Why Classical VCs Change Their "Way" - Talking About Web3 with Web2 VCs

Source: AnT Capital

The following is a written record of a recent in-depth conversation between A&T partners and two industry peers. We invited two senior investors from traditional institutions who are transitioning to Web3 investments, referred to as Peter and David (both are pseudonyms), to discuss the logic and thoughts of investors with rich traditional investment experience in the transition to Web3 investments.

Q: When did you start believing in Web3?

Peter:

I started believing in it when I participated in a hackathon in 2016. At that time, Ethereum had just experienced the well-known DAO hack, but what I saw was that although ETH faced a huge impact, many developers were just focused on building interesting things rather than worrying too much about the price fluctuations of ETH.

Todd:

I started believing in Web3 in January 2021. Although I joined the crypto world in 2018, I didn't see crypto as Web3; it was more about blockchain, a new technology. It wasn't until I saw Mirror.xyz that I realized it brought something different and valuable to the industry. Compared to Web2 platforms like Zhihu or Medium, Mirror provides content creators with an option to help them raise the funds they need during the creation process, which is very difficult to achieve in Web2.

Peter:

From a user experience perspective, I do agree with your view on Mirror. For me, DeFi is also Web3, even though they are not Web3 applications. Before Uniswap, there was a well-known DEX called DDEX, and I was an active user of that application because they did not monopolize your data rights, allowing me to fully control my assets as they moved between different applications.

Liam:

I started believing in Web3 because I immersed myself in the cryptocurrency market. For me, Web3 means less permission, ownership, transferable economic value, and so on. In March 2020, while I was still at Deutsche Bank, I first learned about Bitcoin as another type of asset. I believe Web3 will start with currency and is a paradigm shift in the financial system.

Q: What are you most looking forward to in Web3? It can be a model, a product, or a way of thinking.

Peter:

From a user experience perspective, ownership is the most critical aspect. Ownership is something we cannot have in the Web2 internet world. That's why I felt very excited when the NFT bull market came. Starting with NFTs, we can have a Metaverse where people spend more time and gain entertainment. In the long run, as everything becomes data-driven and the amount of data increases, we can own more different things in the digital world.

Todd:

I completely agree with the idea of ownership, but there are still many obstacles to achieving this. The only things we can truly own right now are NFTs and FT, but we may not be able to own data. This part will be left for later discussion.

David:

An open financial market is what I look forward to the most. Many friends ask me how to buy and sell Chinese stocks in the US market without an overseas bank account. Synthetic asset platforms can indeed become an option for them to achieve the same goal, synthesizing stock price fluctuations in the on-chain world.

Q: What is the biggest obstacle on the road to achieving Web3?

Peter:

First is the barrier to entry. If you want to enter the real Web3 world, you need a wallet to manage your private keys, which is a high barrier for many people. I know many projects are working hard to lower the wallet barrier, but currently, they are still not doing well enough.

The second issue is privacy. The on-chain data is very transparent, so basically, every transaction is under everyone's watch. Therefore, we see many different types of applications entering this public space trying to capture this data and provide products to users, telling them what others on the chain are doing. This indeed provides many functionalities, but we have no privacy in such places. I have seen many projects trying to solve this issue, like Tornado Cash. These ideas can allow users to manage their privacy. If you want to make some transactions public, you can open them to the public. If you want some privacy, you can still achieve that, so we will soon find breakthroughs in this area.

The last part is about decentralized storage. Currently, most things in the crypto world are still stored in centralized cloud storage. When it comes to ownership, we don't really own it; decentralized storage is what can truly realize data ownership for anyone.

Todd:

Which is more important for the expansion of Web3: low barriers or competitive application scenarios? Because you mentioned many projects are trying to modify the user experience.

Peter:

The first scenario will discuss serving users who are proficient in crypto, or crypto-native users, while the second scenario will discuss how to bring the masses into the crypto world. From an investor's perspective, there are several ways to succeed. One is to serve those core users and build the initial community around them rather than expanding aggressively from the start. I think this will be a more practical approach.

However, I do see some other projects that are creative enough, and I applaud them for being brave. For example, in the public chain space, Flow is doing a lot of work to cater to non-crypto users. Another project, Stepn, is very interesting; it's a move-to-earn model that created a very simple user experience for non-crypto users from the beginning.

