The web3 movement has captured everyone’s attention. When a space has attention, money soon follows. 2020 and 2021 saw a historic bull-run for many major crypto assets. Both venture and retail capital flowing into this space has exploded. Several major institutions have also started to support crypto assets.

This influx of investor money has attracted a lot of builders to this space. Unfortunately, it has also attracted a lot of scammers and people making empty promises. A saying often quoted by people in the crypto space is that “great projects are built during bear markets” as a lot of the projects without strong fundamentals run out of capital and die. This is definitely not true, many great projects are built during bull runs. However, it can be hard to cut through the noise.

The number of tokens available for retail to buy has skyrocketed in the past couple of years. Tokens are great, they allow everyday investors to get access to upside early on in a project’s lifecycle. However, choosing where to put your hard earned money among the sea of options can be very difficult.

As of Mar. 24, 2022, around 508,074 ERC-20-compatible tokens exist on Ethereum's main network. -- Investopedia

The following checklist can serve as a default set of parameters that you can evaluate any web3 project with.

Value investing framework for web3 projects

Before we get started, this article assumes that you have a basic understanding of the web3 space. If not, please refer to this article or this podcast episode. Here’s a very brief definition of some of the terms mentioned in this article.

• Smart contracts: Code that lives and runs on a blockchain-based smart contract platform like Ethereum and Solana. Bitcoin can not run smart contracts.
• Protocols: One or more smart contracts that do a specific task. A protocol could be comprised of other protocols. L1s like Ethereum, Solana, etc., L2s/sidechains like Optimism, Arbitrum, etc., and programs built on top of the L1s like Aave, Fractional, Serum, etc. are all referred to as protocols.
• dApp: Decentralized apps. Frontend to protocols. Will ask you to connect your wallet. dApps are how end-users interact with protocols. A single app may run on multiple protocols. Examples include Matcha, Mirror, Partybid, etc.
• Rug pulls: Blanket term for scams. Getting rugged = getting scammed.
• PMF: Product Market Fit. Point where the product becomes something that the market wants.

A simple google search should return good results for any other confusing terms. For a more comprehensive list please refer to this list (or just start spending time on Twitter and Discord). Let’s get started

General checks

These are checks that are standard for evaluating any project that you are thinking of investing in.

Founder and founding team

Strong founders can guide projects to success through adversity. Evaluating founders and founding teams is especially important for early-stage, pre PMF projects.

Crypto has a culture of anons. Many prominent projects in the space have anonymous/pseudonymous founders. This works well when the anon has built up credibility over a long period of doing good work. For example, samczun is a legendary white-hat that works with paradigm. He has been anon from the start and is one of the most reputed security researchers in crypto. Other reputed anons include Punk 6529, Hasu, etc.

However, more often than not, this goes badly. Pseudonymous identities allow you to start with a clean slate- if you screw up you can delete your pseudonymous identity. If you have done something bad that is tied to your real identity you can assume a pseudonym and not let it affect you. 0xSifu, one of the founders of the Wonderland protocol, was recently revealed to be a convicted felon who had served time in prison for fraud. 0xMaki, the founder of sushiswap, drained most of the protocol’s funds(however sushiswap survived and 0xMaki eventually returned the funds). Having doxxed founders definitely adds to the project’s credibility. There have been countless NFT and shitcoin rugs by anon founders. The exception to this might be if the pseudonym has a stellar on-chain reputation.

There also might be pseudo-anon arrangements, where VCs get to know the founder’s identity so that they can conduct diligence, but it is never revealed to the public. However, this is tough to pull off. The founders of BAYC(Bored Ape Yacht Club), an extremely successful NFT project on Ethereum, were fully anonymous till their recent raise. However soon after the raise, Buzzfeed got access to their real identities and leaked them to the public. This made many in crypto Twitter quite angry.

Vision

Again, this is especially applicable in the early stages. You need to be able to see the most optimistic version of the product. ie. if everything goes perfectly according to the plan, what does the world look like in 10 years- what new behaviours will users have, what problems will no longer exist, etc. However, you should not allow founders to build castles in the sky. The project’s vision needs to be at least somewhat realistic. The ability of the company to execute on the vision needs to be evaluated using other factors.

Almost every 10k NFT project coming out these days has a metaverse play in its roadmap. Very few will make any progress.

