Trends from surveying the Web3 value chain

Making sense of Web3 like a VC #2

Author

Samuel Chong
May 19, 2023

Welcome to a new series on using the neglected science of value chain analysis to inform early-stage investing decisions.

In my previous issue, I talked about how value chains are packed with alpha and how inspecting them enables you to bootstrap intuition rapidly.

But how do you actually do this?

Let’s dive in and inspect the Web3 value chain, but first..

  1. Flow of goods/services: → What do they do and how do they do it?

  2. Flow of cash → How do they make money and who do they sell to?

  3. Gross margins → How much of the cash do they get to keep? 

  4. Total addressable market → How big can this get?

  5. Funding momentum → Is this the right time?

The Web3 value chain

3 verticals should stand out at first glance based on the congregation of the Flow of Cash - i.e. Content & Community, Primitives, and Tooling Infrastructure.

But let’s break this down further and inspect the first 2 components of each vertical in this week’s issue.

*Note: examples provided are non-exhaustive.

**No gifs and memes today because we’ll need to focus :(

Hardware infrastructure

  1. What do they do?

    Similar to how Web2 requires data centres to host them, Web3 needs a similar place to live in - i.e. distributed blockchain nodes.

    These are the people selling the actual hardware.

  2. How do they do it?

    Hardware infrastructure players develop and sell hardware to node operators. These hardware are often off-the-shelf CPU devices but can sometimes be specialised devices (e.g. ASIC miners for the Bitcoin network)

  3. How do they make money?

    Aside from ASIC miners whose prices fluctuate with the current Bitcoin prices and hash rate, hardware infrastructure is typically sold for fixed prices. Purchases are also one-off in nature.

    This means that their revenues do not scale directly with increases in transaction volumes or asset prices. But it also means their revenues are less sensitive to these factors. It is a low beta exposure to the Web3 space akin to selling picks and shovels during the gold rush.

  4. Who are they?

    • Bitmain, Bitfury, Canaan - Develop and manufacture mining and mining-related hardware. Mainly focused on the BTC network. Also develops their own software for mining use cases

    • Dappnode, Avado, Stereum - Develop node-in-a-box hardware + software for the ETH network

    • Traditional electronics manufacturers - Most blockchain nodes (especially for Proof-of-stake) are assembled with off-the-shelf components

Node operators

  1. What do they do?

    These are the people who buy the hardware required to run blockchain nodes.

  2. How do they do it?

    Node operators procure hardware to run blockchain nodes for the protocols (network) of their choosing. They process transactions and provide security to these networks.

    They also allow Primitives, Dapps, and Wallets to access the Web3 world via their nodes. This is similar to how Web2 servers work today.

  3. How do they make money?

    In exchange, they receive transaction fees from the protocols and these originate all the way at the top of the value chain - i.e. users who use Dapps that are built on top of this network.

    These transaction fees are not a function of the transaction size but are instead subject to supply & demand for blockspace at the point of the transactions.

    Primitives, Dapps, and Wallets also pay per use to access these nodes.

  4. Who are they?

    • Infura, Alchemy, Pokt - Nodes-as-a-service similar to AWS, Google Cloud, Azure of the Web2 world

    • Blockdaemon, Figment, Bitcoin Suisse, StakeFish - Node operators facilitating non-custodial staking (yield generation) for institutional clients.

    • Individual/community/project node operators - These are your solo validators or those who run nodes for a community. Developers also run nodes to get private and quick access to their desired blockchain

Protocols

  1. What do they do?

    When people talk about blockchains, this is what they are referring to. It is the base layer where everything else on-chain is built on (eg. BTC, ETH)

  2. How do they do it?

    The guys at Bankless summarise this well - Blockchains sell blocks. Or more specifically, they sell the available space in each block (i.e. blockspace). Blockspace is in turn powered by the execution “engine” of the blockchain and governed by its consensus algorithm.

    Developers can then build applications that use these block spaces.

  3. How do they make money?

    This is where things diverge from the traditional world. Most protocols do not have direct cash flows and instead function as a foundation (e.g. the Ethereum Foundation), making money in one of two ways:

    • Issuing a portion of the governance tokens to the foundation and selling these tokens over time to cover operating expenses

    • Operate in other verticals to provide additional services. e.g. Foundations of protocols are often node operators and developers (Primitives, Dapps) as well

  4. Who are they?

    • Layer 1 chains (L1s) - BTC, ETH, Cosmos, Near, IPFS (storage)

    • Side chains (to L1s) - Polygon, Gnosis

    • Layer 2 chains (L2s) - Lightning, Optimism, Arbitrum, zkSync, zkStart, Scroll, Base (by Coinbase)

Primitives

  1. What do they do?

    These are players that develop the “immediate” applications on top of protocols. Primitives create a strong foundation for richer use cases (Dapps) to be built on top of themselves. In the Web3 world today, users often bypass the Dapp vertical and use primitives directly.

  2. How do they do it?

    Primitives are basically Dapps that focus on doing one thing very well.

    They are designed to be interoperable so each primitive can be joined with another. When you hear terms like “money legos”, this is what they are referring to.

  3. How do they make money?

    Primitives typically charge both Dapps and users a fee for interacting with their smart contracts.

    These activities include minting of tokens (incl. NFTs & stablecoins), swapping & bridging tokens, lending & borrowing tokens, staking, providing and buying insurance, and market-making.

