NFT games and the Metaverse - by AG and DarkForestCapital - MetaPortal https://metaportal.substack.

com/p/metaportal-research-nft-games-and

MetaPortal

NFT games and the Metaverse

AG and DarkForestCapital
May 20 5 4

As an FYI, we will use the term "NFT games" throughout this article. NFTs have recently
entered mainstream consciousness, and the term is easier to understand than blockchain
games.

Why video games?

So why are we talking about video games at all? Because they are the most obvious gateway
into the metaverse. While traditional games like Roblox and Fortnite don't Ft our
characterisation of the metaverse, NFT games are much closer to it. They exhibit things
like ownership, identity, and Fnancial value while preserving the self-sovereignty of the
players.

In our intro post, we also talk about metaverse as the future of work. The Frst sign of that is
the emergence of play-to-earn games as a viable economic model, particularly in the
frontier and emerging countries.

Lastly, drawing parallels between the incumbent gaming companies and their NFT-based
disruptors allows us to build mental models around valuations for the NFT games. If Roblox
is valued at $43 billion, how much should investors pay for Axie InFnity, for example?

© 2021 DarkForestCapital. See privacy, terms and information collection notice

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One of the fascinating dynamics in gaming has been the evolution of the business model.
With arcade games, we had the pay-per-use revenue model. Then, in the 1980s, the model
shifted to pay-per-copy. Once you bought a copy of a game, it didn't matter if you played 1
hour or 100 hours. During this period, games were sold oUine through retail outlets and
revenue was generated upfront with limited monetisation beyond the initial sale. 

In the late 1990s, distribution began to shift from brick and mortar to digital. However, it
wasn't until 2014 that digital sales Frst overtook retail distribution, making up 52% of all
sales. It became easier to build and distribute video games which led to the rise of free-to-
play. This led to the evolution of the business model from pay-per-copy to subscriptions,
followed by microtransactions and downloadable content (DLC) in the early 2000s. In the
2010s, games began to experiment with loot boxes and season/battle passes to drive ongoing
revenue and increase its stickiness.

Today, the most prominent games generate nearly all of their revenue from ongoing
transactions instead of an up-front payment. For example, a game like Roblox, with 200
million monthly active users (MAUs), generates most of its revenue through the sales of its
in-game currency, Robux.

"We generate substantially all of our revenue through the sales

of Robux to users. Users can spend Robux to purchase access to

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experiences, enhancements in experiences, and items in the Avatar

Marketplace. Robux are available as one-time purchases or monthly
subscriptions." - Roblox S-1 filing

This evolution in the business model means that the Fnancial success of a game now
depends on ongoing engagement. And excellent graphics, characters and storylines are not
enough. First and foremost, games have to be fun. They have to be social, and they need
network eaects. Minecraft and Roblox look like they were developed in the early 2000s. Yet,
they have close to 350 million MAUs combined.

Analysing the incumbents

To understand the beneFts and the potential of NFT games, we Frst need to take a closer
look at the incumbents like Roblox, Fortnite and Minecraft.

Roblox

Roblox is a game creation platform powered by user-generated content (UGC). Through

Roblox Studio, it gives developers the tools to build and publish experiences and content for
the Roblox virtual world. Anyone can then experience that content by using Roblox Client.

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Roblox is quite popular. Their platform has over 18 million experiences, boasts 43.3m daily

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active users (DAUs) and 200m MAUs. It has beneFted signiFcantly from Covid-19. Around
60% of its users are under 13 years old, and lockdowns meant more time spent gaming.

Roblox eywheel centres around UGC. High-quality content attracts more users to the
platform and drives engagement. Engagement then leads to more Robux, the in-game
currency for the platform, being spent, which eventually Fnds its way to the developers.

Despite its popularity, Roblox is still losing money. In Q1 2021, Roblox Corp reported a net
loss of $130m despite $387m in revenues. And while revenues are growing, up 140% over Q1
2020, so are the losses. The major expense items for Roblox are third-party payment
processing fees that they pay to the likes of the App Store, developer exchange fees and
infrastructure costs. There are other costs, like personnel costs for its 1,054 employees.
While Roblox doesn't have any earnings, the market seems to appreciate its vision and the
top-line growth, valuing the company at $42 billion at the time of writing. This is up from
$2.5 billion in 2018 before Roblox went public.

