A VCs guide to the Web3/Crypto galaxy 👍 🌌 🚀
gm frens đź‘‹
At some point, on every crypto journey, one has to put aside the memes and the fun and the games and dig into what this ecosystem really is.
I have been hard-pressed to find a clear and easy-to-follow overview of the Web3 world from an institutional investor perspective. But this year, through my work at PJC alongside my colleague Matt Hayes, I’ve had a chance to research the newest frontiers of crypto and evaluate dozens of potential opportunities. As part of that, I’ve put together the guide below. If you’re an investor, non-crypto native, looking to start something in the space, or just curiously browsing, I hope you find this memo useful and actionable.
I intend this to be a living document, and I’d love to hear your thoughts on what resonated with you, and what I should be writing about next. Feel free to leave a comment below or connect on LinkedIn / Twitter!
What we’ll cover:
- The “internet” vs. “the blockchain” — a basic mental model
- What is Web3, and why is it important?
- Where are we in the life cycle? (Hint: very, very early)
- Three investment areas in the core building blocks of Web3: DeFi, NFT picks and shovels, DAOs
- Three predictions for 2022
1. The “internet” vs. “the blockchain” — a basic mental model
A long time ago, in a galaxy far far away, the internet was born. It was enabled through shared protocols (TCP/IP, HTTP, SMTP, etc.), a set of rules that standardized how things work in devices connected to the internet. The value in the internet was aggregated through applications that transported data on top of the protocols, not the protocols themselves. This enabled Google, Facebook, Twitter etc. to produce incredibly high returns for investors. Think fat application stack, thin protocol layer.
This relationship is flipped in Blockchain stack. Value accrues in the underlying protocols because:
(1) the shared data layer allows data to be held in a central place and shared equally between applications on top of the protocols
(2) there is speculation that any application built on top of the protocol will increase its value and create a virtuous cycle of value creation. This is because tokens are needed to access and use the protocols, and they go up in value the more they’re used.
In that sense, it makes sense that the market caps of Bitcoin ($800B+), Ethereum ($368B+), Solana (37B+) are exponentially larger than the applications built on top of them.
2. What is Web3, and why is it important?
Web3 represents a fundamental shift in the power dynamics of the internet. Instead of traditional corporate entities owning the networks, content, platform and underlying tech of all the apps we use every day, Web3 introduces a decentralized model where the users own a piece of everything.
Whereas Web2 is owned and run by essentially five companies, Web3 leverages tokens and decentralized technology to empower the builders, users and content creators who bring it to life. It’s moving from an internet built on “rented land” to an infinite frontier of possibility.
Cryptocurrencies, Decentralized Finance (DeFi) and Non-fungible tokens (NFTs) are the first applications that have found product-market fit and gained wide consumer adoption.
Before Web3, users and builders had to choose between the limited functionality of Web1 or the corporate, centralized model of Web2. Web3 offers a new way that combines the best aspects of each.
3. Where are we in the life cycle? (Hint: very, very early) 👶
When I left Google towards the end of 2019, Bitcoin was worth just over $9,000. Today in February 2022, even after the recent market slide, it’s trading at about $42,000. The market cap of all cryptocurrencies, including Bitcoin, Ethereum, Solana and so many more, is about $1.6 trillion.
2021 was a breakout year for crypto: there are now 80+ million unique crypto wallets; Bitcoin surpassed $1T in market value; Beeple sold his NFT artwork for $69.3M; ConstitutionDAO tried to buy a rare copy of the U.S. Constitution; and El Salvador even adopted Bitcoin as a legal tender.
If you’re deep in the tech/startup/investing bubble like I am, consuming copious amounts of crypto Twitter, TechCrunch, podcasts, tech news and memes, it may seem like mass adoption is already here. But we’re not there yet. Even though there has been a spike in media coverage for DeFi, cryptocurrencies, blockchains, NFTs, DAOs, wallets, only about 1% of the world’s population has a unique crypto wallet. We’re still in nascent stages of this new wave and mass adoption of Web3 tech is only starting.
As Tascha Che from Soundwise recently put it, mass market applications only start to reach major traction once the underlying tech reaches one billion users. For context, there are only about 180 million active Ethereum addresses in early 2022. Using that as a proxy for Web3 adoption, at current growth rates it’ll take another five years to reach 1 billion users.
The breakthrough moment: Venture investment in crypto exploded in 2021 🚀
In crypto, I think we’re at the inflection point of a brand new S-curve of transformational innovation. Historically, tech companies that captured the biggest market shares have started at the very beginning of these inflection points. 2021 was a pivotal year for the Web3 ecosystem: at the beginning of the year, it was still a relatively nascent community, but by the end, it was truly mainstream.
