Investing in Lightning Network Startups. Part 2
This is the second part of the series of articles based on the podcast by Kevin Rooke with Oleg Mikhalsky. You can watch the full podcast here.
In this part we mostly focused on funding and building Lightning projects. You will also find out more about bottom-up and top-down approaches to Bitcoin adoption with such examples as El Salvador and Twitter. In the end, there is a useful tip about how to evaluate the progress of Lightning. A little hint: number of nodes and capacity are not the only metrics for that.
Kevin Rooke: Some other early stage smart contract platforms have 10 times higher valuations than Lightning companies at the same stage. Do you think that Lightning companies are appropriately valued today?
Oleg Mikhalsky: The economics of valuation in most token-based projects works in a very simple way because there are also tokens allocated to investors with a lock-up period. Investors typically can sell a part or all of their tokens after the lock-up expires. They usually sell a part and get back their liquidity with a desirable upside and keep the remainder in tokens. Because of this artificial “early exit” opportunity there is an incentive for investors to get into these overvalued or highly valued startups, because they can quickly get their money returned an even with some upside from their startup investment and at the same time retain a portion of token for some potential future growth. Sometimes also marketing, PR and hype create misallocations of capital. This has happened in the past in software industry already. Because of the sheer abundance of capital, there is a lot of misallocation of capital in the VC space, even outside of the high-tech and blockchain space [This article was written before the cool-off in VC started during May-June 2022].
Valuation is actually a product of supply and demand. The Bitcoin and Lightning space is still not over-invested and it’s reasonably good, because it doesn’t create distortions, unhealthy ecosystems and hypes. I think above all relationships within the players in the ecosystem are valuable. But valuations are just kind of a “product” or a way to execute on a relationship. It’s just important to find the right investors, to have a meaningful conversation about the valuation and come to something that is reasonable. So valuations have reason and there needs to be a meaningful dynamics of valuation growth over the following rounds, so that the startup can continue raising in a reasonable way with other external investors.
Kevin Rooke: Do you think that there are enough founders building on Lightning for you to come in and fund the right ones and build those relationships? If not, how do we get more founders excited about building on Lightning?
Oleg Mikhalsky: We would love to see that more founders start building on Lightning every day and maybe even better if more founders would be coming from different ecosystems with different experiences, for example, from the podcasting ecosystem like Adam Curry. We’re already seeing founders from the gaming industry who are very excited to start building on Bitcoin and Lightning and we are working with a few of them. Founders from a specific industry bring expertise as to how this exact industry works and how to be successful in it. I think it’s important for founders to know what kind of problems exist in specific industries. But also right now we’re still building a lot of infrastructure and it’s critically important to be a founder who is “born into Bitcoin and Lightning”, who really understands the fundamentals and is hands-on with the technology stack.
We welcome both types of founders and expect to see more of them entering the space, especially as Bitcoin and Lighting narrative gets elevated to the enterprises level like in case of Twitter and Cash App and also to generalist venture capitalists, and to particular industries such as payment, gaming and digital content for example. The further a company progresses in its lifespan, the span of attention of each of the original founders shifts, you really focus either on the business side or you dig deeper into the technical side. So, a healthy combination of business focused and technically focused founders is definitely something that can bring a lot of value, diverse experience and opinions to the ecosystem in the times to come.
Kevin Rooke: How do you convince a founder that Lightning is the technology on which they should build a project rather than another cryptocurrency or simply sticking with fiat?
Oleg Mikhalsky: It can be very individual because it just depends on where the person is on the spectrum of all the aspects of the ecosystem. Bitcoin is a multi-disciplinary phenomenon — it has a technology, a monetary system, regulation, geopolitics, innovation and disruption, as well as a social phenomenon. So, I don’t think there is a silver bullet. But the promise of Bitcoin is a decentralized distributed all-inclusive monetary system that is very easy for a person to onboard and transact at low cost without counterparty risk. I think this is really the big promise that no other technology offers in this space. In some of the technology stacks out there , it’s not really clear to me in particular how the marketing claim is actually achieved with technology means. And it’s a dangerous gap. But maybe it’s actually a gap in my understanding, and that’s why we don’t invest in other ecosystems.
To your question, I would really ask the person to explain how they’re going to achieve what they’re claiming to build using that specific blockchain or technology. I bet in most cases the person will not be able to really provide an in-depth technical answer on how that thing is actually going to work there to deliver the promise of what is being built. This is the vector of attack. We don’t need to build everything on Bitcoin. We need to build things that are relevant.
Kevin Rooke: Do you think that Bitcoin and Lightning adoption is going to primarily come from top-down decisions, or will we continue to see more like bottom-up organic growth?
