Original author: JOEL JOHN

Compilation of the original text: Deep Tide TechFlow

In the past week, I have made an observation. You could put money into Axie Infinity at the beginning of the gaming boom, walk away, and come back to find you made more money than most VCs in Web3 games. The price of Axie dropped to $0.14, and now it has risen to $6, a return of 40 times.

Its highest peak once exceeded 1000 times. The reason is that most seed-stage VC projects in Web3 games are either far from liquidity, or may die before raising more funds in the current market environment. But there are some flaws in my thinking:

• Seed stage VC projects shouldnt pay off in the 18-24 month timeframe.

• Im assuming that investors allocated money to Axie Infinity when the game was still a narrative that no one cared about.

But the underlying logic is still that you can put money into a liquid asset during a bear market and get a better return than you would in an early VC deal in that narrative. This conundrum got me thinking a bit about the scope of risk in cryptocurrencies, how attention precedes venture capital. This article summarizes my thoughts on how narrative drives money and attention in our industry.

Before we get started, some numbers. Nearly 1300 of the more than 3500 tokens have moved from less than 10 wallets in the past month, according to the data product tracker I use. Of the 14,000 dApps tracked by DappRadar, fewer than 150 have 1,000 users. In this industry, our focus moves from one asset to another very quickly. A similar situation exists with our confidence in fundraising mechanisms. The data below shows the number of mentions of ICOs and distribution platforms in prominent cryptocurrency communities over the past few years.

If you were around in 2017, you probably thought venture capital would change forever. Many of the startups that raised money in that market are now gone. According to data sources, cryptocurrencies raised between $19 billion and $60 billion that year from retail and institutional players. But the survival rate of that batch of ICO projects is comparable to the survival rate of startups that we have traditionally seen.

You can see the results between January 2019 and January 2021 in the chart above — the golden age of cryptocurrency venture capital. Interest in ICOs evaporates quickly. Investors saw opportunity during a brief period when founders with big dreams no longer had access to retail capital to build. Startups are valued at between $5 million and $10 million. Founders and investors had to work together again to survive.

Part of the reason founders are turning to VCs to raise money is to better understand the risks of issuing tokens too early. You have to spend your time managing the community, doing legal work to ensure compliance, and tying your net worth to a liquid asset, all while running a business. A founder might get annoyed by someone on Discord making a comment about a team member and decide to dump all their tokens on an exchange with only $10,000 in liquidity, causing themselves to wake up 20% poorer.

Years later, we’re back to Launchpad season — exchanges playing God’s role in deciding which venture capital projects get millions of dollars in funding from retail investors. While there are a lot of barriers this time around, at least they ensure that retail investors are getting better terms for investing than the multi-billion dollar valuations seen in 2017’s ICOs.

I chose the example of how ICOs gave way to Launchpad because of the data available. Enough years have passed since the ICO boom to see what happened with the benefit of hindsight. If you look at some of the more emerging topics, like DeFi, NFTs, or Web3 games, the public interest in discussing them has completely disappeared.

But unlike ICOs, the stories of DeFi, Web3 games, and NFTs are still evolving.

dying narrative

DeFi has moved from the peak of excessive expectations to the stage of enlightenment. A Uniswap competitor did not emerge. Aave and Compound have strong positions in the lending market (for spot, over-collateralized assets). Successive iterations of these products will be more consumer or institutional oriented and less obsessed with speculation.

Robert Leshner turns his focus to launching a mutual fund, and Stani turns to Lens (Web3 Social), showing how founders who have been in the industry are preparing for the next round.

Google search trends, TVL, and user count are good indicators for observing attention and capital flows in DeFi. As of now, funds on DeFi platforms have dropped from a high of $160 billion to a low of $40 billion.

If you look at the data on the number of users, it has decreased by 50% in the past few months. But compared with March 2020, when DeFi Summer just started, the number of users still increased by 100 times.

In other words, while interest and usage have declined, the number of users within these product categories is still far greater than before. However, if you look at search trends for the same feature, youll see a completely different story.

Interest has returned to 2018 bear market levels. It’s like no one cares about the industry anymore. I looked at the data for NFT and ChatGPT, and they both show similar trends. Alien searches are on the rise. (Maybe we need to start investing in alien service businesses.)