VCs invested $30 billion+ in crypto startups in 2021. Over 40 crypto unicorns were created in 2021. Blockchain-related startups raised $20M on an average day in 2021, and average seed growth increased from $1.5M in 2020 to $3.3M. (Pitchbook, 2021).
With all this institutional capital flowing into the Web3 ecosystem, we’re seeing valuations reach new highs and allocations become increasingly competitive. VCs will have to differentiate across different verticals such as stage (early vs late), geography (west vs east), and value add (tokenomics, governance, developer access, liquidity, hiring, etc.).
A word on crypto valuations đź’°
While valuations of both private and public tech companies have skyrocketed in recent years, they are still usually tied to a metric such as growth or revenue, or underlying levers like CAGR, retention, cash flow, and customer demographics. Even if an average SaaS revenue multiple is 4x the revenue multiple you’d assigned it a few years ago, the business is often grounded by strong fundamentals.
In the crypto world, the drivers of value work very differently. Because usership is truly global, and adoption can hit an inflection point seemingly overnight, it can be harder to pinpoint an accurate metric or fundamental driver which governs crypto valuations.
This lack of a standard approach to valuation, coupled with the vast amount of dry powder in venture driving the crazy valuations we’re seeing in today’s market.
4. Three investment areas in the core building blocks of Web3: DeFi, NFT infrastructure, DAOs
Some of the key characteristics of Web3 products are decentralization, transparency, immutability, and automation. These elements can be applied to various industries, creating a multitude of use cases — all of which provide slightly different investment opportunities.
In this section, we’ll look at the broader themes that will emerge as a result of entrepreneurs building on these new protocols, and ten specific sectors of investment built around them: DeFi, NFT infrastructure, DAOs.
We’re still early enough where investing into the infrastructure and “picks and shovels” of web3 gives diversified exposure to this sector that is not reliant on the success/failure of any particular application built on top.
DeFi — explosive asset growth, $250B+ market in Jan 2022 🤯
DeFi is a global, open alternative to the current traditional financial system or TradFi which relies on middlemen. DeFi is a blanket term for products and services built on smart contracts that anyone can use to borrow, save, invest, trade with and more. Think peer-to-peer transactions between buyers, sellers, lenders, and borrowers, without the need for banks or other centralized institutions to mediate.
Banks make money by charging borrowers higher rates for loans than what they pay you. Because DeFi protocols are owned by users, if you hold the protocol’s tokens you get the upside instead of the bank.
The chart above shows the cumulative revenue protocols generated for its users and token holders for the top projects like Ethereum, Polygon, Avalanche, Arbitrum and Fantom.
As a concrete example, consider MakerDAO which launched in 2017. It is a protocol that allows users to issue a decentralized Stablecoin — DAI — pegged at 1-to-1 to the value of the U.S. dollar by using digital assets as collateral. Users can borrow the Dai Stablecoins against Ethereum’s native cryptocurrency (Ether), allowing anyone to take out a loan without relying on centralized entities.
Areas in DeFi that saw the most investments:
- Exchanges and custody: Hold digital assets and blockchain-based securities. Custody services include the deposit and withdrawal of supported crypto assets into a custodial account as well as staking.
- Fraud prevention / KYC: Enabling verified / compliant identities might allow for new applications, agreements, less over-collateralization, easier integration with real world legal systems.
- Regulatory compliance: tax filing for individuals, governments, and corporations. tracking, monitoring, reporting and risk scoring for both large and small participants in the crypto ecosystem
- On-Ramp to Fiat: Embedding crypto payment rails directly into Web3 apps, allowing users to sign up for app, buy tokens and start playing in the same place.
- Better onboarding for DeFi: Frictionless access to Yield farming, pooled asset trading, lending, and tracking.
NFTs create a bridge for investors and big brands to enter the Metaverse đź–Ľ
NFT means non-fungible tokens, which roughly means it’s unique and can’t be replaced with something else. A bitcoin can be replaced with another bitcoin, a Bored Ape Yacht Club NFT for example cannot.
While it’s lucrative to invest in good NFT projects, picking the right project is tough with hundreds being released every week. During the 1840s Gold Rush, being a miner meant relying on luck to strike gold. But investing in picks and shovels and NFT infrastructure allows investors to participate in the NFT Gold Rush with less risk and large upside.
Marketplaces: Discover, buy, and sell NFTs. Given how quickly NFTs sell results in very high trading volume in NFT marketplaces. Platforms typically take a percentage cut of each sale, which can range from 2.5% to 5%. We’re also seeing verticalized marketplaces appear, eg. Yesports.gg for e-sports teams.
Creator tools: As NFTs get more mainstream traction, the process is easier than before. These tools are making it so that people can create NFTs without needing to know how to code or create smart contracts all by themselves.
Opensea, the largest NFT marketplace even has a free minting tool, where you don’t have to pay gas fees upfront. The smart contract is only deployed on the blockchain after someone buys your NFT.
