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In our previous piece, we explored how value accrues to protocols. A considerable part of “value” is narratives. In today’s piece, we explore how narratives evolve, their impact on founder’s strategies and blind spots in venture investing.

TL:DR for those in a hurry

1. Token prices often influence venture investing in crypto. Narratives driving prices have short shelf lives. Ventures take much longer to scale

2. Themes picked by founders and investors based on narrative windfalls can be terrible as attention flows elsewhere when products go live.

3. Crypto’s original sin is in charging users. Tools like account abstraction may reduce the cost for founding teams to onboard and retain users longer.

4. Strong narratives do not compensate for bad products. Botted metrics do not compensate for the lack of community.**

Here’s an observation I had over the last week. You could have deployed money into Axie Infinity at the start of the gaming rally, walked away - and returned to more money than most venture investors in Web3 gaming would make. At the bottom, Axie was trading at $0.14. Currently, it is at $6—a 40x return.

It peaked at a little over a 1000x multiple. The reason is that most seed-stage ventures in Web3 gaming are either not close to liquidity or will likely die before they can raise more capital in the current market environment. I’ll explain this further with a chart in a bit.

But there were flaws in my thinking.

1. Seed stage ventures are not supposed to give returns within 18-24 month timeframes.

2. I presumed an investor would have allocated money to Axie Infinity when gaming was an obscure theme nobody cared about.

But the underlying theme remains that you could have deployed money into a liquid asset during the bear market and seen better returns than investing in early-stage venture deals within the theme. This whole conundrum made me think a bit about the risk spectrum within crypto, how attention precedes capital & the blind gaps within venture investing as an industry. This piece summarises my thoughts on how narratives drive money and focus within our industry.

Some numbers before we begin. Close to 1300 of 3500+ tokens being tracked by a data product I use had less than 10 wallets moving their tokens in the last month. Of the 14,000 dApps being tracked by DappRadar, less than 150 had 1k users when I wrote this. As an industry, our attention shifts from one asset to the next in no time. A version of this occurs with our conviction in fundraising mechanisms too. The data below shows mentions of ICOs and launchpads in prominent crypto-native communities over the last few years.

ICOs captured retail attention but eventually gave way to “launchpads” by exchanges—one instance of a narrative evolution in real-time.

If you were around in 2017, you would have thought venture capital is about to change forever. Many startups that raised money in that market are no longer around. Based on your source for the data, crypto raised between $19 billion and $60 billion from retail and institutional participants that year. But the mortality rates of ventures from that cohort of ICOs were on par with what we traditionally saw with ventures.

You can see the result between Jan of 2019 and January 2021—a golden age for venture capital in crypto in the chart above. Interest in ICOs vanished rapidly. Investors saw an opportunity in a brief period where starry-eyed founders no longer had access to retail capital for building. Valuations were at $5 to $10 million for startups. Founders and investors had to return to working together to survive.

Part of what drove founders to switch to raising from VCs was a better understanding of the risks of launching tokens too early. You had to spend time managing the community, doing legal work to stay compliant & tie your net worth to a liquid asset - all while building a company. Founders could wake up 20% poorer because somebody on Discord got annoyed at a comment made by someone on the team and decided to dump all their tokens on an exchange with $10k in liquidity.

Years later, we are back in launchpad season—when exchanges play gods and determine which venture gets millions of dollars from retail participants. While there is much gatekeeping this time, at the very least, they ensure retail has better terms of investing than the billion-dollar valuations we saw in 2017 ICOs.

I took the case of how ICOs gave way to launchpads because there was data on this. Enough years have passed since the ICO boom to understand what happened in hindsight. If you take more nascent themes like DeFi, NFTs or Web3 gaming, you’d see the absolute obliteration of public interest in discussing them.

Unlike ICOs, the story for DeFi, Web3 gaming and NFTs is still evolving.

DeFi has gone from a peak of inflated expectations to a slope of enlightenment. There are no new competitors for Uniswap emerging every day. Aave and Compound strongly capture the lending market (for spot, over-collateralised assets). The successive iterations of these products will either be more consumer-facing or institution focused and less obsessed with speculation as a use case.

Robert Leshner's transition of focus to launching a mutual fund (CeDeFi?) and Stani's transition to Lens (Web3 social) show how founders that have been around are positioning for the next run.

Google search trends, TVL and user counts are good places to see how attention and capital flow through DeFi. Money on DeFi platforms has dwindled from a high of $160 billion to a low of $40 billion as of writing this.

If you look at the user count data, there's a 50% reduction over the past few months. But it is still up 100 times from March 2020, when the start of DeFi summer was just about to take off.

In other words, while there is a reduction in interest and usage, a far higher number of users are retained within these product categories. However, if you were to look at search trends for the same function, you would witness a very different story.