Fortnite

Fortnite is, in some ways, similar to Roblox. Although as part of Epic Games, its Fnancials
as a standalone business are hard to estimate. We do know, though, that over 2018 and 2019,
Fortnite brought in $9 billion in revenue for Epic. In April, Epic Games raised $1 billion at a
valuation of $28.7 billion. 

Fortnite's MAUs are lower than Roblox or Minecraft, at around 80 million, compared to 200
million and 140 million, respectively. At the same time, users spend approximately 50%
more time in Fortnite. It also holds the record for peak concurrent users, at 12 million,
triple the 4 million that participate in Roblox live events. Much of this success comes from
Fortnite's role as a social hub with its Creative Mode, Party Island and events like the
Marshmello and Travis Scott concerts.

Traditional games vs NFT games

We believe that NFT games are superior to traditional games in almost every way. In fact,
their only disadvantage at the moment is the quality. However, as we mentioned above,
successful games are about fun, social experiences and network eaects, not necessarily
quality.

And the quality gap is closing. There are two main game engines for building games, Unreal

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from Epic Games and Unity from Unity Technologies. Enjin platform, for example, has
software development kits (SDKs) available for the Unity engine, and my understanding is
that Unreal is being worked on as well. And the Sandbox game developed its custom Voxel
Engine on top of the Unity engine. So the tooling is getting there. We tend to agree with
Kieran, one of the founders of Illuvium, once quality catches up, it's truly game over.

Kieran
@KieranWarwick

The only thing stopping DeFi gaming going to Pluto is the availability of
AAA games but that is to be expected given the infancy of the space.
Once gamers start experiencing the same quality they love with the
added ability to earn, it’s game over to traditional gaming.
May 15th 2021

12 Retweets 102 Likes

So let's talk about some of the advantages of NFT games. We'll use Roblox as an example.
As a publicly-traded company, it's much more transparent than Fortnite or Minecraft.

Economics

Roblox hasn't made money since the company was founded in 2004. It has 1,054 employees -
that's about 23% of revenue. It pays roughly 25% of its revenue to payment processors, 30%
to developers and 17% for infrastructure. There are other costs as well. When the equity
market ceases to be distorted by unlimited liquidity and zero rates, this will no longer be a
sustainable business model.

NFT games have very diaerent economics. The headcount is much lower. Illuvium has
about 40-50 people working on it. Sky Mavis, the core team behind Axie InFnity, has 30 and
Sandbox is at about 100. There are no payment processors – the blockchain handles that
part. Developers and creatives monetise directly, keeping close to 100% of proFts. At the
same time, protocols make money on fees from primary and secondary sales on their
marketplaces, things like breeding fees in Axie InFnity or land sales and potentially ads. 

Fundamentally, NFT games have a better business model. Well designed token economics
allow NFT game protocols to bootstrap adoption by incentivising both players and
developers. Protocols make money on the activity between those parties, with signiFcantly

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lower costs and overhead. Everyone wins.

Ownership

Another interesting diaerence is economic ownership. Roblox, for example, compensates

developers with Robux, its own currency. Roblox Corporation sets the rate at which Robux
can be redeemed for Fat and can change it at "its sole discretion". The last time I checked,
the exchange rate was 1 Robux to $0.0035. 

As a side note, Roblox makes almost all of its money on selling Robux to users. In the S-1, they said
that the "average price for a Robux for the nine months ended September 30, 2020 was $0.01".
That's about 2.85x what Roblox pays developers for their Robux. 

Robux is simply an in-game currency. It has no claim on proFts of Roblox Corporation and
no voting rights. So there is always going to be tension between shareholders and
developers. Compare that to NFT games, where developers get better terms on
compensation and own the upside in the game's success. They also have a say in the
development of that game via voting rights.

There is also ownership of the in-game assets. NFTs allow for authenticated ownership of
digital goods. From a player's perspective, it turns in-game assets from a purely casual
purchase into an investment. NFTs allow thriving in-game economies in the public sphere,
not in grey markets. And thriving economies attract more users and developers and
generate revenues for the NFT gaming protocols. That's the same eywheel as Roblox but
with much better aligned Fnancial incentives. 