Based on these DeFi data, I have a few observations.

• The narrative is poised to go at the start of a bull market.

• Often caused by technological developments.

• Early entrants in a given space experience outsized returns as narrative and usage scale simultaneously.

• Compound, UniSwap, and Bored Apes are all examples of narratives combining with product usage to generate outsized returns for investors.

The challenge is that you have to invest in narratives that will disappear before they can potentially attract enough users. We may need to go back to Axie Infinity again to take a look.

get the timing right

I came back to Axie because it covers several topics very well.

• By 2021, Axie has been on the exchange and has been in product development for about 2 years.

• It can be said that it was underestimated at the time.

• Axie marks the beginning of the Web3 gaming theme.

It should be noted that this is not an evaluation of Axie. Im optimistic about what the team can do, and weve been working on the argument for Web3 games internally. I remain a big fan of Sky Mavis and the work they are doing for consumer blockchain applications. Our focus is on price and user activity.

If you pay attention to the chart above, youll see that there was an influx of users before Axies price significantly increased to $150. Investigators on the chain likely saw how new users were flooding into the product and priced it well ahead of July 2021.

But by October, when the number of new users began to dwindle, Axie became more of an asset than a product. This is a trap that all on-chain products are prone to fall into. The hyperfinancialization of in-game assets means that a New York hedge fund can pay a guild member to work hard in the game. The mode of earning in-game revenue depends on the inflow of in-game assets. Sometimes this liquidity comes from speculators and institutions.

Between July 2021 and January 2022, many investors formed beliefs on the sidelines and wrote theses on how the industry would develop. Founders will also be aware of the difficulties in building DeFi dApps and believe that gaming is the next big thing. Just like many founders today are dabbling in artificial intelligence.

The real risk lies in the 18 months after January 2022. Do you see a smooth decline in the number of new users in the graph above? This is the shrinking user base of all Web3 native game apps. Tools built at the edge, like something like the Steam of Web3 games, quickly struggle to find users.

This misunderstanding of actual consumer demand from short-term price increases is a trap we see many founders fall into. The risk for founders is that without traction, it will be difficult to raise follow-on financing in the current market environment.

The founders may have missed the right opportunity in the right market. The danger for founders is shutting down the business before enough attention or capital flows into the category.

As a venture capitalist, on the one hand you will see liquid markets that reward traders greatly, and on the other hand you will be competing with a group of founders who are involved in the topic with you. This was not a pleasant experience for any of the participants.

My point is:

• Markets typically price in narratives in the short term.

• Given the liquid nature of Web3 investments, liquid assets may be exited within a quarter.

• Given the illiquid nature of venture capital, startups may not have a market to tap into when the product comes online because the product takes time to develop.

• This often means slow death and gambling on the users return. The product actually becomes a bet on Niuhui.

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

Crypto-native investors who make venture capital investments are either admirers or early movers. They either have the distribution and reach to start a new category, or they have the vision to understand that a whole new industry is on the rise. If a new thesis is formulated solely on price action as a driver, they are very late in the market. Chances are they dont see an exit opportunity unless its a business that can scale to an IPO or be acquired. Both of these situations are rare in the token space.

Another way to influence founders is through business model evolution. For example, the effective royalty rate for NFTs has dropped from about 2.5% to 0.6% in the last year due to the emergence of royalty-free marketplaces like Blur. As of this writing, approximately 90% of NFT transactions do not charge any royalties.

Essentially, this means that any business built on the idea that a large number of traditional artists will enter the industry, who in turn need the tools to generate income, will completely disappear. Countless creator economy businesses had to pivot in the last year as the paradigm shifted.

As with all emerging technologies, chaos is a way of life in the crypto world.

free

Lets take a step back and go back to the late 2000s. After a long day at school, you log on to Facebook to chat with your friends. There are countless funny videos on YouTube. Ads are sprinkled throughout these events, but you rarely pay a dime for these things. The Internet creates habits before you pay for them.

In contrast, Web3s obsession with ownership and exclusivity has led us to create small user bases. According to their blog, Arkham Intelligence has over 100,000 users. Nansens V2 product has over 500,000 registered users today. Dune has one of the largest data scientist communities in the industry. There is only one thing in common between them: free.