Infrastructure: As the NFT market grows exponentially in size, there’s a need for projects to track NFT market data and build user-friendly “on-ramps” for non-technical users.
DAOs enable large scale human coordination and goal alignment 🚦
A DAO, or “Decentralized Autonomous Organization,” is a community-led entity with no central authority. DAO tooling refers to the ability to design and manage incentives to satisfactorily maintain the desires and needs of all DAO members. The most important aspect is keeping them aligned on shared goals as the product or community grows.
As more DAOs spin up, there is opportunity to invest in the tools solving the same challenges that they face while growing:
Contribution management: How to quantify, incentivize, and properly reward contributions. How to surface the right opportunities/information to the right people at the right time.
Compensation management: Payment distribution infrastructure — stream payments to contributors, fund grants, keep track of payments through treasury management.
Decision making: how can members express their opinions by voting in proposals which, if passed, automatically translate to on-chain action such as moving money from the DAO’s treasury to fund a grant recipient.
Treasury Management: Fund management solutions, provide more transparency into its asset allocation and spendings in order to assess performance and financial health.
Frameworks: Suite of smart contracts and interfaces that allow users to launch and operate an on-chain organization with a few clicks, providing out-of-the-box core features like fund management, membership management, and voting.
Three predictions for 2022đź”®
1. DAO infrastructure and governance designs evolve
With over $10B in DAO treasury, DAOs need drastic improvements in collaboration tools in order to operate more efficiently and keep shareholders aligned on shared goals as the community grows. There will be endless opportunities for these Web3-native entities to create value across unusual asset classes. DAOs have reportedly been created to buy everything from a Premier League football team to a golf course, and everything in between.
In 2022, DAOs will continue gaining traction as an effective mechanism to galvanize and coordinate global investments and communities. Governance models and legal structures will mature to enable more effective management of these DAOs.
This year and beyond, DAOs will need tools to figure out how to do M&A, run payroll and benefits, and coordinate activities in larger and larger organizations.
2. Growth in the utility of NFTs
In 2022, we will see NFTs provide utility in several ways beyond their scarcity and collectibility. One way is NFT staking or farming. That means staking NFTs to a protocol to earn a yield. Staking gives NFTs passive yield-generating utility, and can be thought of as decentralized finance (DeFi) meets NFTs.
Another NFT utility that will grow in popularity is redeemability. Redeemable NFTs allow the holder to exchange the NFT for either a physical or a digital good. While not new, brands, and celebrities are realizing that NFTs are great vehicles for brand marketing and establishing brand loyalty. This redeemability element of NFTs creates a blockchain-real-world crossover linking the metaverse and real life.
3. Improved usability
For crypto, the path to mainstream adoption is hindered by one huge obstacle: usability, which makes it intimidating to the average user. It makes sense that the most popular cryptocurrency exchanges, BlockFi, Coinbase and Robinhood, have by far the best user experiences.
I predict improvements in three areas in 2022:
(1) Easier onboarding: exchanges and wallets will start to employ a much simpler, user-friendly interface and a straightforward buying-and-selling process. Account creation should be simple, seamless, and quick.
(2) More transactions, more often: I think we’ll see a rise in better-designed wallets, services and vendors that make it easier and more seamless for users to buy crypto assets and services. Then, once users buy cryptocurrency, they won’t just let it sit somewhere in limbo. This is particularly true in emerging markets in Southeast Asia and Africa where access to financial services is more limited.
(3) Easier storage: When users aren’t yet purchasing anything with their cryptocurrency, they need somewhere to store it safely. Somewhere cut off from the internet. But as useful as this practice is, it is still relatively unknown among many users.
This year we will see a well-designed service that makes managing your offline cryptocurrency seamless and secure. A combination of 1Password and online banking.
Conclusion ✌️
Despite Web3’s meteoric rise, we are still in the early innings of a brand new technological revolution. Web3 has many unresolved problems preventing mass adoption, but talent and capital is pouring in to address these issues. If successful, crypto will be an order of magnitude larger by 2030 because the user economics here are an order of magnitude more attractive.
Whether you’re an investor, builder, or just curious about the space, hope you found this post helpful. Reach out here, LinkedIn or on twitter @gauravbhogale and let’s continue the conversation.
Sources and further reading
- Fat Protocols — Joel Monegro
- Web2 vs. Web3 — Ethereum.org
- Web3, eli5 — Messari.io
- S-curves in entrepreneurship — Andreas Goeldi
- An Engineer’s Hype-Free Observations on web3 — Dave Peck & PSL Team
- The Web3 World — Canvas Ventures
- Organization Legos , State of DAO Tooling — Nichanan Kesonpat
- The Usability of Cryptocurrency — Tony Scherba
