Business analysis: Web3 economy is a scam, but a leg one

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Here’s a trade.

  1. You start a business. Let’s say it’s a platform business, where you connect buyers and sellers of something. You connect people who want to rent out their cars or their houses and people who want to use them, or you run an exchange to connect buyers and sellers of stock or art or Beanie Babies. 
  2. Your platform charges a fee. Say you charge 2% of the value of each transaction for yourself. 
  3. You start doing some transactions with yourself. You list your house on the platform and then rent it from yourself, you sell some Beanie Babies to yourself, whatever. You set up different accounts under different names (or enlist your friends) to conceal this. You charge yourself a fee; you do $1,000 worth of transactions and pay yourself $20. Your net cost here is pretty much zero, since you’re just sending money to yourself, though there may be some frictional costs.
  4. The next month, you do it again, but more so. You do $2,000 of transactions with yourself and pay yourself $40.
  5. Next month, you go to a venture capitalist. “Look at this business,” you say. “We are doing gross transactions of $2,000 a month, our revenue is $40 a month, we are already profitable and we’re growing at 100% per month.” 
  6. The venture capitalist is like “ooh this business looks amazing, I love a fast-growing platform business, I will invest at 20x revenue.” By “revenue” she means $480 a year (your current annualized run rate) so she values your business at $9,600. She buys 10% of your company for $960.
  7. You stop trading with yourself, the platform’s revenue goes to zero, the venture capitalist is out $960 and you keep the money. A year later you run this trade again with a different business and a different, or the same, venture capitalist. “I have learned so much from my failed startup,” you tell VCs.
  8. Or! Even better! You put out a press release saying “Prominent Venture Capitalist Invests In Awesome Fast-Growing Platform,” you get a lot of attention, and people start trading on your platform for real. You start to get real revenue, you become a real business, you stop trading with yourself, revenue keeps going up, and you and the venture capitalist both become rich.

The main point of this trade is that, in a frothy market for fast-growing companies, you can sell $1 of the right kind of revenue for much more than $1, and so it is worth your while to create some revenue, dress it up to look like the right kind of revenue and then sell it to someone.

But another point of this trade (the one in Step 8) is that in network-effects businesses these things can be self-fulfilling, and a fake business can turn into a real one. If someone is looking to rent a house in an app, she’s going to go to the app she’s heard of; if yours is getting a lot of press for growing quickly and raising lots of money, she’ll go to your app. 

This trade, as I described it, is basically fraud, and sometimes people do it and get in trouble for it. But there are subtler and far more interesting versions of the trade. Here is a very important one; let’s call it the “Web2 version”:

  1. You start a platform business.
  2. You charge a fee of $2 per transaction.
  3. You go to venture capitalists and raise some money.
  4. You use the money to pay people, say, $3 per transaction to use your service. You pay them $3 per transaction and they pay you back $2 in fees. They keep $1. Free money!
  5. You get a lot of users, because everyone wants to use a service that pays them to use it.
  6. Now you have the good things: Lots of (real) users, lots of revenue, fast growth.
  7. You do have one bad thing, which is that you lose money on every transaction.
  8. That’s fine! “Customer acquisition costs are high right now,” you (and your investors!) say, “but they will come down as the platform matures and achieves scale.”
  9. You go to some more venture capitalists and raise a ton of money on that premise. Or you go public on that premise. 
  10. You stop paying people to use the service.
  11. Maybe Step 8 was right! Maybe by this time your users are so dependent on the service, and the service is so good, and the network effects are so powerful, that they keep using it once you start charging them to use it instead of paying them to use it. And then your service is a huge success and you’re a billionaire.
  12. Or maybe it was wrong, the service dies, the venture capitalists lose their investment and you get to keep whatever cash you took out and do this again in a year as a battle-hardened repeat founder.

