fungible tokens, says Tom Schmidt, general partner at crypto VC Dragonfly Capital Partners, which has backed several NFT companies, including Element Market, a digital asset marketplace.

“In the very early days, there wasn’t that much to invest in, and the domain knowledge required to underwrite a lot of these investments was just high,” Schmidt says.

“There wasn’t a lot of traction yet and doing a few million dollars a day in volume just wasn’t super attractive.”

Andreessen Horowitz is the only brand name among the 10 most active investors in the space, according to PitchBook. The most active investors are names you’re probably unfamiliar with. At the top of the list is Hong Kong’s Animoca Brands, a developer of games and digital tokens that has raised more than $576 million in venture capital.

Animoca has invested in 59 NFT-related deals, far outpacing the second-most active investor, AU21 Capital of San Francisco, which has done 43 NFT deals. Rounding out the top five are Genesis Block Ventures of the Cayman Islands and the UK, with 35 NFT deals; Exnetwork Capital of the Philippines, with 31; and Andreessen, with 29, PitchBook
reports.

NFTs for beginners

Think of an NFT as a digital representation of something unique, such as a masterpiece by Picasso or the first edition of a comic book. Like bitcoin or other crypto assets, NFTs can be sold or traded. However, NFTs are non-fungible assets, meaning they cannot be exchanged with one another like bitcoin. Each NFT is the only one of its kind.

NFTs mostly run on the Ethereum blockchain, though other blockchains can also support the creation of the tokens. Once an NFT is made, its ownership can be traced through the chain, providing an easy way to check the provenance of an item. This unique and readily identifiable ownership record has attracted artists and traders, since proving the history and ownership of art has always been one of the most difficult parts of art collecting.

Like crypto enthusiasts, many of the first users of NFT are speculators who hope to buy low and sell high. NFTs are highly tradeable items, and venture capitalists have pumped hundreds of millions of dollars into marketplaces to allow people to create, sell and trade their NFTs. They have placed their biggest bet on NFT exchange OpenSea, which has raised more than $420 million to date, including $300 million in January at a post-money valuation of $13.3 billion, according to PitchBook.

Other NFT marketplaces include Rarible, which has collected $16 million; SuperRare, which has raised $10.4 million; and Nifty Gateway, which pulled in $500,000 before being acquired by VC-backed cryptocurrency exchange Gemini for an undisclosed amount in 2019. “We believe that both real-world and digital collectibles will migrate onto blockchains in the form of nifties,” Gemini co-founder and CEO Tyler Winklevoss said in a statement at the time.

VCs also see a big opportunity for NFTs to play a significant role in Web3, the metaverse and decentralized ecosystems. In an environment with no central lending system, an NFT provides a distinct representation of an asset whose ownership can be traced.

Follow the money

That is what led Australian venture firm Tenacious Ventures to lead a A$1.5 million ($1.1 million) seed round for Geora, a company that uses NFTs to link traceability data in agricultural projects.

Applications within the metaverse or the Web3 space have embraced the idea of NFTs as a means to transact with other users. Companies in this space include Bored Ape Yacht Club, which makes cartoon characters that are auctioned in exchange for cryptocurrency. Justin Bieber purchased a Bored Ape NFT – a cartoon image of a teary-eyed ape – for $1.29 million-worth of Ethereum in January. As of early February, Andreessen Horowitz was in “advanced talks” to invest in Bored Ape, which was reportedly seeking $200 million in funding, which could value the company at $5 billion, per Axios.

The biggest venture bets so far have been in companies that facilitate the creation or trading of tokens. Koodos, a New York-based company that allows people to collect and create internet content, has raised $2.02 billion from 18 investors, including Accel, First Round Capital and Tribe Ventures. Blockchain and digital collectible platforms Forte and Sorare have also attracted strong interest. Forte has raised a combined $955 million from 34 backers, including A16Z, Animoca, Battery Ventures, Canaan Partners and Coinbase Ventures, while Sorare has pulled in $738 million from 40 investors, including Accel, Atomico, Benchmark, Bessemer Venture Partners, IVP and Softbank Group, according to PitchBook.

Looking at NFT investment through the lens of familiar industries, the sector that has attracted the most capital is entertainment software, with $2.23 billion invested in 231 deals and a median deal size of $2.3 million, PitchBook notes.

The second-largest sector is financial software, with $1.17 billion invested in 273 deals and a median deal size of $2.25 million. Software development applications come in third, with $967 million going into 16 deals and a median deal size of $4 million.

Companies using NFTs in business/productivity software have also garnered lots of attention from investors, with 56 such deals done at a median deal size of $1.55 million. However, the overall dollar amount going into the space, $126.1 million, is substantially less than the other subsectors, according to PitchBook.

