Overview
Looking back, it may seem obvious that a failed project was doomed from the start. But the reality is that many participants of varying levels of expertise and investment size have stumbled in the broad, blockchain-enabled, crypto ecosystem. The market cycles have been fast and market participants have had to learn quickly, as reflected in the volatility of the markets. This ongoing case study provides valuable insights for early-stage liquid companies.
There are countless articles recounting the lessons learned from Mt. Gox, The DAO, Terra, and other exploits. However, rather than rehashing those lessons, this article aims to promote approaches that can help mitigate the risks of being involved in the next one. It's no wonder that many people who are not involved in the industry are hesitant to participate and have a negative perception of scams, volatility, and a lack of utility. News headlines often feature 90% drops in value, scams worth hundreds of millions of dollars, and meme-based projects.
To change the narrative and shift the perspective for both retail and institutional participants, the industry must focus on the true fundamentals that will drive the vast potential of building around blockchain technology. The first step is identifying what to avoid. The following is a non-exhaustive list of red flags that should be considered when approaching the space from an investment perspective. While these items are not new concepts or revolutionary ideas, they can be overlooked in a context that focuses on upside potential.
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1. Real Value Creation
When evaluating a project, the most important criterion is the value it creates, which is not measured solely by the appreciation of tokens or equity, but rather by real-world utility. This can come in the form of revenue or other tangible benefits, such as security, transparency, reliability, or some other service; the key is the generation of utility (that could potentially be monetized) in order to be sustainable long-term. However, evaluating value becomes more complicated when considering different types of tokens/equity, such as utility, governance, transactional, or other tokens.
Identifying a project that lacks value is often easier than identifying one that creates value. For example, Ponzinomics, which is a fraudulent economic system that pays off early participants with funds from later entrants, is a clear indication of a lack of value. While incentivizing user adoption through ownership, decision-making power, or earnings shares can facilitate value-generating interactions, unsustainable incentives can lead to a quick rise and an equally quick fall in a project's value. It is important to distinguish between sustainable utility creation and unsustainable circular business models, as the latter can cause a project to lose value as soon as incentives are removed or token values decrease. This can play out quite quickly, as we have seen in both traditional finance and decentralized finance, since at the point of a bank run, there will remain no value for those who are not able to get out in time.
In token-based companies in the crypto industry, the use of their own tokens (often viewed as a stock by investors) as currency can blur the line between underlying and perceived value. One potential benefit of this structure is that it can incentivize user adoption through ownership, decision-making power, and earnings sharing, without the need for outside capital. If effective, it can create value-generating interactions and accelerate the flywheel effect. However, without a strong moat, the removal of incentives or a drop in token value may prompt participants to switch to similar projects. Unsustainable incentives can result in falls that are as quick or even quicker than the rise. To distinguish between sustainable utility creation and unsustainable circular business models, it is essential to make this ultimate distinction.
2. Path towards monetization
After ensuring that a project is creating value, it is important to consider how that value can be monetized. While there are numerous promising projects being developed, their potential as investments may be limited if they cannot be monetized effectively. This can be achieved in various ways, such as through the generation of fees for security, storage, exchange, computation, or other services that would generate revenue in a non-blockchain environment. For instance, Uniswap could potentially impose a fee on exchange transactions, which could then be distributed to token holders. Conversely, for many X-to-Earn models, it is important to understand how the "earn" component is being financed, and whether the "X" component will continue to generate it sustainably. The monetization of projects can be highly subjective due to the numerous approaches available, making it a highly theoretical concept.
3. Community Engagement
Economic systems are essentially incentive systems that rely on properly structured incentives to drive sustainable long-term value. Unlike traditional business models, many blockchain businesses use native tokens that serve as double-edged swords. While these tokens bring in the value of community ownership, which is not usually considered in investment analysis, they also create an added incentive for users. By sharing rewards, users are motivated to act in the interest of their ownership stake. Community ownership can be highly productive in driving network effects and platform value, but if the value of ownership drops significantly, it can lead to an exodus of users due to the loss of incentives. Particularly on the application layer, in which alternatives can be more readily available and switching costs lower, the positive impacts of community incentivization can turn counterproductive. A strong community can be incredibly profitable and powerful, but if it is driven by short-term goals, it may eventually become a fad and lose momentum.
4. Protecting Moats
Having a competitive advantage can be crucial in protecting market share, especially when communities are highly valued in a project. This advantage, commonly known as a "moat," can take the form of intellectual property, increased efficiency, or switching costs. However, in the crypto space, where code can be easily replicated, network effects are often the key moat that sets projects apart. This highlights the importance of sustainable incentives. For instance, the Sushiswap vampire attack attempted to attract users from Uniswap by replicating its business model and offering token incentives. If Uniswap had been less agile and at a smaller scale, it may have struggled to remain competitive.