David:

I completely agree with what you all discussed. For me, it will be crypto education. Most Web2 internet users have no idea about Web3; they don't know how to use wallets, how to buy cryptocurrencies, or how to participate in communities. Therefore, there needs to be some simple and intuitive ways for these people to join more quickly.

Liam:

Many people are not interested in DeFi, but if they want to participate in Web3, the first barrier might be learning how to use Metamask. But I think they can start with hardware wallets, which are safer and more suitable for Web2 user experiences.

Q: If Web2 companies want to transition to Web3, can they succeed?

Peter:

Web2 companies need to change their mindset. For example, they need to try openness and collaboration rather than thinking everyone is a competitor in the future. They also need to try using token incentives to attract users instead of directly buying users.

David:

This is very difficult for most Web2 companies. Because we are entering a new era, what is being built is no longer companies or enterprises, but more like digital nations, working on open-source protocols. So the entire mindset of building in Web2 and Web3 is changing.

From a community perspective, to build a Web3 or crypto project, there must be a mindset of building a community and establishing consensus among users. This process is somewhat similar to how some great companies were built in the past, but the entire mindset is quite different.

Q: How do you view the monopoly issues existing in Web2 from a Web3 perspective?

David:

For Web3 companies, entrepreneurship still needs to find some new application scenarios. If you want to compete with AAVE and Compound in lending and borrowing, it is actually very difficult to find new opportunities.

Peter:

We often encounter the question of what to do if Tencent or Alibaba enters the space. Actually, AAVE and Compound can also do these B2B things, and they have better persuasion for some B-end users.

Todd:

Many things can be done by giants, but every team has its limitations in what they are good at. Additionally, many teams may not have a deep understanding of a new direction, but not every team has such a deep understanding of an innovative point.

In fact, some new teams can have some innovations in crowded tracks. For example, we invested in a Staking Reward last year, and our investment logic was that it was like CoinmarketCap for the staking track. However, CoinmarketCap did not do this, and Staking Reward has been deeply involved in this track for a long time, accumulating many deep users.

I think AAVE has contributed many innovative points to this market over the past year, so I also think it is reasonable for it to shift to other tracks; you need to step out of a certain circle to gain something new.

Peter:

Actually, it hasn't reached a particularly competitive stage yet. For example, Opensea and Uniswap haven't done this on every chain, which actually gives everyone many opportunities. There are too many directions to explore. For example, Uniswap is definitely the largest traffic source on Ethereum in the DEX space, but Metamask did not create a swap just because it has many users; instead, it integrated Uniswap as an aggregator. However, Metamask's swap charges a very high fee, so its revenue is also very high. There are also many marketplaces and aggregator forms in the NFT space, so there are many things that can be done at the project level.

Liam:

In fact, there is no institutional monopoly in Web3; it is all voted by users with their feet. If you think about it, are the leading projects perfect? They are far from it. Besides the forms of UniV2 and V3, there can be many other forms, such as some order book forms. So first movers have an advantage, but they still need to innovate to attract users.

Q: How do VCs view anonymous projects?

Peter:

VCs, like companies, are a product of history and are not immutable; they will change. From an investment perspective, VCs invest a sum of money in very early-stage projects to acquire equity or tokens at a very low price. This is essentially no different from traditional VCs. The difference lies in the form of financing and valuation judgments. For example, in the early investment agreements, the token percentage does not have further dilution, right? But if you invest in equity, after rounds of financing, your equity may only account for 1% or a fraction of a percent, while tokens do not have dilution. So you will see some VCs have very low costs.

Additionally, regarding due diligence on projects, in traditional projects, you need to conduct financial and legal due diligence. However, in the current digital context, you don't even need to visit the company; you might just have a remote chat with the founder. Crypto has indeed brought many good things; once a project is launched, many things can be clearly seen.

For anonymous projects, regardless of how trust is established, the name or location of the person is not very important. Personally, I have participated in some fair launch projects, and not taking institutional money is also a good way. If it is more application-oriented, it is completely feasible. However, if it is an ecological public chain, it still requires institutions to make a significant early investment; doing a completely fair launch is quite challenging.

Peter:

If we are investing in a fund, we may be investing in the aesthetics of that fund. But for fair launches, it is more about catering to the aesthetics of the entire market. However, catering to market aesthetics can be very volatile. If a fund can be more open and transparent, for example, in the form of a DAO, making investment tracks public, then I would prefer this form.

