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Venture capitalists are pumping money into Web3. Here’s why.

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Venture capital (VC) investments in the Web3 sector have been on fire this year, with several established venture capital firms launching a Web3 and crypto arm. Paradigm’s $2.5 billion fund and Electric Capital’s $1 billion fund are just a few examples.

So why are these companies so bullish on Web3 investments?

Excessive returns

The token economies that underlie many Web3 projects can result in outsized returns compared to Web2 investments. This is especially true in the current climate of soaring inflation, rising interest rates, depreciating startups, and volatile markets. While the cryptocurrency market has seen its share of ups and downs in 2022, its total market capitalization has increased by almost 200% in 2021, with Bitcoin and Ethereum earning around 60% and 400%, respectively. Other cryptocurrencies posted impressive returns like Avalanche, up around 3,300%, and Solana, up around 11,000%.

More sectoral, DeFi (decentralized finance) had a market cap of just $2 billion in 2020 and opened with a Market capitalization of $160 billion in 2022 — growth multiplied by 80 in just two years. Many leading investors and institutions are making the bold prediction that DeFi, which currently represents an immaterial percentage of the traditional S&P500 financial market, could be worthwhile 100 times more in just five years.

Related: 3 Steps to Web3: The Ultimate Guide to Navigating Web3 for Non-Tech Founders

The NFT sector shared the same level of explosive growth, becoming a $40 billion market in 2021, a 21,000% increase from 2020! The NFT market is almost on par with the traditional art market, and for good reason. If you were an early investor in specific projects such as CryptoPunks or Bored Ape Yacht Club, you would have enjoyed a staggering 100x return in less than a year.

Of course, for every outsized winner, there are countless losers. Since your typical venture capital fund targets an annual return of between 20 and 30%, a venture capital fund only needs to select a few solid investments. As we have seen, there are many opportunities to invest in potential unicorns in their early stages, returning 100x and covering the myriad failures. This special Web3 period represents an opportunity reminiscent of the early days of the Internet boom, which spawned many of today’s most notable VCs.

Liquidity

Traditional equity investments in startups are illiquid. Investors will generally have to wait for a liquidation event such as an IPO or acquisition to cash out themselves. Of course, there is a secondary market for private stocks, and buyouts by private investors have been around for some time. However, this is a very complex process and is not considered a liquid investment.

On the other hand, most early-stage Web3 projects issue tokens that can be traded on exchanges at any time. In theory, if an investment grows 100X in a short period, investors often have the opportunity to realize the returns much sooner, since there is no lock-in period.

Moreover, a startup that depends on its token economy inherently means that it is built on-chain. Being “on-chain” (data is publicly stored on the blockchain) means that startups and their key metrics are much more transparent than in private markets. Indeed, investors in Web3 projects can see how much capital they have, how capital is deployed, etc. This information is usually available with a click or two on platforms such as Etherscan.

Passive income

Instead of just making traditional equity investments and hoping to reap a capital gain on the way out, tokens offer VCs a unique opportunity to generate passive income on their holdings.

This can be done by one of the following methods:

  • The most popular is stake your chips. This means pledging your assets to support a blockchain network that leverages a proof-of-stake consensus mechanism.
  • Another method is agricultural yield. You can deposit your tokens into a liquidity pool and earn interest.
  • Finally, you can use liquidity mining. This means you can provide liquidity to a DeFi protocol and earn rewards.

Related: 9 Key Trends Shaping the Blockchain Industry

The rewards of these passive income mechanisms can be quite compelling. They often go from two to 25 percent, or in the case of some riskier projects, more than 1000 percent. Plus, these rewards are typically distributed daily, which is a dramatic change from what we’re used to with term deposits or interest-bearing dividends.

Ultimately, this means that venture capital funds could generate attractive passive returns for themselves and their partners long before any liquidation, thereby incentivizing them not only to maintain their position, but to contribute more to the success of the project.

Capital efficiency

The internet and its subsequent innovations have allowed startups to exploit near-zero marginal cost solutions and unprecedented economies of scale. This made pre-Internet businesses look seriously capital inefficient.

Take Netflix as an example. Netflix employs a few thousand employees and boasts a market cap of over $100 billion in 2022. In contrast, its physical predecessor, Blockbuster, only managed a peak market cap of $5 billion with over 60 000 workers and many properties.

What is the link with Web3? Token economies and the base layer infrastructure of Web3, which underpins the way projects pool capital, coordinate, and incentivize holders, threaten to make Web2 businesses just as inefficient as their pre-Web predecessors.

Chris Dixon from a16z wrote that he “never worked on a project that spent a lot of money on sales and marketing. You don’t need to spend money on marketing when users are real owners, love what they do and enjoy telling others about it.” Web2 companies often spend millions on aggressive marketing to accelerate consumer acquisition, while Web3 startups have the luxury of scaling the network through token incentives.

UniSwap is a leading decentralized exchange with a fully diluted market capitalization of $6.2 billion and 50 employees. That’s a staggering market value of $124 million per employee. To put that into perspective, the most successful company of all time, Apple, is around $18 million per employee.

This proves that startups no longer need to hire a plethora of talent. Instead, they can strategically leverage their token incentive network to help them build, scale, and thrive, essentially becoming a low-cost entry-level talent acquisition model.

Bottom of the S-Curve

As stated earlier, this is an incredibly new space defined primarily by a sense of urgency and excitement reminiscent of the early days of Web1. Similar to Web1, there are also many hype and stupid money in space, so we have to proceed with caution.

Most major financial institutions predict that the wider Web3 industry will grow at a compound annual rate of around 50% to become a multi-trillion dollar industry over the next decade. Despite their early criticism of crypto, JPMorgan, Goldman Sachs, and Citi recently created crypto research divisions to take advantage of this rapidly growing opportunity.

Today we are at the bottom of the S-curve, which means this could very well be the dawning of a once-in-a-lifetime opportunity.

Related: Are Investors Realizing the Potential of Web3.0?