Interest has gone back to 2018, bear market levels. It is as though nobody cares about the sector anymore. I checked the data for NFTs and ChatGPT - both on similar arcs. Search trends for aliens are on the rise. (We may need to start investing in alien servicing businesses. Do lmk if you are building anything along those lines)

Putting these numbers for DeFi together, I had a few observations to make.

• Narratives pick up steam at the beginning of a bull market.

• These tailwinds usually occur due to technological developments.

• Early entrants in specific sectors produce outsized returns as a function of narratives and usage scaling simultaneously.

• Compound, UniSwap and Bored Apes are each an instance of narrative tailwinds blending with product usage to produce outsized returns for investors.

The challenge is investing in a theme in the middle of a narrative tailwind that may die before it sees enough velocity to attract an enormous enough trove of users. We may need to return to Axie Infinity again to understand what I mean.

I go back to Axie because it captures several themes quite well

1. It was a listed asset with ~2 years of product development by 2021

2. You could argue it was undervalued at the time.

3. Axie marked the beginning of Web3 gaming as a theme (and possibly, its decline too)

If you notice the chart above, there was a huge influx of users to Axie well before its massive rally to $150. On-chain sleuths likely saw the extent to which new users were flocking to the product and priced it well through July 2021.

But by October, when the new user count had begun diminishing, Axie became less of a product and more of an asset. It is a trap all on-chain products are vulnerable to. Hyper-financialisation of in-game assets meant a hedge fund in NY could be paying for someone hustling it out in a game through a guild. The play-to-earn model depended on inbound liquidity for in-game assets. And sometimes, this liquidity came from speculators & institutions.

Venture-style investing in the theme has a six-month lag between July 2021 and January 2022. Many investors watched on the sidelines, forming convictions and writing theses about how the industry would evolve. The same would have occurred with founders realising the difficulty in building DeFi dApps and believing gaming is the next big thing to jump into. Much like many founders today are hopping on to AI.

The real risk is in the 18 months that come after Jan 2022. Do you see how that figure for new users flatlines in the chart above? That’s the shrinking of userbases for all Web3 native gaming applications. Tools built at the periphery, like “Steam for Web3 games” or “Reputation for Web3 games”, soon struggled to find users.

**This misinterpretation of a short-term price rally for actual consumer demand is a trap multiple founders we see fall into. **The risk for the subset of founders is that without traction, it becomes tough to do a follow-on raise in the current market environment.

It is quite possible that the founder was building in the right market at the wrong time. The peril for founders is shutting shop before sufficient attention or capital flows into the category.

As a venture investor, on one end, you would have seen how liquid markets heavily rewarded traders, and on the other, you’d be battling it out with a crew of founders that had hopped on the theme with you. It is not a pleasant experience for anyone involved.

My point is -

1. Markets often price in narratives in the short run.

2. Given the liquid nature of Web3 investing, liquid assets may provide exits within a quarter.

3. Given the illiquid nature of venture investing, ventures may not have a market to tap into when their product goes live because products take time to evolve.

4. Which often inevitably means a slow death and a gamble on the return of users. Products effectively become a bet on “the return of a bull market.”

The exception is when a category scales to have sufficient interested users, and you build something unique. Somewhat ironically, DeFi has crossed the chasm. At 3 million users, founders building in DeFi no longer have to worry about new users entering the market.

They can build for the crowd that is here today and now and have sufficient interest from users as long as they are not producing the 30th iteration of a copycat product.

Crypto-native investors making venture-style bets are either tastemakers or front runners. Either they have the distribution and influence to birth a new category. Or the foresight to understand there is a whole new sector emerging. If one is to go by price action alone as a driver for emerging theses, the odds are pretty high that they are entering a market very late. It is quite possible that they do not see a meaningful exit unless it is a business that can scale to an IPO or be acquired. Both of which are rare occurrences in token-land.

A different way this affects founders is when business models evolve. NFTs, for instance, have gone from an effective royalty rate of ~2.5% to 0.6% in the last year, thanks to the arrival of royalty-free marketplaces like Blur. As of writing this, some 90% of NFTs traded collect no royalties.

In essence, it translates to the complete obliteration of any venture built on the idea that large troves of traditional artists would be coming to the industry, and they, in turn, would need tooling to handle revenue. Countless creator economy ventures had to pivot in the last year as the model shifted.

As with all emergent technologies - chaos is a way of life in crypto.

Let’s take a step back and go to the late 2000s. After a long day at school, you hop on Facebook to talk to your friends. YouTube has countless funny videos. Google sends you down rabbit holes about secret, clandestine banking groups. Dispersed across these activities are ads, but you rarely ever pay a penny for any of these things. The internet formed habits before it expected you to pay up.

In comparison, Web3’s obsession with ownership and exclusivity has driven us to create small pools of users interacting in echo chambers. According to their blog, Arkham Intelligence has over 100k users. Nansen’s V2 product crossed 500k registrations today. Dune has one of the largest communities of data scientists in the industry. There’s only one thing common between them: a free tier.