5. Qualified Team
When it comes to supporting startups, investing in the team behind the idea or product is often more important than the idea or product itself. It is essential to support trustworthy, capable, proven, and motivated teams, and this becomes even more critical in the crypto ecosystem where many contributors operate pseudonymously. Therefore, analyzing the core team's motivations, goals, and resources can provide valuable insights into a project's progression. Even in decentralized blockchain-based companies, the founders and core team members remain impactful. Examining their work ethic, morality, and understanding of their vision should guide the forecast. Without the right combination of market expertise, technical know-how, and network, even the best ideas can fail to be executed properly. Reviewing the team can also extend beyond the core group to the broader contributor network, but this can be a challenging task given the numerous ad-hoc participants involved.
6. Product Market Fit
Despite the excitement surrounding the development of various projects, there exists a gap between what will attract early adopters versus the wider public. Although many participants in the crypto industry are interested and optimistic about the technology's potential, a new product seeking to replace existing solutions on a large scale must offer significant advantages. The process of convincing users to move from familiar platforms can be challenging due to the switching costs and learning curve involved. Therefore, the new product must not only be comparable but also superior and capable of inspiring confidence. While decentralization can appeal to early adopters, most people prefer trusted intermediaries. However, an interface, price, ease of use, and security that are markedly better may provide the incentive for users to migrate to Web3 and blockchain companies.
7. Regulation Anticipation
Most questions regarding regulation will yield an uncertain answer. Across assets, geographies, and industries, the treatment can be completely different or may not have a defined policy in place. While there may be more clarity in the coming months to years, it is wise to use logic when anticipating regulation today. Even if something is not explicitly illegal, immoral business models may still face consequences. Additionally, the future treatment of crypto-related assets can be guesstimated based on their uses, impacts, and implications. Although ever-evolving, early indications may classify blockchain tokens as commodities and application tokens as securities. Ultimately, it is prudent to be conservative and assume that investment-like assets/tokens will be treated similarly to stocks, and governance structures/DAOs will be treated like traditional entities. This approach may help to avoid future problems. Companies that push the boundaries too far in their actions may suffer negative consequences, as Ripple did in their legal proceedings.
8. Proper Structure
When it comes to structure and governance, it can be easy to get lost in a complex web of decision-making. DAOs, Labs, and other unique entities are all undergoing a process of trial and error. The optimal structure has yet to be determined, especially in terms of finding the right balance between decentralization and adherence to traditional norms. While it's possible that a completely new approach could prove to be the most effective, the further a company diverges from proven methods, the greater the risk of encountering unknown problems that could cripple the organization. There is a wide spectrum of structures, entity locations, and strategies being employed, but it's important not to overlook the potential implications further down the road as the project scales.
9. Logical Valuation
Lastly, and tying back to the first point, it's crucial to contextualize the implications of a token or company's valuation. Market capitalization (if appropriate to tokens) can be easily evaluated for reasonability compared to a range of assets outside of the crypto industry. More sophisticated models can forecast potential cash flows (or a translated estimate for value created) based on actual or potential monetization, which can help determine the implied market size/market share, take rates, and growth needed to justify such a valuation. When it comes to the application layer, it is often more reasonable to use traditional underwriting models. However, underlying blockchains are distinct as they can be seen as a monetizable version of the protocols of the internet, (eg. TCP/IP (Transmission Control Protocol/Internet Protocol), HTTP (Hypertext Transfer Protocol), SMTP (Simple Mail Transfer Protocol), and FTP (File Transfer Protocol)). As a result, more creative approaches are required here to get to the ultimate objective of capturing the value of security provided, in comparison to other "trust" solutions. Ultimately, beyond simply understanding the market price (pre- and post-dilution), conducting a valuation exercise can be the most helpful way to map the trajectory required to justify and assess the market's rationality. This comprehensive exercise can at least frame the underlying assumptions, where logic can then be applied to evaluate them.
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Next Steps
The absence of the aforementioned factors could indicate a potential lack of longevity in an investment. Each perspective within the ecosystem likely has different insights and metrics that have been useful in evaluating investment opportunities. New opinions are always welcome in creating a more informed and well-rounded point of view. Ultimately, seeking sustainable projects doesn't guarantee immunity from exposure to failed ones, but it can help filter out investments that are more likely to fail.
Disclaimer: The information provided in this article is for discussion purposes only and should not be considered as investment advice. The content of this article is based on personal opinions, observations, and research, and it is subject to change without notice. Readers are advised to conduct their own due diligence and consult with a qualified financial advisor before making any investment decisions. The author and the publisher of this article are not responsible for any actions taken based on the information presented herein. Investing in financial markets involves risks, and past performance is not indicative of future results.
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