Value chains are packed with αlpha

Making sense of Web3 like a VC #1

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

I do not yet know how many issues it will take to cover everything as I am trying to distil my VC experience into bite-sized 5-minute reads but this will become clearer along the way!

To kick things off,

Early-stage investing is hard…

Why is this relevant to you? Because anyone putting money into Web3 is technically an early-stage investor.

I am talking about proper OG investing where you are willing to hold your bags for at least 5 years (if not forever) and not just dump them on retail the first chance you get.

Anyway back to my point. It is hard because the opportunities here are super diverse, noisy, and distracting.

  1. Diverse: There are 4 main layers (i.e. Protocol, Infrastructure, Application, Access) with many verticals in each layer and even more business models under each vertical - How do you decide which areas to focus on as your thesis?

  2. Noisy: Even after defining your thesis in (1), there are a ton of imposters to sieve through because of how much capital has entered the space over the recent cycle.

  3. Distracting: A year in Web2 is 10 years in Web3. The space moves very quickly and new narratives are popping up every day. How do you avoid FOMO and devolving into a spray-and-pray strategy?

These 3 problems often lead to one of two outcomes as investment teams are usually very lean.

  1. Missed opportunities - Spending too much time to come to a decision

  2. “Bad Satisficing” - Prematurely coming to a half-baked conclusion because of time, resource, and intellectual constraints. This is likely what happened if you have a large portfolio of shitcoins 💩 

As you can imagine, the problem is even worse if you are a retail investor acting solo.

Intuition is a win condition for early-stage investing

Given limited resources and a vast universe of opportunities to explore, the key to success is to consistently choose the right segments or verticals to focus on. ie. Which verticals are most likely to bear fruit?

Sure, you can brute force this problem with strong intuition but intuition tends to be volatile if it is not honed. Consistency is a key ingredient here.

Honing intuition, in turn, requires accumulated experience in the relevant domain.

In other words, intuition takes time to build, which makes it a luxury most retail investors do not have.

How then would you bootstrap a proxy to this intuition?

Option 1: Expert interviews

This is where you speak to domain experts of the industry you are planning to invest - leveraging their intuition to inform your decision on where to focus your time and resources on.

But even though this might seem like an obvious solution, it is often not feasible to most investors as it is often expensive. That being said, the economics of this method improves as your investment amount gets larger.

Besides, this method is still lacking in completeness as vertical-specific perspectives are often inadequate to capture nuances of the entire industry.

Opinions can also be biased based on individual experiences as there are no downsides to them leading you down the wrong direction.

This means that expert interviews are at best a tool that can be used to test specific hypotheses you have in mind further down your investment process.

Option 2: Inspecting the value chain

A value chain describes how each player in an industry interacts with other players. Inspecting value chains gives you a good sense of where value tends to accrue.

It is a feasible method for all investors because it is cheap to perform - only requiring desktop research and logical reasoning to form your initial view.

That being said, a refined version will require you to speak to industry practitioners (eg. founders, sales, operations) to corroborate your understanding. What you are trying to drill down for each vertical at this stage is (i) who they sell to, (ii) who they buy from, and (iii) how they go about doing (i) and (ii).

It is a complete method because you can capture the whole industry in your analysis. Biases are also better mitigated because you, the one taking the risk, generate the opinions.

Bootstrapping intuition by inspecting value chains

There are 5 components I focus on when running a value chain analysis:

  1. Flow of goods/services: This will give you a sense of the cost structure of each vertical - e.g.

    • Who buys from whom, nature of “item” bought & sold (eg. recurring vs transactional, products vs services), how these “items” are bought & sold (eg. 1:1 vs 1:Many, direct vs indirect relationship with customers).

  2. Flow of cash: Helps you identify which vertical has a chokehold on the industry. You want to be close to the money and invest in where value tends to accrue.

    • Closely tied to the flow of goods but may not always match

    • Who pays whom, recurring vs transactional payments, direct vs indirect payments.

  3. Gross margins of each vertical: Simply knowing the flow of cash is incomplete. You need to understand the quality of these cashflows - i.e.

    • Which verticals can better retain these cashflows (value)?

    • All things equal, you should pick the vertical that has the highest gross margins

  4. Total addressable market: Reveals the size of cashflows going into each vertical. Combining size with direction (flow) and quality (gross margins) will give you a complete picture of the most lucrative verticals.

  5. Funding momentum: Timing is often a key consideration in investing and being too early can be as bad as being wrong. However, you should use this information to test 2 hypotheses - (i) Are you too early and (ii) is this vertical somehow just overlooked?

    • If 1 - 4 points to a certain vertical, it should be the most well-funded as well

    • If it is not, maybe your analysis is wrong, or maybe you found alpha and valuations are likely to be cheap - Congrats!

    • The next step is to verify your hypothesis with primary research -i.e. Speaking to people in each vertical to corroborate your views - e.g. founders, investors, or product guys

Coming up next

In the next issue, I will be walking through an example using the process described above so keep a lookout for it same time next Saturday!

Get dat crystal ball fam,