The web’s genius was making the user not bear the cost of most of our actions. What it received, in turn, was distribution. Web3’s great peril is in how much it costs for each interaction. Spending $8 to acquire images on a blockchain doesn’t appeal much to users that don’t need a community online. Why bother with your $10,000 ape when you have friends on Reddit?

The value proposition of spending $50 to purchase an ENS may not be apparent to users that have owned e-mail addresses for decades, for free. Axie Infinity initially required $1200 to buy NFTs to play the game. The guild model depended on this high barrier to entry. Last year, they released a free-to-play version realising the perils of keeping a high wall to entry.

One place this combination of “Free” and “own” happens quite elegantly today is on Reddit. At 400 million MAUs, the social network is a behemoth. Some 15 million wallets have collected their collectables so far. That is roughly twice the size of DeFi users during its peak month. Accounts with specific ages and characteristics were allowed to buy collectables from Reddit.

In this instance, most users are still on the “free” product, and a small subsection is minting, trading and owning collectables. Distribution is solved through a website that has been live for over 18 years.

A new class of applications has been seeing large users come in through compiling opportunities. Rabbithole and Layer3 fit that mould quite well. Instead of charging users, they give away value to those curious enough to explore new opportunities on-chain. According to tweets from the founder of Layer3, the product has enabled some 15 million on-chain actions for the crypto-curious.

This shift in product strategy is already happening. If you visit Beam.eco - you’d see a wallet that sets itself up in less than 10 seconds. Asset.money helps you collect NFTs with less than three clicks. The user does not have to worry about gas costs, on-ramps or setting up wallets. Naturally, there are security trade-offs at play here. They are similar to how e-mail went from everybody running their servers to being hosted on third-party servers run by players like Hotmail and Google.

Remember the bit where I said venture in crypto cannot be timed on narratives alone? The only way you escape, that trap is by the oldest trick in the book

1. Attract a user base and retain it long enough

2. Accrue value steadily over a long time frame

Some tokens in the industry have managed to do precisely that. Uniswap comes to mind in DeFi. OpenSea has maintained relevance inspite the attack on royalties over the year. The tail end of venture land is a large bet on how and when attention and capital would flow.

The only way to escape an unhealthy reliance on investor or speculator capital is with the purest form of capital all businesses can access. Their customers’ attention. As VC funding contracts, more startups (and protocols) would have to return to finding users that care.

The most relevant example I have found of this is Manifold.xyz. The product focuses on enabling creators to mint NFTs with relative ease. Last month, they clocked over $1 million in fees, according to data from TokenTerminal. Glamorous? Possibly not. Relevant in the current market? Absolutely.

What I have found common among many players that do well over market cycles is their early mover advantage. It is a repeated story.

Small teams enter an industry during periods of peak narrative. They see the market drying up slowly. Less than five players are often willing to continue building as competition leaves. When attention and capital do return, they are the ones that are best positioned to scale. Looking through these lens, the themes that large investors are writing off are the ones to be involved with so long as you can survive.

Often, founders get shaken out by a shift in status before a lack of runway takes them down. A while back, it used to be "cool" to be in Web3. It is likely to cringe to mention your work in the industry now. Teams feel the need to cook up their statistics to feel relevant. Too often, we see founders making tall claims through airdrop-fueled bot activity on their products.

For a seasoned investor, these games are often quite evident and send the wrong signals about the team. No matter how good their product is.

For founders, here's a cheat sheet for survival.

1. Understand the difference between a VC betting on narratives and those digging deep into your theme. One of them will be flipping your SAFT. The other could co-author your whitepaper.

2. Being early is a moat in itself. But it could also mean it takes months before someone builds conviction on what you are making. Most of your pitches will be investor education classes. It is a blessing and a curse.

3. Survival is the ultimate flex in a market where all your peers die. Keeping spending to a minimum to survive is often the right thing.

4. Consumer attention often precedes investor capital. It helps to speak to users to iterate on the product before pitching it to investors.

5. It is acceptable to shut down a venture if you do not find PMF in a meaningful timeframe. Life is too short to be employed by your VCs past a point. There need to be more candid conversations around how firms can wind down with the least friction. (This was hard to write, but it must be mentioned).

Given crypto is such a liquid market, investing (time or money) requires understanding whether you are early to a theme or riding a wave. The trap is often in spending years on a collapsing theme. For what it’s worth, I do not believe Web3 gaming as a theme is done for. Its story is still being written by countless founders who still have conviction in the theme. I am trying to figure out chapters of that story myself every week.

The trap is in confusing public market price action with private market investing opportunities. A narrative could be dead by the time a product comes to market. Follow-on rounds may vanish. And consumers may not care. That is an uphill battle many founders will have to fight in the coming quarters.

If you are building, make sure to drop your decks here. We may be able to help.I’ll see you guys next with notes on staking.

J

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