Todd:

In the crypto field, some funds have realized that the form of VCs will change. For example, the founder of Polychain tweeted that he believes our industry's VCs will soon be disrupted, overturning most VC organizational forms.

David:

Compared to fair launches, VCs still have many advantages. The connection between projects, investors, and investment institutions is still very useful. Institutions can provide some traditional post-investment services, including helping with recruitment, PR, and connecting resources, including KOLs and exchanges.

Q: How do you view the phenomenon of first and second market inversion? What areas are you optimistic about in this year's primary market investments?

Todd:

Internally, we have always looked forward to the arrival of a bear market. In our understanding, the best time for funds to invest is during a bear market because the competition and valuations faced by funds in a bull market are not very friendly. Institutions tend to do more research compared to individuals; it is essentially a matter of monetizing knowledge. Institutions are suitable for investing in a bear market, while in a bull market, they just count money.

Many traditional funds have recently been more active in investing, facing high-valued projects with less fear. In fact, we maintain a frequency of investment during the bear market. To return to your question, every partner in our fund has their own track. For myself, I am more optimistic about some middleware completions in Web3 because we have seen the major components of Web3, but we need some things to complete this middleware.

David:

We prefer overseas companies. We divide Web3 into four layers: application layer, tooling, middleware, and infrastructure. The last layer is protocols, such as L1. Our focus is still on middleware and tooling, such as DAO tools, data analysis platforms, and NFT analysis platforms, which we call the tooling layer. Another aspect is middleware and infrastructure, such as DID and data middleware, as well as nodes and storage. We refer to this part as middleware because we are familiar with this area in Web2, and the risks are more controllable. However, investments in the application layer, such as gaming and NFTs, are not as manageable for us, requiring less effort.

Finally, regarding the protocol layer, we pay less attention to L1 and scaling solutions because there are currently fewer good projects we have encountered. Additionally, cross-chain is also a focus for us.

Returning to the bull and bear market question, indeed many traditional Web2 funds are very FOMO about investing in Web3. We remain calm internally and rationally view high valuations.

Peter:

For us, we would invest in an L1 or L2 scaling or privacy protocol because I think the richness of the protocol layer is strong, and there will be many economic activities in the ecosystem. We pay less attention to the application layer and have already invested quite a bit in middleware and tooling, and we will continue to monitor that. From a valuation perspective, everyone may prefer the bear market and dislike the high valuation bubble. When competition is very fierce, many people will drive valuations very high, and the result is that everyone's returns will decrease. This is also a game. Regarding valuations, everyone votes with their feet. If people think the price is unreasonable or can get a more flexible price from the secondary market, they will also use their own ways to price the project, so everyone has their own valuation logic.

Q: How do you view the ideology of Web3 users owning versus the capital-driven ideology of Web2? How to value token investments and equity investments?

Peter:

The first is the ideology. Compared to traditional equity markets, the personal and community components in the Web3 market are definitely higher, so there will be some fair launch practices. From another perspective, everyone's ideal is completely democratized and fully transparent, but many still rely on the judgments of institutions and KOLs. Therefore, for a long time, institutions will still have a significant influence.

Regarding the valuation issue, broadly speaking, we will judge how the project exits, such as Coinbase's IPO or Coinmarketcap being acquired by Binance. These are relatively traditional methods. We are quite flexible about exit mechanisms.

David:

This mainly depends on whether the project's value lies in the token or the equity.

Q: How do you view the cyclical nature of investment tracks?

Peter:

The ideal situation is that you can predict cycles and directions well. For example, some previous funds could invest in NFTs very early or in the last wave, invest in some large DeFi projects; this is certainly an ideal situation. If the situation is not so ideal, some things are just unknowns regarding what will rise or what is rising. However, we need to think about whether this is a wave of enthusiasm or something long-term. If your perspective is the latter, from an institutional standpoint, synchronizing with the market is also quite good. If you know that this thing has a bubble in the short term but is a long-term growth opportunity over 5 or 10 years, then believing in that allows for sustained investment. If you think this is just a wave, then you might not chase the hot spots. Those that are continuously optimistic will continue to lay out their positions.

Todd:

I would add that in cases where projects exist for a relatively short time, it may be possible to pursue short-term gains in the secondary market. We will consider whether this project can truly solve some market problems; it may face some lows, but in the long term, the fund will also gain some value.

