Finding a product-market fit
In 2007, Marc Andreessen wrote a famous essay The only thing that matters, arguing that among market, team, and product, the market direction is the most important aspect investors should pay attention to when evaluating startups.
When talking about the investable universe, Mark primarily talks about the companies that identify real demand with lots of potential customers. “The product doesn’t need to be great; it just has to basically work.”
Looking back, Uniswap is such an example.
If you had an investment opportunity in Uniswap in 2018 and focused on product, you would’ve likely missed the opportunity to invest in the unicorn. Most of the professionals in the finance field would’ve likely suggested to you the design is quite dumb.
If you had focused on the team, you would’ve had questions regarding the qualification of the inexperienced founder, first-time entrepreneur, building finance application without a finance background, etc.
However, if you had focused on the direction you would’ve been able to note that there is a large potential demand for an on-chain trading venue that could support price discovery & exchange of value, and Uniswap was the first project that actually worked. That’s it.
Attempts before Uniswap were either order books that are infeasible on-chain or AMM designs such as Bancor which required usage of their governance token to be able to trade, negatively affecting user experience.
“First to market seldom matters. Rather, first to product/market fit is almost always the long-term winner.”
Due to the right timing and being functional, Unsiwap became a unicorn and multibillion-dollar project. This is not an attempt to underestimate or degrade the importance of founders. Without being talented they wouldn’t be able to notice demand and be the first to produce the product that ‘just works’. However, if the founder of similar qualities as Hayden Adams had chosen to build the first prediction market instead of DEX, the project would’ve likely failed.
Going even further back in the past, we can find another similar example-Ethereum.
Imagine Vitalik had pitched you the Ethereum whitepaper in 2015.
Again, if you had focused on the team you would’ve had concerns about the inexperienced founder, a first-time entrepreneur who didn’t attend Ivy League school, executing such a challenging task that is supposed to have worldwide implications.
If you had the qualifications to assess the technology, you would not have found it the most impressive piece of architecture. I believe that among blockchain experts Ethereum Virtual Machine is one of the most heavily criticized inventions.
Yet, if you thought about the direction you could’ve figured out this is the first blockchain supporting smart contract development that ‘just works’.
Despite facing immense pressure from competitors in the following years, by all standards, Ethereum is still the leading blockchain in this category. Being in the right market compensated for all the deficiencies as Ethereum attracted the brightest minds to innovate it, around it, and on top of it.
How about in today's markets? How could early-stage startups find a product-market fit? How to identify the real demand?
Without forward-looking bias, estimating the product-market fit is more of an art, requiring a significant level of imagination. To be fair, luck plays an extremely important role as well. Who would’ve imagined all sorts of highly unlikely events happening at the same time that led to the explosion of P2E gaming?
While we can’t predict the future, we can at least try our best to determine the potential demand. Knowing the market and user behavior is one such method.
Most people consider Uniswap v3 and dYdX to be the most successful DEXs as they are leading the rankings in terms of volume generation in spot and derivatives markets, respectively. But why are they leading the rankings?
Certainly, capital efficiency makes Uniswap v3 have much more competitive pricing, and with the more and more retail volume going through DEX aggregators, the pricing quality becomes crucial in obtaining this volume.
But in fact, the reason for v3 superior trading volume lies in the high participation of MEV bots. As illustrated below, on a daily basis bots account for up to 75% of Uniswap volume. Thus, even if no users were giving a dime about Uniswap’s capital efficiency, Uniswap v3 would still be generating a larger volume than most of the DEXs, as long as there are liquidity providers willing to get arbitraged.
Bots and whales dominate the Ethereum on-chain activity. Knowing this, do you want to invest in an Ethereum DEX that eliminates MEV and optimizes the experience for small traders? Probably not.
The reason why AMMs and DEX Aggregators are among the most successful DeFi verticals is particularly that they are serving the two largest groups of on-chain users: bots and whales, respectively.
Connecting the dots
“Ironically, once a startup is successful, and you ask the founders what made it successful, they will usually cite all kinds of things that had nothing to do with it. People are terrible at understanding causation. But in almost every case, the cause was actually product/market fit.”
Investors seem to be terrible at understanding causation as well. Recently, I heard many attempts to quantify the characteristics of Axie, Uniswap type of founders, to know what to look for in future projects. While an interesting intellectual exercise, I believe it has marginal value to the decision-making process.
Not having a product-market fit immediately is not a big deal, unless…
Finding the PMF can be a very long process requiring constant iterations. The issue, however, arises once project implements aggressive growth strategies without achieving the PMF.
As there is a high risk that the project won’t hit the PMF in their first attempt, aggressive liquidity mining combined with the version 0 of the product generally leads to an issue of premature scaling, where a project is exchanging perpetual ownership of the network for inflating short-term product metrics and attracting the speculators rather than the real product users.
Nevertheless, this seems to be a dominant practice in the industry. Founders tend to complement the launch of the product with aggressive liquidity mining due to:
- the overconfidence in the project — while confidence is good, having a healthy dose of skepticism is certainly helpful,
- the idea that you should launch tokens while the market is hot regardless of the fundamentals — good reasoning only if you are looking into a good pump and dump scheme,
- the project already has strong memetics either due to the OG founder who has a cult-like following or the excitement of the community for the project
Due to the peculiarity of crypto, we often see projects from the third category achieving astonishing valuations without even having MVP. Or alternatively, some projects maintain 10 figures valuation without ever reaching significant usage.
Do these sorts of projects take into question our PMF reasoning above? Should community power & memetics become a category as important as market, team, and product, or is it derived to some extent from each of these?
Regardless, I believe that this category of projects is rather an exception than a rule and that as the industry matures the importance of this factor gradually decreases. Essentially, community power just buys time and resources for the projects to find the PMF. Without the real demand, the projects would eventually die out.
Therefore, depending on your investment time horizon, you may place different values on community & memetics vs other factors.
You may be intellectually right that the product will never succeed in getting the real usage, but you could still make a very good trade out of it.
“Would you prefer to be intellectually right but lose money or to be intellectually wrong but save the trade?”
The issues in PMF estimation
Speculation in crypto starts even before the token launch. Do high user numbers suggest that the product has found a PMF or the majority of users are just pre-mining the token because the project announced a seed round with Paradigm?
There are certainly many nuances in finding and estimating the PMF and in choosing how much value to place on the market, product, and team. After all, each category is critical and has to satisfy a certain threshold for the project to be successful. Yet, if I would have to rank these elements according to their importance in evaluating the projects, I would do so in the following order:
- Direction
- Team
- Product
🦄 About IOSG
IOSG Ventures, founded in 2017, is a community-friendly and research-driven early-stage venture firm with offices in China and Singapore. We focus on open finance, Web 3.0 and infrastructure for a decentralized economy. Our portfolio covers more than 60 projects, including Layer 1 (NEAR, Polkadot, Cosmos), DeFi (1inch, Synthetix, UMA, Dodo, Liquity, Gelato). We commit ourselves to work alongside various developer & DAO communities and helping the most aspiring founding teams to achieve success. As a developer-friendly fund with long-term values, we have launched Kickstarter Program which offers capital and resources for innovative and courageous developers. Since we consistently cooperate with our partners and connect with communities, we work closely with our portfolio projects throughout their journey of entrepreneurship.
If you would like IOSG Ventures to consider your project, please send a summary of your project along with a pitch deck and/or white paper to hello@iosg.vc
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