The Web2 version of the trade is central to the story of the last decade in the U.S. tech industry. We sometimes called it the “MoviePass economy,” the idea that venture capitalists would subsidize consumers’ lifestyles because they valued customer growth above everything else (including profitability). Or there’s the term “blitzscaling,” the idea that by throwing enormous quantities of money at a company in a network-effects business you can make it the dominant player and then pivot to profitability. There is no single outcome to these stories, no simple lesson to take from them. Sometimes it’s the outcome in Step 11 above: User acquisition costs decline with scale and network effects, you jack up the price, and the unprofitable fast-growing subsidized service becomes profitable. Other times it’s the outcome in Step 12. MoviePass went hilariously bankrupt. 

One way to characterize the Web2 version is that instead of trading with yourself, you got your investors to trade with you. You generated volume on your platform from your investors, indirectly, by taking their money (the investment in Step 3) and turning it into revenue (the customer subsidy in Step 4). A dollar of investment capital can be turned into revenue, and then sold to new investors at a multiple of that revenue. This is arguably good for your (early) investors. They want a higher valuation. They are happy for you to turn their money into revenue. They hope that you will turn it into long-term stable recurring revenue (Step 11). But if you just turn it into fake revenue, then maybe they can still sell their shares to the next sucker before it collapses.

The popular current term for crypto platform businesses, or the economy of Web3, can be summarized as the following:

A basic premise of Web3 is that every product is simultaneously an investment opportunity. If you sign up for a Web3 social network or chat room or trading venue or let’s-buy-the-Constitution lark, you will get some of that project’s tokens, which will entitle you to use the project’s app or exchange or Constitution, and which will give you some notional say in the decentralized governance of the project. Also the tokens will appreciate in value if the project takes off and more people want to use it. It’s as if being an early user of Facebook or Uber also automatically made you a shareholder of Facebook or Uber, and when those services got huge you got rich.

The move is to combine (1) Web3 economics (every product is an investment) with (2) the basic trade I have sketched out here (turn investment capital into revenue). Here is how that move might work:

  1. You start a platform business on Web3, crypto, blockchains, etc. It has a “governance token,” which is a little bit like a share of stock but you get to say it’s not a security.
  2. You charge a fee of 2% for people who use the platform. Holders of the governance token might have some undefined, it’s-definitely-not-a-security future economic right to those fees. 
  3. You give people governance tokens for using your platform. These are rewards to incentivize early adopters, and they decline over time on an explicit schedule: People who use the platform a lot on the first week get a lot of governance tokens, people who use it a lot the second week get fewer, people who use it in the sixth month get even fewer, etc.
  4. There is an exchange of money for tokens, but indirectly. People use your platform, they pay you (in dollars, Ether, etc.) to use the platform, and you pay them (in governance tokens) for using the platform. Also, though, they get to do whatever it is they do on the platform. In theory this could be renting out houses or cars or whatever, though in practice most crypto platform businesses are about trading crypto. Let’s say your business is an exchange for trading non-fungible tokens. People trade NFTs on your platform, they pay you a fee for each trade, and (early on) you give them governance tokens for each trade.
  5. So each early user of the platform is also an investor, and the more they use it the more they are investing.
  6. They can sell the governance tokens freely because all of this stuff is effectively unregulated.
  7. How much are the governance tokens worth? It is hard to say, but they are sort of like shares of stock. Their value is some increasing function of the expected future fee revenues of your platform, plus they have some intangible meme-y value based on how much hype your platform is getting.
  8. The more trading there is on your platform, the more fees you collect and the more successful your business looks, and the more your governance token is worth, both because its expected cash flows are higher and because it gets more hype and attention.
  9. So people rush to your platform to trade as much as possible, which pumps up the value of the governance token, and they cheerfully pay you the 2% fee to get governance tokens that they can sell at an immediate profit.
  10. These people do not necessarily want the NFTs that are being sold on your platform, so they trade with themselves. They set up two crypto wallets and sell NFTs from one to the other, creating fake volume, “wash trades.” The trades aren’t real, the trades are just (1) an excuse to pay you a 2% fee on a large notional in exchange for a lot of valuable governance tokens and (2) a way to make your platform look popular so that the governance tokens become valuable and they can sell them at a profit.
  11. And people buy the governance tokens because (1) your platform is popular, (2) it is growing fast, (3) it is making money, and (4) it is getting a lot of hype — exactly the reasons a venture capitalist would have invested in your platform in the Web2 version.
  12. Eventually you stop handing out so many governance tokens (the rewards decline on a set schedule, see Step 3), and people stop doing huge wash trades with themselves to build hype and collect governance tokens.
  13. Maybe then your thing collapses, the early wash traders made a fortune, and the people who bought their governance tokens are holding the bag.
  14. Or maybe not! Maybe all the fake trading created enough hype for your platform to attract real trading, and your platform becomes good and people keep using it even after you stop paying them to use it.