David:

There is a basic consensus in this industry that the entire crypto industry will continue to alternate between bull and bear markets. However, when we invest in projects, we hope that the project can survive into the next bull market and exit in the next bull market. If it is application-layer NFTs or gaming, it will gain a significant return in a short time, but it will only be a short-lived boom.

Q: How to value a project?

Todd:

Each specific track will have its own valuation method. The simplest valuation method is to look at similar projects and their comparable company standards. Another is that some projects we believe will have a place in the long term will be relatively easier to value. For example, staking as a service; if you believe crypto will become mainstream, it may later become a giant company like AWS or Alibaba Cloud. Looking at traditional equity companies, their market valuations can also provide us with some reference. For instance, if you invest in a project, it may become a large company in five years.

The valuation of this round of DeFi is because the market's focus is currently not on this area, so funds will go to higher-yielding places, leading to a decline in secondary valuations. However, for some blue-chip DeFi projects, you can calculate their income, so compared to traditional financial industries, a 20x or 30x PE is relatively reasonable. Therefore, for some DeFi projects, as long as it remains a core player in the track in the long term, its price will reflect the fluctuations in the secondary market.

David:

Opensea's comparison in traditional Web2 is somewhat similar to Taobao, but because its product is different from another, its logic is also more like Xianyu. I would like to add this point.

Peter:

Regarding the time aspect, as Todd said, finding comparable methods may be the most useful, looking for similar projects and their positions. Of course, it also depends on the product characteristics. If it is a public chain project, using traditional valuation may not be very accurate, but for DeFi projects, using traditional valuation is more reasonable. Additionally, the current behavior of projects subsidizing users is also very common, leading to a situation of inflated metrics. So to summarize, if you really want to calculate valuations, you still have to believe that the industry will return to rationality and average levels in the long term. The industry is still very early, so there isn't a very formulaic valuation method yet.

Q: Compared to finding founders among executives in traditional large companies in Web2, how can Web3 efficiently find project founders?

David:

I will briefly mention that most of the time, it relies on friends within the circle to exchange and recommend new projects, but there are also a few cases where good projects are found online, on Twitter or Discord.

Peter:

I won't elaborate much on friend recommendations. Finding projects on Twitter or Discord is indeed quite useful. Friends from large domestic companies have many regulatory considerations, so there is still a process of ideological transformation. In the long run, if there is a change in mindset and recognition of the industry, they will eventually transition to doing this; it is a matter of time.

Todd:

I would add that we often do two things. The first is that we invest in some portfolios, and we invest in them because we recognize this track. I will talk to these founders to understand the new development directions and the best teams in these tracks, sourcing good projects from this channel.

Additionally, everyone has a bot to scrape new projects; these are all personal practices, such as when you scrape, you will have your own parameters.

Q: How do you view how Web3 open-source projects maintain their competitiveness?

David:

When I first entered the crypto market, I also thought about this issue. Since everyone's code is open-source, how do you maintain competitiveness? After getting involved in Web3, I believe a team also needs strong marketing and operational capabilities. Additionally, they need relationships and networks in these fields, such as exchanges, public chains, KOLs, and strong investor support.

Moreover, because Web3 projects are international, the ability to operate an international team and manage projects is also very important. Another point is that the team should have someone who can understand tokenomics design well and innovate. While there may not be significant new innovations in DeFi tokenomics, innovations in token design for GameFi and SocialFi projects can be a plus.

Todd:

Examples like Uniswap, Sushi, and Pancake show that Uniswap still carries the largest amount of funds and attention in the market. Additionally, the team's innovation is crucial; for example, Uniswap can create V2 and V3, but Sushi and Pancake cannot. They can copy the code but cannot gain recognition and innovation. Additionally, Pancake has received strong support from Binance, as well as support from the BSC ecosystem, so having strong resources is very important. Another point is Sushi; their team's community operation capability is relatively strong, so the team's operational and community abilities are essential. These three points basically cover our investment considerations.

Peter:

In the primary market, people are indeed very important; it is about whether this team can sustain its innovation ability. Additionally, open-source does not necessarily make the track more competitive; competition is multifaceted. UniV3 actually modified an open-source license; initially, it was set with a time limit and could not be fully open-sourced, but later it gradually became open-source. So open-source is not a black-and-white issue.