A fool and their Web3 investment will soon be parted
These are turbulent times for Web3, the moniker under which an array of economic activities having to do with blockchain, the metaverse, cryptocurrency, NFTs and distributed ledger technology (DLT) are taking place. But if you hold your hand up to shield your eyes from the apocalyptic eclipse and adjust your fingers ever so slightly, you should be able to catch a glimpse of the venture community’s continued enthusiasm for all things crypto in spite of the current carnage.
However, in comparison to a few months ago, just prior to the current bear market, there’s been a palpable change in both the elapsed-time-to-funding and the degree to which investors expect their founders to demonstrate a better command of crypto business models.
Bullish on Web3
Before the bear market, the Web3 startup feeding frenzy was so vicious that investors didn’t have the luxury of time to dig deeply into some of the underlying fundamentals. According to Haya Al Husry, a program manager at Outlier Ventures, “We watched as other investors closed their rounds in as little as two to three days which meant there was literally zero due diligence.” Outlier is a global metaverse accelerator with several investment programs, some that focus on specific blockchains, and others like a decentralized finance program (aka “DeFi”) that are chain-agnostic.
Now however, with rounds taking weeks or months to close instead of just days, investor ebullience has given way to a more comprehensive review of startup Pro Formas. Not only do investors want to know that founders clearly understand the impact of cryptocurrency volatility on the bottom line, they want to see exactly how startups plan to mitigate that impact.
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Whereas many retail investors feel the sting of cryptocurrency volatility in their attempts to buy low and sell high (or even if they’re “HODLing” — holding on for dear life), many Web3 startups end up getting stung by the transaction and gas fees associated with the chain(s) on which their project does its business. Those costs are almost always paid for with the chain’s native cryptocurrency. In many cases, if the value of the cryptocurrency goes down, the transaction and gas fees go down accordingly (in terms of U.S. dollars). Likewise, If the value of the cryptocurrency balloons (as cryptocurrencies are known to do), so too may the U.S. dollar-adjusted value of the transaction fees.
Some founders enter the investment conversation with an awareness of this nuance. Others do not. “Of the ones that do,” says Al Husry, “a common mitigation strategy is to pass volatility-driven cost increases over to the end customer.”
Depending on the underlying chain, that could have serious unexpected consequences for end users. In May of this year, the buyer of a $25 NFT ended up paying $3,325 when $3,300 worth of fees were levied on the transaction, thanks to both Ethereum’s congestion pricing and the then-soaring value of ETH (the native cryptocurrency of Ethereum). If customers of a project are asked to eat the cost of cryptocurrency volatility in a way that unexpectedly drains their pockets, it won’t be long before those customers vacate the project (and investors are vacated of their dollars).
For enterprise applications that rely on public DLT as a means of decentralizing trust and improving transparency in multi-stakeholder ecosystems like supply chains, a mitigation strategy of the sort that Al Husry describes is imperative. CFOs with a penchant for a predictable total cost of ownership will bristle at any application whose cost of ongoing usage is unknown, much less subject to the volatility of cryptocurrency. In other words, simply passing on the volatility of cryptocurrency to the end customer will be a non-starter in many situations.
In situations where end-customer unwillingness to absorb the risk of volatility poses a threat to the Web3 project’s business viability, other mitigation options exist. For example, some projects rely on a clever approach that divides a single fee across a batch of transactions, while other projects build on chains whose total costs are unrelated to cryptocurrency volatility.
The long-term impact of cryptocurrency volatility on a project’s total cost of ownership is a fundamental financial detail of running a Web3 project, but one that’s easy to overlook for both founders and investors. Founders should come to any investment conversation prepared with more than just a keen understanding of the impact of cryptocurrency volatility to their bottom line. They need to prove how that volatility will be managed or mitigated so as to be non-consequential to their investors’ ROI.
Meanwhile, savvy investors looking to avoid a surprise in some months’ or years’ time should pin their founders down on this part of their model to understand exactly what measures will be taken to mitigate the impact of cryptocurrency volatility and to what extent, if any, customers will be impacted by that strategy. If the founders have omitted this footnote or don’t have the answer, your spider senses should be tingling.
As Al Husry told me, “We advise our founders that if the tide goes out and you’re standing there naked, it’s going to show.” In other words, whether you’re a founder or an investor, make sure you’re covered for the shifting currents.
Mance Harmon is cofounder and co-CEO of Swirlds Lab and cofounder of Hedera.
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