Market- Timing and TAM

You need to understand why now is the right time for the product to exist. This is a tough question to answer, and can only be perfectly answered in hindsight. However, trends in macro, tech and culture can give clues on whether the world wants this product but does not know it yet.

It is typically better to be too early than too late. If you are too early to a market it will be tough to stick to your intuition and keep pushing forward when the market does not seem to respond. If you can stay alive till the market realizes the need for your product, you can emerge as a dominant player. If you are too late to a market you probably can get some market share but it is unlikely that you will emerge as a dominant player.

This is relevant for web3 as we are still so early in the lifecycle of all major web3 primitives- DeFI, DAOs, NFTs, etc. It is tough to predict when each sector will get a significant market. However, it is fairly certain that if web3 succeeds, some version of these primitives will eventually succeed. Identifying projects that can survive till PMF is crucial when investing in this space

TAM, ie. Total Addressable Market, is a quantified version of the project’s vision. It is a measure of how big the industry that the project operate in is. Bigger TAMs are often better, as even getting a small percentage of the market can be very valuable. TAMs grow as the industry grows.

Web3 specific checks

Products vs Protocols

The internet runs on protocols like HTTPS, FTP and SMTP. Trillion-dollar companies have been built on top of these protocols. However, despite so much value flowing through it, internet protocols have no intrinsic economic value. In web3 this is reversed, thanks to tokens. When value flows through a protocol in web3 the protocol actually accrues value.

In web3, the protocol is often seperate from the product. The tweet below is a good example of how the “Twitter protocol” - a messaging service where you don’t specify the recipients & “Twitter app” - a discovery service that shows you the “best” content of the Twitter protocol for you, could have been two very different products. In web2 this is bundled into a single app, while in web3 it is often split into distinct components.

This is not to say that web3 apps won’t be valuable, just that protocols will end up being much more valuable. Quoting Sai, the internet saw fat apps and thin protocols. Web3 will see thin apps and fat protocols. While value capture is reversed, usefulness is still tied with apps. As a result, many startups build both the protocol and dApps that users can use to interact with protocols.

It is important to understand whether the token you are buying is tied to a dApp or a protocol. Investing in protocols can be much more lucrative than investing in individual dApps, but protocols are much more winner-takes-all. Most individual dApps will be less valuable than their underlying protocols but there will be many more winners within a space.

Most of this section was taken from my post on consumer products in web3. You can read the full post here.

Composability

When investing in protocols, one of the main factors of consideration is how composable the protocol is. Composability refers to the ability to stack together smart contracts permissionlessly. The more stuff that gets built on top of your protocol, the more valuable it becomes.

DeFi has some great examples of composable protocols. Protocols like Uniswap, Aave, Compound, etc. form the building blocks of more complex protocols like Alchemix, Instadapp, etc.

Tokenomics

Tokenomics, ie. token economics, is analyzing the characteristics of a protocol’s tokens. The main thing to understand with tokenomics is that it is simple supply and demand. If the demand for your token is more than the available supply, the number will go up.

• Factors that increase demand:
  • Making the token deflationary: This could be because the total number of tokens is fixed or because more tokens are being burnt than issued. Bitcoin is deflationary, it’s total supply is capped at 21 million.
  • Making the token disinflationary: Disinflation refers to reducing the inflation of a token over time. This lowers expected future supply. This can be done by reducing issuance or by burning more tokens. Eth has burn-introduced disinflation thanks to EIP 1559.
  • Incentivizing staking: Staked tokens are locked up and can not contribute to liquidity.
• Factors that increase demand:
  • Utility: Tokens might be required to perform an action in the corresponding protocol(eg GRT).
  • Governance privileges: Token holders may get to propose and vote on protocol changes.
  • Speculation driven demand

Types of tokens:

• Fungible tokens: Divisible and non-unique tokens. Analogous to currency in the real world. Commonly known as coins. Follows the ERC20 standard on Ethereum and the SPL standard on Solana. Some way that fungible tokens can be used are as:
  • Equity tokens: Function similarly to shares in a company. This is rare today as most jurisdictions outlawed it after the ICO boom of 2017.
  • Utility tokens: Tokens that are needed to perform some action within a protocol. L1 tokens like ETH and SOL are examples of utility tokens, they are needed to pay gas costs in their corresponding chain.
  • Governance tokens: Tokens that give holders the right to propose and vote o protocol changes. The weight of your vote is often proportional to the amount of tokens you hold.
• Non Fungible Tokens (NFTs): Unique tokens. Each is a unique representation of an asset on the blockchain. Some way that NFTs can be used are as:
  • Art: NFTs allow for people to truly own digital art.
  • Utility: NFTs can be used in several ways, the most common of which is to gate access. Most PFP(profile picture) NFT communities like BAYC give holders access to a gated online space(usually a Discord server). NFTs can also be used for in-game assets. Axie infinity, a popular play-to-earn game, uses breedable NFTs to represent their in-game characters.
  • Governance: NFTs can be used in addition to fungible tokens to reduce the effects of plutocracy in protocol governance. For example, the Optimism protocol issues soulbound NFTs(non transferrable NFTs) for the core team. This prevents the protocol from being taken over by someone who can buy up power in the form of tokens.