Oleg Mikhalsky: We did research about hyperbitcoinization — mass adoption of Bitcoin. The focus of our research was to try and understand what players and factors can move the needle both in the top-down and bottom-up direction of Bitcoin adoption. In reality, there is movement in both directions. There is now Cash App and Twitter, and there is also El Salvador [Lugano Plan B Project was announced after the podcast was recorded]. But El Salvador started from the Bitcoin Beach project which was almost bottom-up. With a top-down approach, there is some risk or at least sentiment about a risk of centralization. For example, is it a custodial solution or how is it controlled, to what degree is it centralized? But a centralized entity can act and move faster. But what we want to have in the end is a truly decentralized open all-inclusive system where anybody can participate or enter the system and withdraw from it based on their own choice. And this direction of adoption is also happening. But as it’s happening organically, it just happens at its own pace unless there are some black swan events.
Volatility creates pain and it is not only about Bitcoin price fluctuation, it’s also about fiat price which is the reverse of Bitcoin price. A country with a volatile fiat currency can discover Bitcoin’s value proposition after a significant drawdown in the exchange rate. So, as we go through the bitcoin cycles, the bottom-up approach is also going to accelerate because the spikes and drawdowns accelerate learning. And learning is one of the ways to promote bottom-up adoption. In the end it’s probably going to be a combination of both. The top-down approach has a pro that it is faster. But it also has an aspect of centralization. But the other side of the spectrum, bottom-up, is also evolving. There is more education with more meetups and conferences than ever before and also systemic events outside of “crypto twitter” which unfortunately are typically painful events, especially because the money and monetary system is very conservative and changes in it create stress. People are not used to constantly seeking for a new solution in money. Money is one of the things that people don’t want to risk. They don’t want to innovate unless they are hedge fund type of people, traders.
Kevin Rooke: How do you assess the situation in El Salvador today? Is it leaning too far to the top-down approach? Do you see a real bottom-up adoption happening outside of Bitcoin Beach?
Oleg Mikhalsky: Unfortunately, I missed the conference in El Salvador and I’m still collecting data points about what is actually going on. But again, there are fundamentals. A lot of El Salvador’s GDP is formed from remittances. And remittances using the Lightning network make a lot of sense. There are economic incentives for people to adopt it because it brings more inclusivity, reduces overheads and increases the opportunity to participate in the global market (all of these given that user experience, reliability and performance of lightning wallets and applications meet the needs). El Salvador also becomes a tourist attraction in certain ways. When people go there, it may be easier for some of them to just transact using a Lightning wallet than to deal with foreign currency exchange. There is also the volcano mining topic. There is really a lot of innovation going on there which I think creates a huge momentum. I think we’re going to see more interesting results this year, the potential is huge.
Kevin Rooke: Let’s finish this off with a couple of predictions. I want to hear your predictions for 2025 on the number of nodes and the public capacity of the Lightning network.
Oleg Mikhalsky: I guess I will need to make educated guess here which I do not want to! There is a continuous search for killer apps that could drive adoption of Lightning and mass. Next year there may be more research around and more implementations of financial products on Bitcoin and Lightning. We’re probably going to see steady progress, but not exactly flipping the switch yet when everybody is transacting with millions of satoshis every second. On the other hand, with digital content and games theoretically there could be a very popular game because of which a lot of new users will onboard onto Lightning. It may also be some consumer killer app as well. It does not necessarily manifest in millions of nodes being fired up because there is work being done on how to create accounts on nodes in a semi-custodial way. There are also infrastructure capacity and liquidity questions that need to be addressed. But we are not in the space to create a big splash momentarily, we can create sustainable innovation that will deliver value over decades. We don’t need to rush without reason.
Kevin Rooke: Some of the growth on Lightning may not show up in the number of nodes, in the capacity. I think we’re starting to see payments flying through the network faster and faster just out of efficiency improvements. It’s not necessarily because more money is in the network or more nodes are in the network. We’re just getting better at routing money through the network, nodes are learning, improving. So there’s definitely going to be many different ways that growth could present itself. Maybe those two metrics are not necessarily going to be the single rules that you should rely on.
Oleg Mikhalsky: I would be super curious to watch source code development, code-based development, developers, tools for developers, and obviously venture capital as well. We’re going to see more and more developers building on Lightning as more infrastructure, tools and education opportunities become available. I would name these important metrics: developer-founded startups, open source code activity, transaction volumes, numbers of transactions, and monetary volume of transactions can be among of the metrics to follow.
In Conclusion
To assess Bitcoin and Lightning startups properly, it makes sense to focus on fundamentals and find out how exactly the chosen technology stack will be implemented to achieve the intended goals. Though these technologies are very promising for many cases and show steady growth, it is not necessary to build everything on Lightning and Bitcoin. In the future we will probably see killer apps in payment and gaming as for these spaces the Bitcoin and Lightning system has already demonstrated a lot of potential which in turn is justified by fundamental properties of this new monetary system and payment rails.
This was the second part of the article based on the podcast. The first part can be found here.