Of course, VCs would not be investing billions of dollars in NFT companies if they did not think they would multiply their investment by at least 10. “It’s the returns and the concept [of NFTs] that inspires this level of interest [from venture capitalists],” says Jesse Hurley, head of global fund banking at Silicon Valley Bank. “They see NFTs as where the next bunch of value creation can be, so it’s one of the hottest trends we’re seeing combined with something like ESG.”

Traditional VC interest in NFTs is also due to maturation of the companies in the market, says Schmidt of Dragonfly. Start-ups around NFTs have begun to mature and dial in more to what very fundamental investors want, he says.

“In the very early days, there wasn’t that much to invest in, and the domain knowledge required to underwrite a lot of these investments was just high”
Tom Schmidt
Dragonfly Capital Partners

“The fundamentals have changed from when we were investing in 2018 and 2019,” Schmidt says. “Often, the reality didn’t quite match the vision, but increasingly we’re seeing real user numbers, real traction, real AUM and real uses cases. It’s been heartening to see as a fundamentals-driven investor.”

Risks before reward

As with any emerging technology, maturity takes time, Schmidt notes.

So far, there have not been any major exits from NFT companies, although a few early players have been acquired by VC-backed businesses. Exits are expected to happen in several ways. One scenario involves consolidation, where a Web2 company such as Meta (owner of Facebook) buys an NFT company to bolster its position in Web3. Another scenario is that NFT companies go public. After Coinbase’s IPO, some top NFT projects may turn toward the public market or take advantage of launching a token on the blockchain to build liquidity.

One risk of investing in NFTs that VCs may not have considered is it may bring them into conflict with their LPs with ESG policies. NFTs are the opposite of clean energy investments. Ethereum, the blockchain on which most NFTs run, uses a proof-of-work model which requires tons of computing power and electricity – often generated from fossil fuels.

“I expect NFT companies that  arecentered around technology – rather than those that rely heavily on services – will scale more easily and efficiently”
Rico Mallozzi
Sapphire Sport

The developers of Ethereum have promised to move to a less energy-intensive process called proof-of-stake this year though its impact will not be immediately felt.

Another risk to consider is that gaming companies that have embraced NFTs may struggle to implement the new business model. PitchBook reports that there has already been some pushback from some gamers who disavow NFTs. Pilot use cases still need to translate into actual use.

Sapphire Sport vice-president and head of platform Rico Mallozzi notes NFT projects also face the same scaling challenges that befell legacy internet giants – and they come with an added layer of regulatory uncertainty because they involve cryptocurrencies.

“They [NFT companies] will still need to hire the best talent, cultivate a strong community and create defensible flywheels, but where it starts to diverge is around regulatory risks,” Mallozzi says. “As the industry matures, they will need to adapt to this evolving landscape. I expect NFT companies that are centered around technology – rather than those that rely heavily on services – will scale more easily and efficiently.”

Enter DeFi

The push into NFTs may be a sign that VCs are taking a greater interest in the broader sector of decentralized finance. DeFi is a concept that brings banking services, such as loans and payments, to a distributed ledger. Unlike today’s structure, where one entity handles all of that and keeps the information on the client, a decentralized finance structure keeps all of this in a blockchain, thus cutting down on data storage needs and fees. DeFi works across a blockchain and is governed by a set of code or protocols.

“[An NFT] is a vehicle that is just a lot more accessible to a mainstream audience versus an outright complicated DeFi application”
Amy Wu
FTX Ventures

FTX Ventures general partner Amy Wu says that even if the current trends do not move towards a greater interest in DeFi or Web3 right away, the rise of NFTs is at least encouraging some funds to reassess their approach to the crypto world. An NFT “is a vehicle that is just a lot more accessible to a mainstream audience versus an outright complicated DeFi application,” Wu says. “And now we’re seeing a rising number of NFT funds that are getting more sophisticated with how they’re looking and assessing which NFTs to back.

Schmidt notes that VCs are taking a cautious approach to DeFi because it is in a regulatory gray area and they may not have the domain knowledge needed to understand the nuances of some protocols.

For his part, Schmidt is not sure that the growing interest in NFTs means VCs are more broadly interested in DeFi. “Frankly, DeFi is still a little esoteric, and a lot of VCs maybe consider it a bit more niche,” he says. “NFTs are increasingly blending with more conventional consumer technology and have more mass-market appeal, so that’s attracted more conventional VCs.”

2.9m

Number of NFT artworks
sold as of February 4,
according to Crypto.io,
which tracks digital
art sales

Sapphire Sport’s Mallozzi says he does not believe NFTs are the endpoint of VC interest in investing in crypto. They are just one part of something that will continue to evolve.

“In my mind, there’s no end game. It’s a new dimension for us to live our lives in a different type of experience,” Mallozzi says. “When the internet was created, it was a new dimension in our lives, and then came social networks and online TV and all these things we couldn’t even imagine. We’re going to see that same type of thing when this market comes to fruition as all of these building blocks come together.”