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Venture capital (VC) investments in the Web3 sector have been in full swing this year as several established VC firms launched a Web3 and crypto arm. Paradigm’s $2.5 billion fund and Electric Capital’s $1 billion fund are just a few examples.
So why are these firms so optimistic about Web3 investments?
Outsized returns
The token economies underlying many Web3 projects can result in outsized returns compared to Web2 investments. This is especially true in the current climate of rising inflation, interest rate hikes, discounts in startup valuations and market volatility. While the cryptocurrency market has seen its share of ups and downs in 2022, its total market cap grew nearly 200 percent in 2021, with Bitcoin and Ethereum returning about 60 percent and 400 percent, respectively. Other cryptocurrencies saw impressive returns such as Avalanche, up about 3,300 percent, and Solana, up about 11,000 percent.
More sector specific, DeFi (decentralized finance) had a market cap of just $2 billion in 2020 and opened in 2022 with a market cap of $160 billion — an 80x growth in just two years. Many prominent investors and institutions are making the bold prediction that DeFi, which currently accounts for an insignificant percentage of the traditional financial market S&P500, could be worth 100 times more in just five years.
See also: 3 Steps to Web3: The Ultimate Guide to Navigating Web3 for Non-Tech Founders
The NFT sector saw the same explosive growth, becoming a $40 billion market in 2021, a 21,000 percent increase from 2020! The NFT market is almost on par with the traditional art market, and for good reason. If you had been an early investor in certain projects like CryptoPunks or Bored Ape Yacht Club, you would have had an amazing 100x return in less than a year.
Of course, for every outsize winner, there are countless losers. Because your typical venture capital fund aims for an annual return of between 20 and 30 percent, a venture capital fund needs to select few solid investments. As we have seen, there are many ways to invest in potential unicorns in their early stages, returning 100x and covering the myriad of failures. This particular time in Web3 represents an opportunity reminiscent of the early days of the internet boom that produced many of today’s most notable VCs.
liquidity
Traditional stakes in startups are illiquid. Investors typically have to wait for a liquidation event, such as an IPO or takeover, to cash out. Sure, there’s a secondary market for private stocks, and buyouts by private investors have been around for some time. However, this is a very complex process and is not considered a liquid investment.
On the other hand, most early-stage Web3 projects issue tokens that can be traded on exchanges at any time. Hypothetically, when an investment grows 100x in a short period of time, investors often have the opportunity to realize the returns much sooner since there is no lock-up period.
Additionally, a startup that relies on its token economy inherently means it is built on the chain. Being on-chain (data is stored publicly on blockchain) means startups and their key metrics are far more transparent than in private markets. Because investors of Web3 projects can see how much capital they have, how the capital is used and so on. This information is usually only a click or two away on platforms like Etherscan.
Passive Income
Rather than just making traditional equity investments and hoping to make a capital gain on exit, tokens offer VCs a unique opportunity to generate passive income from their holdings.
This can be done through one of the following methods:
- The most popular is staking your tokens. This means you are using your wealth to support a blockchain network that uses a proof-of-stake consensus mechanism.
- Another method is yield farming. You can deposit your tokens into a liquidity pool and earn interest.
- Finally, you can use liquidity mining. This means you can provide liquidity to a DeFi protocol and earn rewards.
Also see: 9 Top Trends Shaping the Blockchain Industry
The rewards of these passive income engines can be quite compelling. They often range from 2 to 25 percent, or over 1000 percent for some riskier projects. Additionally, these rewards are typically paid out daily, which is a drastic change from what we’re used to from interest-bearing term deposits or dividends.
Ultimately, this means that venture funds could generate attractive passive returns for themselves and their partners long before a liquidation event, stimulating them not only to maintain their position but to further contribute to the success of the project.
capital efficiency
The Internet and its subsequent innovations enabled start-ups to tap near-zero marginal cost solutions and unprecedented economies of scale. This made pre-internet companies appear seriously capital inefficient.
Let’s take Netflix as an example. Netflix employs a few thousand people and has a 2022 market cap of over $100 billion. In contrast, its brick-and-mortar predecessor Blockbuster, with more than 60,000 employees and ample real estate, only managed a peak market cap of $5 billion.
How does this relate to Web3? Web3’s token economies and base-layer infrastructure, which underpin the way projects pool capital, coordinate owners, and incentivize, threaten to make Web2 companies look just as inefficient as their pre-Web predecessors.
a16z’s Chris Dixon wrote that he “has never worked on a project that has spent a lot of money on sales and marketing. You don’t need to spend money on marketing when users are true owners, love what they do, and love to tell others about it.” Web2 companies often budget millions for aggressive marketing to accelerate customer acquisition, while Web3 startups have the luxury have to scale the network through symbolic incentives.
UniSwap is a leading decentralized exchange with a fully diluted market cap of $6.2 billion and 50 employees. That’s an incredible market value of $124 million per employee. To put that in perspective, the highest-grossing company of all time, Apple, is around $18 million per employee.
This proves that startups no longer need to hire tons of talent. Rather, they can use their token-incentive-based network strategically to help them build, scale, and thrive, essentially making them a low-cost, foundational model for talent acquisition.
Bottom of the S curve
As mentioned, this is an incredibly new space, defined primarily by a sense of urgency and excitement reminiscent of the early days of Web1. Much like Web1, there is also a lot of hype and silly money thrown into the space, so we should tread carefully.
Most major financial institutions predict that the broader Web3 sector will grow into a multi-trillion dollar industry at a compound annual growth rate of about 50 percent over the next decade. Despite their initial criticism of crypto, JPMorgan, Goldman Sachs, and Citi have recently set up crypto research departments to capitalize on rapidly expanding opportunities.
Today we are at the bottom of the S-curve, which means this could very well be the emergence of a once-in-a-lifetime opportunity.
See also: Do investors see the potential of Web3.0?
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