Here is a checklist of things to keep in mind while analyzing a project’s tokenomics. This is mainly for fungible tokens but a lot of these apply to NFTs as well.

• Supply: As mentioned earlier, you want there to be less supply available. You should look at both how much liquid supply there is right now and how much there will exist in total(not possible to calculate in arbitrarily inflating tokens, ie. those without a fixed emission schedule)
• Inflation: Check what the current inflation rate of the token is and if there are mechanisms in place to reduce it over time. Inflation is bad for the token price.
• Token allocation and distribution: It is important to note how distributed the token is among the protocol’s community. If tokens are too concentrated in few wallets, those “whales” could shock the market when they decide to sell. If you are buying a token at launch you will also want to see if the project is using fair launch mechanisms like gradual Dutch auctions.
• Vesting schedules: Some protocol’s have lock-in clauses and vesting schedules for their tokens, especially in private rounds. When these vesting schedules expire, a lot of liquidity is introduced into the market. People whose tokens were locked might want to sell. This supply shock can crash the token’s price. However, of the project is strong, the price usually recovers.

• Incentive structure: Tokens need to incentivize good behaviours with extra rewards. Protocols need to encourage long-term holding and reduce sell pressure. One way this is done is to reward people who stake their tokens.
• Fully diluted value: This is total supply * token price. A common shitcoin narrative is to calculate gains after the token appreciates to some amount(often 1$). They fail to account that at that price the token’s market cap would cross into trillions and sometimes even be more than the GDP of the world. There might be temporary spikes of meme-driven price action but unsustainable market caps always crash.
• Value accrual: There should be mechanisms in place for the protocol’s success to translate into the token price increasing. Many early DeFi protocols such as Uniswap and Compound fell victim to this. The protocols were extremely successful and generating lot of revenue but it was not reflecting in the token’s price due to poor tokenomics design. Many of these protocols have since made changes that allow tokens to accrue value better.
• Memes: This is an extremely powerful force for price action. However if memes are the only force driving token price you should probably run.

Most of this can be easily obtained through blockchain explorers. For more complex analysis’s you can explore on-chain data analysis tools like Dune.

Other factors

Product Market Fit (PMF)

A product is said to have PMF if there is demand for your product in the market. It is not straightforward to quantify PMF, several frameworks attempt to do it(the Superhuman PMF engine is especially famous). However, it is often obvious when a product has PMF. Getting to PMF is often the hardest part of building a startup, most never make it. Projects that have achieved PMF can demand a premium as the risk of it failing is greatly lowered.

It is important to note that PMF can be lost. This could be because of changing market conditions, competitor products that the market likes more, changing technology, or other external factors. Investors need to periodically re-evaluate if the product they are investing in has PMF.

Thesis driven investing

This approach involves forming a thesis about a space and investing based on that. Some popular thesis’s in web3 include:

• The modular blockchain thesis: This thesis revolves around having a core consensus chain and several specialized chains that plug into it. Investors that follow this thesis usually believe that Ethereum will emerge as the universal consensus chain. Execution will be outsourced to rollup chains that periodically commit to the main Ethereum chain. To learn more about this thesis you can refer to writings by Bankless and Polynya.

• Multichain future: Investors that follow this thesis believe that there will be multiple chains, each with their own ecosystems, interconnected with bridges. The Cosmos blockchain is built on these values.

• You might form a thesis around a specific subsection of crypto such as web3 gaming, DeFi, metaverse, creator communities, music NFTs, etc.
• You might want to play with seasonal narratives like DeFi summer 2020, Solana Summer 2021, etc. These narratives are hard to catch at the right time and are shorter term plays than the ones mentioned earlier, but can be very lucrative if you can get them right.