The genius of the Internet is to remove the cost of most actions from the user. In return, it gains influence. The great danger of Web3 is how expensive each interaction is. For users who dont need to socialize online, spending $8 to buy an image on the blockchain is not attractive.

Why pay $50 for ENS when users have had email addresses for free for decades? Axie Infinity initially requires an NFT purchase of $1,200 to play the game. Guild mode relies on this high bar. They released a free-to-play version last year, realizing the dangers of keeping the bar high.

Today, Reddit makes this"free"and"have"The combination is very clever. As a social network with 400 million monthly active users, Reddit is a giant. About 15 million wallets have collected their collection so far. This is roughly double the number of DeFi users in peak months. Accounts with certain years and characteristics are allowed to buy collectibles from Reddit.

In this case, most users still use"free"product, only a small percentage of users are minting, trading and owning collectibles. Distribution is a solution through a website that has been running for 18 years.

Rabbithole and Layer 3 fit this pattern very well. Instead of charging users, they provide value to those curious enough to explore new opportunities on-chain. According to a tweet from the Layer 3 founder, the product offers around 15 million on-chain operations for those interested in cryptocurrencies.

A shift in product strategy is already happening. If you visit Beam.eco, you will see a wallet that is set up in less than 10 seconds. Asset.money helps you collect NFTs in less than three clicks. Users don’t have to worry about gas fees, entry, or setting up a wallet. Of course, there are security tradeoffs here. This is similar to the shift in email from everyone running their own servers to third-party servers run by service providers like Hotmail and Google.

Countertrade

Remember when I said that narrative alone can’t determine the timing of crypto ventures? The way to escape this trap is the oldest trick in the book:

• Attract user groups and maintain them for a long time;

• Stable accumulation of value over a long time frame.

Some coins in the industry have successfully done this. When it comes to the DeFi field, I think of Uniswap. Despite the royalty attack, OpenSea remains relevant. The tail end of the venture capital universe is a big bet on how and when attention and capital will flow.

The only way to escape an unhealthy reliance on investor or speculator capital is to tap into the purest form of capital available to all businesses, the attention of their customers. As VC funding shrinks, more and more startups (and protocols) will have to find users who care about their products.

The most relevant example I found is Manifold.xyz. This product focuses on helping creators mint NFTs with relative ease. According to TokenTerminal, their fees exceeded $1 million last month. Is it performing well? maybe not. Is it relevant in the current market? Absolutely.

One thing I find common among many players who have successfully navigated market cycles is their first-mover advantage. This is a recurring story.

Small teams enter an industry when market sentiment is at its peak. They see the market shrinking. Typically fewer than five players are willing to continue building as the competition leaves. They are the ones most likely to scale when attention and capital return. Viewed through this lens, the narratives that big investors are abandoning are the ones you should be a part of as long as you can survive.

A while ago, being part of Web3 was cool, now it might feel awkward to mention that you work in this industry. Teams feel the need to make up statistics to stay relevant. We often see founders exaggerating their products through airdrops and driving transaction volume.

For founders, this is a survival note.

• Understand the difference between a VC betting on the narrative and a VC digging deep into your sector.

• Early entry into the market is a moat in itself. But it also means it can take months or more before someone becomes convinced of your product. Much of your pitch will be an investor education session. This is both a blessing and a curse.

• In a market where all peers are failing, survival is the end game. Keeping expenses to a minimum to survive is usually the right thing to do.

• Consumer attention often precedes investor dollars. Talking to users helps iterate on the product before pitching it to investors.

• If product-market fit cannot be found within a meaningful timeframe, it makes sense to wind down the business.

Given that the crypto market is a very liquid market, investing (time or money) requires understanding where you are in the narrative. The pitfall usually lies in spending years on a collapsing sector. Personally, I dont think the Web3 game is over. Its story is still being written by countless founders who still believe in the sector.

The pitfall is confusing public market price action with private market investment opportunities. By the time the product hits the market, the narrative may be dead. Subsequent financing may disappear. Consumers may not care. This is an uphill battle that many founders will have to face in the coming quarters.