  4. Who are they?

    • Liquidity/market-making/swap - Curve, Uniswap, Sushiswap 

    • Borrowing & lending primitives - Aave, Compound

    • Staking primitives - Lido, Rocketpool, Stader

    • DeFi/NFT insurance - Armor.fi, Risk Habour, Nexus Mutual 

    • Stablecoins - USDC, USDT, Maker 

    • Cross-chain bridges - Hop, Synapse, Layer 0

    • Derivatives - Dopex, Lyra, Perpetual Protocol

    • NFT Primitives - NFTX, Collection.xyz, Fungify, Jpegd, Taker, Bridgesplit

    • Social media - Lens

    • Identity - ENS, Unstoppable Domains, Spruce, BrightID, Hashkey DID

    • Storage - Arweave, Filecoin, Storj

Dapps

  1. What do they do?

    These players build applications that more closely resemble the “apps” in Web2.

  2. How do they do it?

    Dapps typically wrap 1 or more Primitives into familiar user journeys and increase their range of functionalities - e.g. Web3 games, decentralised social media/content, DeFi/NFT vaults

  3. How do they make money?

    Similar to Primitives, Dapps charge users a fee for interacting with their (wrapped) smart contracts and they are free to set their own prices.

  4. Who are they?

    1. Web3 games - Axie Infinity, NBA Topshot, Cryptokitties, Star Atlas

    2. Decentralised social media/content - Buttrfly, Chromadin, DiverseHQ, DumplingTV, mirror.xyz, primitives.xyz

    3. Defi/NFT vaults - Balancer, Yearn, Beefy, Fractional Art, Nftfy, Unicly, Altr

    4. Tokenised Real World Assets - HomebaseDao, artemundi, CitaDao, OpenEden

Wallets

  1. What do they do?

    Wallets store users’ crypto assets and act as gateways for users to access the Web3 world. Think of it as “accounts” in Web2.

  2. How do they do it?

    Wallets are a type of Dapps that make it easy for users to generate their public keys (blockchain address) and private keys securely. They typically do not hold custody of these keys and also often provide services for users to convert from fiat to crypto and vice-versa.

    Wallets have also begun to wrap Primitives into their own interface - e.g. swapping tokens within the Metamask wallet.

  3. How do they make money?

    Since Wallets are a type of Dapps, they monetise in the same way - by charging a fee when users interact with their (wrapped) smart contracts.

  4. Who are they?

    1. Hot wallets - Metamask, Station, Phantom

    2. Cold wallets - Ledger, Trezor, GridPlus, Ngrave

    3. Smart Contract & Multi-sig wallets - Safe, Argent, Soul

    *Note: If you realise, I seem to classify everything on-chain as a Dapp. This is because they are all smart contracts at the end of the day but that’s a story for another time!

Tooling infrastructure

  1. What do they do?

    This is a diverse group of players that provide off-chain products and services to almost every other vertical, including end users.

  2. How do they do it?

    They develop tools to standardise smart contract development, audit smart contracts for security, extract & analyse blockchain data, enable projects to better run their token-based governance process, Web3-based messaging, custody & self-custody solutions.. the list just keeps getting longer!

  3. How do they make money?

    Because most of their products/services are rendered off-chain, their pricing models usually resemble that of traditional subscription or usage-based fees. Their paymasters depend on the type of products/services they offer. This means that it is easier to apply conventional valuation methods on this vertical!

  4. Who are they?

    1. Smart contract standards & security - OpenZeppelin, Certik, Code4rena, Consensys, Slowmist

    2. Data & analysis - Bloxroute, Blocknative, Dune Analytics, Chainanalysis, Covalent, Nansen, Token Terminal, Etherscan, Coinmarketcap

    3. Governance tooling - Sybil, Snapshot, Tally, boardroom

    4. Messaging - XMTP, Swarm, Matrix

    5. Custody / Self-custody - Bitgo, Fireblocks, Liminal, Atato, Propine

Content & Community

  1. What do they do?

    These platforms generate Web3 content (e.g. written, podcasts, video) for end-user consumption. They also organise Web3 communities via events and social media channels.

  2. How do they do it?

    Examples of Web3 content include the latest developments, narratives, and research in the space. Most players cover all forms of content as they can be easily repurposed. Events are organised to connect the various verticals with one another and to bring these verticals closer to their users.

  3. How do they make money?

    Their goal is to establish themselves as a thought leader and build a large audience - which they can then monetise via sponsorships/ads, ticketing & merchandising, premium subscriptions, or even being a delegate (Which I covered in a previous issue here).

  4. Who are they?

    1. Written - Coingecko, Bankless, Decrypt, Coindesk, theblock, Coinbureau

    2. Podcasts & Video - Uponly, Bankless, DailyGwei, Unchained

Users (+Investors & MEV Searchers)

These are the people like you and me who use DeFi, NFTs, or off-chain services. However, the Web3 space is unique, as users are often also investors in the projects (companies) offering these services.

Another group of users are the MEV searchers. They peer into the blockchain (Mempool) and perform on-chain arbitrage to balance prices across different Dapps.. or at least the good guys do this (once again, story for another time!)

Observations so far

  1. Hardware Infrastructure, Node Operators, and Tooling Infrastructure provide low-beta exposure to the Web3 space

  2. Protocols often do not directly generate cashflows. Their success and failure are amplified by all other verticals

  3. Value seems to be migrating towards to Primitives vertical. Is it time to move away from the Fat Protocol Thesis? 

  4. If the trend in (3) can be extrapolated, Dapps and Wallets will be next to shine on stage

  5. Content & Community businesses have broad and interesting monetisation options despite their relatively boring business models

To be continued..

Phew that was a lot to get through and we’ve only really covered the first 2 components of the value chain analysis.

The latter 3 components will require extensive research to get them right so I might pause on this topic until I have sufficient data gathered - stay tuned!

Okay I lied, here is a cat gif for making it to the end

Keep diggin’,

Sam