August 7, 2023
Web3
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0xScope

Rating Web3 investments: a framework for descerning VCs

Rating Web3 investments: a framework for descerning VCs

We’re standing at the precipice of another technological revolution, reminiscent of the early internet days when Netscape first surfed the web waves. Only now, it’s not just web pages, but the very architecture of the internet that’s poised for a facelift. Enter Web3 — the decentralized evolution of our online world. For those in VC circles, the question isn’t whether to dive in, but how to discern genuine gold from glitter. It’s about backing the game-changers, the visionaries, and the platforms that will redefine our future. So, how can VCs parse this brave new world?

Glitter from Gold

This article will not go on telling you how important is to look into the team, the tech and the community of a project. The scope of this article is to introduce a framework for evaluation of Web3 investments, or any investment for what matters.

Before diving into it, we shall define what makes an investment successful. This is true for any type of investment, from physical goods to Web3 protocols alike. Generally an investment is successful when:

This simple formula carries two implications:

  1. VCs need to see value that is not captured in the current Buy Price, or in other words determine the project’s potential.
  2. VCs need to be able to estimate what a good Buy Price is.

The better a VC will be able to determine the above unknowns, the more successful it will be in discerning good from bad investments. In the world of Web3, this might appear to be more challenging than other industries, but where there is shadow, there is also light. On one hand, the industry is in its infancy, anonymity is a virtue and telling glitter from gold requires a considerable level of technical knowledge. On the other hand, while Web2 investors and researchers need to sign NDAs to see crucial business data, Web3 investors need only access to good analytical tools since much of this data is publicly available, stored on the blockchain for users to explore.

Determining potential: a framework about Value Generating Forces

Figuring out what new projects will create value is not just about who’s got the next big thing but who’s positioned to keep it. Forget the fleeting hype; the real question is: how do firms lock in an advantage that rivals can’t replicate?

Hamilton Helmer in his “7 Powers” describes a framework where he determines how total value generated is affected by two components, the size and growth of the market and the strength of what he defines as a business’ powers.

Let’s look into the size and growth of the market first. The Web3 allure for investors lies not in its current state but in the compelling growth prospects that it holds. Although it’s forecasted to reach a staggering USD 81.5 billion by 2030 (source: Emergen research), the industry stood modestly at an estimated USD 3.2 billion back in 2021. Presently, Web3 counts 15 million active addresses (source: a16z, 2023), but a closer look reveals that these addresses are possessed by an even tighter-knit group, some being controlled by bots. Fast forward to July 2023, according to 0xScope, the daily active users (DAU) for major chains like Ethereum, Arbitrum, and BNB chains reach 300k, 1.2M, and 150k, respectively.

This leads us to the second factor that determines value: power. Helmer identifies 7 powers, here referred to as Value Generating Forces, or VGFs, that are at the base of value creation. He goes on to say that every VGF has two fundamental aspects: a benefit and a barrier. A benefit is the way in which the VGF improves cash flows, such as through lower costs or ability to charge higher prices. A barrier is the way that competitors are prevented from arbitraging the benefit of the VGF. When searching for VGFs in a project, VCs should focus first on the barrier rather than the benefit. This requires an in-depth knowledge of the market and its players.

At each step of their growth, projects can acquire different VGFs. At the origination stage, a new project can create value by either counter positioning or acquiring a new resource. In the take-off/growth stage, value creation happens when the business acquires network or scale economies or its users experience switching costs. In the stability phase, a business acquires a VGF either through branding or with the implementation of a superior inimitable process.

I will not dive into the shades of each of the VGFs, as it goes beyond the scope of this article, but I shall unknowledge the challenges Web3 VCs will experience when applying this framework. Ultimately, utilizing the 7 Powers in a Web3 context requires a deep understanding of the crypto sphere’s technical, economic, and cultural nuances. The very attributes that define the Web3 ecosystem — anonymity, rapid evolution, technical complexity, and regulatory ambiguity — can complicate the application of any business evaluation tools. The uncertainty of growth and competitive dynamics in the nascent, volatile Web3 market makes it challenging to predict how long a company can sustain a competitive advantge. Factors such as counter positioning and scale economies, key to Helmer’s framework, can be tougher to assess given the fluid, boundaryless nature of Web3 projects.

To summarize, in order to assess the future potential of a company and therefore the present value of the Sell Price, VCs will have to first estimate size and growth of the market the project targets and the VGFs the project possesses, if any. This will help investors determine whether the companies will be worth their LPs money.

Determining the Buy Price

Determine at what valuation to invest in a company is the other challenging task. The tried-and-true DCF (Discounted Cash Flow) method has little use in the world of Web3: with the infant-like nature of most of its ventures, it’s like trying to forecast the lottery.

The more popular ride in the Web3 investment theme park, is the Comparative Analysis. It’s like sizing up the new kid on the block against the seasoned veterans, comparing market caps of new projects with those that have been around the block.

Investors may also consider using a Token Economy Valuation. This method puts the token on the center stage, dissecting its utility, demand, supply, and how swiftly it whizzes around within its digital realm. Last but not least, we have the down-to-earth Cost Approach, putting a price tag on the project based on the cold, hard cost of building it from scratch.

There is no one size-fits-all approach, it depends on the project’s unique features, its maturity, its tokenomics, where it stands in the market, and the ever-changing vista of the Web3 landscape.

Conclusion

As we wrap up this exploration of investing in the Web3 universe, one thing is crystal clear — the game has evolved, but the rules remain much the same. Discerning the diamonds from the rough is a dance that investors have long been attuned to, and Web3 merely plays a new tune. It’s a complex melody, intertwining factors such as market size and growth, unique benefits and barriers, pricing methodologies, and the ebbs and flows of token economies.

Nevertheless with the right analytical tools and a keen eye for detail, the glitter can be sifted to reveal the gold. As investors, the quest is not merely to turn a profit, but to usher in a new era of online decentralization, backing the visionaries who dare to redefine the boundaries of our digital world. In the grand scheme of things, the Web3 market may still be a newborn, but it’s a newborn with the potential to revolutionize the very architecture of the internet — and that, dear VCs, is an adventure worth embarking on.

Disclaimer: This article does not provide investment advice. Due diligence remains the bedrock of any investment decision.

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