NFTs also enable one of the most powerful concepts in NFT gaming – play-to-earn. With
most population growth occurring in the frontier and emerging economies across Asia,
Africa and South America, play-to-earn will be huge. It's also interesting that this market is
relatively untapped by the incumbents. For example, the US, Canada and Europe make up
about 60% of Roblox's DAUs and an even bigger share of bookings. Play-to-earn will
activate those younger and growing populations in emerging countries.

The Jiho
@Jihoz_Axie

Why are we here?

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Is it just to make money? That can't be right.

This movement is about creating freedom. Let's never forget this.

Watch this documentary whenever you need to find your north star again.
I know I will.

youtube.com/watch?v=Yo-BrA…

May 13th 2021

74 Retweets 262 Likes

Valuations - bringing it all together

The last question remaining is what does all this mean for valuations of the NFT gaming
protocols? Axie InFnity, for example, has a fully diluted valuation of $1.2 billion, while
Sandbox is valued at $800 million. Are these valuations fair on a relative basis?

We believe that the valuation gap between traditional gaming companies and NFT gaming
protocols will narrow considerably over the medium term.

Axie InFnity currently has about 50,000 DAUs, up more than 50% in less than one month
following migration to its own Ethereum sidechain, Ronin. Over the last 30 days, trading
volume on the Axie marketplace was $16.8m, up about 160%. The protocol charges a 4.25%
fee on marketplace transactions. Since the Ronin migration on April 28, the protocol
generated 191 ETH from marketplace fees or about 3,000 ETH annualised. Breeding fees
over the same period netted 88,500 AXS, or 1.5m AXS annualised. Even at current prices,

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that's close to $15m in annual revenue and growing. The breeding fee was just increased
from 1 AXS to 2 AXS, potentially adding another 1.5m AXS to the Treasury.

Axie Infinity
@AxieInfinity

We have adjusted the breeding fees based on data gathered since the
release of Ronin!

• It now costs 2 $AXS per breed.

• $SLP costs per breed have been increased by 50% across the board.

May 20th 2021

58 Retweets 241 Likes

As hard as it is to comprehend, Axie is already more proFtable than Roblox. Value accrual
in a token-based model is essential, and token economics for AXS are well suited to
capturing that value. We believe that play-to-earn dynamics will continue driving
signiFcant growth in DAUs and marketplace activity, leading to a higher valuation.

Sandbox is a bit harder to analyse given the game is not live yet. However, we know that the
oa-chain game generated 40 million downloads and, at its peak, had around 2.6m MAUs.

When it comes to the game itself, Sandbox is much closer to Roblox than Axie. It has a

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similar set of tools with Voxel Editor, Marketplace and the Game Maker for developers.
Given the superior incentive structures and play-to-earn mechanics, it's feasible that
Sandbox will capture some activity, and therefore value, from both Roblox and Minecraft.
Economic capture for the SAND token comes from marketplace fees, set at 5% of
transaction size. Given the open and transparent in-game economies, if Sandbox reaches
anywhere near its oa-chain MAUs, the SAND token should accrue signiFcant value.

Summary

To sum things up, we see a high probability that NFT games will meaningfully narrow the
valuation gap with traditional gaming companies over the medium term. Furthermore,
play-to-earn dynamics will bring in an entirely new cohort of gamers. As the adoption of
NFT games improves, driven by play-to-earn, developers will follow due to better alignment
of incentives. When AAA studios come in, the quality of NFT games will improve,
prompting yet another round of user growth. It's challenging to see traditional games
competing over the long term due to inferior business models and disadvantages of
centralised systems more broadly.

This means that even at current valuations, tokens like AXS and SAND are good medium-
term to long-term investments. We believe that other tokens in the gaming ecosystem will
also beneFt as the rising tide of user adoption lifts all boats.

There are some risks, of course. The ability of teams to execute, scaling dipculties leading
to high barriers to entry and inadequate value capture, just to name a few. But the risk-
reward is asymmetric in our view and worth taking.

jeet.lions@gmail.com

5 4

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10 of 11 07/29/2021, 2:38 p.m.

NFT games and the Metaverse - by AG and DarkForestCapital - MetaPortal https://metaportal.substack.com/p/metaportal-research-nft-games-and

meta_w Jun 12 Liked by AG

My two thoughts are: I must be a long time out of gaming, and why is this space not huge
already?!
1 Reply

1 reply

Static121 Jun 3 Liked by AG

Fantastic write-up
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