Thesis driven investment such as Multicoin Capital have done exceptionally well over the past few years, you can read their research reports to help form your approach.

Reasoning by analogy

This refers to the process of making decisions based on factors other than the underlying fundamentals. This can include

• It worked in X so it should work in Y. This is common in the traditional startup world. When a new concept (like ridesharing) emerges in one part of the world, local copycats quickly spin up. In web3 this might look like copying a project onto a different chain.
• It is backed by people who you think are smart. You trust that they have done enough research and are are often right with their analysis.
• Web3 version of X. ie. web3 Spotify, web3 Discord, etc. However, this can be dangerous. Creating a web3 version of an existing service can be very powerful, but early versions are often overly skeumorphic. This is similar to early internet entrepreneurs putting magazines and radio on the internet. What ends up working solves similar needs for customers but often in a different form-factor.

Anological reasoning can be a useful tool that supplements first-principles thinking, but decisions should not be made purely based on this.

Second order effects

Second order effects refer to the carry-on consequences that happen after an event. While many people recognize the obvious consequences of an event, most fail to consider the second and third order effects of the same event. It involves asking yourself “and then what?”. Some ways this applies to web3 are

• When regulation is passed, what could be some projects/areas that benefit from it? What could be projects/areas that are adversely affected?
• Does this project have other projects that depend on it? For example, if a ZK proof protocol has a technical breakthrough, the obvious play is that the protocol will become more valuable. However dApps built on top of that protocol will also often become more valuable as they will work better.
• Does this project depend on another project? This is the opposite of the above point. For example, a project that provides insurance for DeFi can only succeed if DeFi succeeds.
• Are there real world shifts or macro changes that could affect your project? This includes blockchains that count on Moore’s law making hardware more efficient, Bitcoin being used as an inflation hedge, etc.

Moats

Moats broadly refer to characteristics that make a project more valuable and make it harder for competitors to disrupt you. I wrote about moats in web3 in detail over here.

Arguably the most important moat in web3 is community. You can get a feel for how strong a project’s community is by their presence on social media channels like Twitter and Discord. Joining a project’s Discord and getting a feel for the vibes there is the best way to analyze a community.

Web3 investment mindsets

HODL

You need to get comfortable with volatility. Crypto is currently very susceptible to macro economic movements. Crypto markets tend to operate in cycles- intense growth followed by a prolonged cooldown. Moreover crypto is 24x7. Holding few good projects through periods of uncertainty will most likely outperform active trading.

Spread your bets

The space is still very new. Most crypto projects will go to zero. A good way to ensure pretty good returns is to spread your investments, both across sectors and within projects within a sector. Investing in L1s like Ethereum and Solana can be thought of like buying an index fund over their entire ecosystem.

Utility > Tokenomics > Hype

Value will accrue to the most useful projects in the space. The chain with the most useful apps on it will win. Try to look for concrete proof of utility. Avoid groupthink, where you invest in a project purely because others around you seem to be putting money in and getting rich.

Survive

One thing that all veteran crypto investors repeatedly say is that your chances of winning dramatically increase the longer you play the game. In order to do that, you should never put yourself in situations where the loss is too much to recover from. You probably should not play around too much with leveraged trading unless you know exactly what you are doing.

Conclusion

This post outlines some ways to assess a web3 project’s true value. It is in no way a guide on making the most profit. Shitcoins and flipping pfp NFTs can produce insane returns. The skill in that game is timing the sell so that you can dump your bag on someone else.

The haters are louder than ever. While it’s true that most of projects today will go to zero, a small percentage will fundamentally change the way the internet operates. Previous iterations of the internet, web1 and web2, had to go through cycles of booms and busts before great projects emerged. Web3 gives us an opportunity to participate in the next major shift.

Web3 is at a very interesting inflection point. There are areas like DeFi where there are billions of real-world dollars locked in, while other areas such as metaverse exist only as a theoretical concepts. Everyone seems to building tools for their own definition of what a DAO is. Over the next few years a lot of clarity will emerge. Regulators have transitioned from brushing this web3 off as a fad to actually paying attention to the space. Some web3 protocols will become bigger than what anyone could imagine and become the bedrock on which very important applications are built. Most others will die a slow death. Protocols in particular will be much more winner-takes-all than dApps, and will accrue much more value. There is a lot of money to be made(and lost).

We are so early. Exciting times up ahead.

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Cover image source: Messari