The Web3 version effectively combines the user incentives and the venture capitalist incentives from the Web2 version. Whereas the Web2 version of this trade indirectly takes money from venture capitalists and turns it into revenue, so that you can sell more shares to venture capitalists at a high multiple of revenue, the Web3 version directly takes money from user-investors and turns it into revenue, so that you (and they) can sell more governance tokens to more user-investors at an even higher Web3-hype-driven multiple of revenue. Web3 has refined and perfected this trade, in a way that makes it just about plausibly sustainable.

“This is, essentially, a pyramid scheme,” said Dror Poleg in an infamous post about Web3 that I quoted the last time we discussed this. “A Ponzi. But it makes sense. It will be the dominant marketing method of the next decade and beyond.” I don’t like it! But I am not confident that he’s wrong.

Anyway here’s a story from last week from Andrew Hayward at Decrypt:

The NFT market got a jolt this week when surprise new entrant LooksRare started piling up massive Ethereum trading volume numbers. But as trading rises on the OpenSea rival, it has become clear that some traders are manipulating LooksRare’s token-based rewards system via a form of wash trading—and the platform doesn’t appear to mind.

LooksRare is built around the LOOKS token, which the platform is airdropping to 185,000 wallets of eligible OpenSea users to try and lure them over to the platform. The platform also pays out its daily amassed transaction fees to all users who stake the LOOKS token in the form of Wrapped Ethereum (WETH).

On top of that, LooksRare also has a stash of LOOKS tokens that it will distribute daily to users who trade NFTs in select, verified collections—including the Bored Ape Yacht Club and Doodles. At a current price of $4.23 per token, the marketplace is giving away more than $12.1 million worth of LOOKS tokens each day, although the tally will shrink over the course of the next year.

For now, however, some traders appear eager to manipulate the rewards model. Over the course of the last day, LooksRare has seen numerous NFT trades that go back and forth between the same two wallets, including a Meebits NFT that sold for about $50 million worth of WETH each time. That’s $100 million worth of trading volume in two transactions.

Dozens of other Loot and Meebits NFTs have sold for about $3 million worth of WETH apiece in numerous back-and-forth transactions, as seen on the top NFT sales list at CryptoSlam. By contrast, the average sale price of a Meebits NFT on leading marketplace OpenSea over the last week was about 4.1 ETH ($13,800 at today’s value), while Loot NFTs sold for an average of under 2.2 ETH ($7,400) each.

It’s a form of wash trading—that is, manipulating the market by making it look like there’s more activity than there would be organically. Wash trading can be used to boost demand for a financial asset or to hide ill-gotten gains from illicit activities, for example. Critics often accuse the NFT market of harboring widespread wash trading and money laundering.

In this case, the wash trading is apparently being done to significantly boost the potential share of trading rewards that users receive for buying and selling NFTs on the site. Traders still have to pay the 2% transaction fee, as well as standard Ethereum gas fees (network transaction costs), but Meebits and Loot are both collections that do not charge creator royalties on top of those fees.

In other words, traders aiming to manipulate LooksRare’s rewards system are betting that the rewards they receive in LOOKS tokens and WETH will be more valuable than the LooksRare transaction fees and Ethereum gas fees they’re spending in the process.

Anyway, the Web3 version of the trade will probably be central to the story of the next decade in the tech industry, so that’ll be fun I guess.