Why are VCs Flocking to Web3 - Key Reasons For Web3 Funding Growth

VCs are always on the lookout to fund the next start-up or emerging technology with high-growth potential. While fintech made major headlines among VCs in the last decade, interest is beginning to cool, and web3 solutions are proving to be the next big thing. Considering their incredible growth within the last few years, VCs have noticed their growth potential.

But projects under the web3 stack have come under harsh criticisms from many traditional players mainly because of their volatility. Regardless, VCs are pouring money into web3 projects. A few examples include a16z crypto, Paradigm, Dragonfly, Multicoin Capital, Coinbase Ventures, Pantera Capital, etc.

In this piece, we zoomed into VC activity in the web3 ecosystem and explored some of the reasons VCs love web3 so much - even though critics term it as "a young industry driven by speculation."

Key Reasons VCs Are Funding Web3 Startups

1. Outsized returns

In recent years, the web3 market has seen explosive growth, giving investors significantly high returns. For example, 2021 saw emerging cryptocurrencies like BNB, MATIC, SOL, DOT, etc. bringing in impressive returns above 1000%. DeFi tokens fired above Wall Street stocks from a market cap below $2 billion in 2020 to over $161 billion in Q1 of 2022. The NFT and Metaverse sector captured the headlines with staggering growth from less than $100 million to $40 billion. Generally, the crypto market shot above $3 trillion in 2021.

While the market is experiencing downtimes in 2023 due to wider economic trends, VCs have already seen its potential and are making bets on promising projects. Of course, only some of these bets may yield profits as thousands of projects are flooding the space. But the few that will turn out well may bring in huge returns enough to meet the profit target of most VCs. Many VCs believe that these times in web3 mark the beginning of a new revolution and a good time to invest in the space before it goes mainstream.

2. New Markets

Web3 technologies have birthed a whole new ecosystem of products and services that open new markets and opportunities for investors. From Metaverse and NFTs to DeFi, web3 offers structures that allow for creating solutions that are far more disruptive and impactful compared to previous internet eras. Hence, providing VCs with the opportunity to diversify into newer investment types. Additionally, the decentralised nature of web3 removes the geographical barriers to investing. VCs can tap into a rapidly growing global market and expand their portfolios across national geographies.

3. Capital Efficiency

Community is a major strength of web3 projects. Unlike web2 models that restrict community to only clients or customers, web3 businesses allow customers to also take on the role of creators, boosting their capital efficiency. Web2 companies were able to leverage the internet to improve profits while reducing costs of operation. But web3 stretches this leverage even further.

In typical web2 companies, you have to employ workers or pay for software to implement certain tasks or solutions, and scale marketing and operations. However, web3 projects combine token incentives and base layer infrastructures - layer one, layer two, scaling solutions, interoperable chains, grants, etc. - to scale network activity and tap into the pool of talents in their communities.

A typical web3 project maintains a small number of employees and softwares, with a large community who see themselves as part owners in the project. These community members can forge new paths and stories, thus helping the underlying project to accrue more value.

A good example is Jenkins the Valet and some other Bored Ape owners that are creating comic books, animations, adverts, etc. through their NFTs. These campaigns have significantly boosted the popularity of BAYC without the parent company spending any dime.

As a result, web3 startups don't have to spend so much money on talents and software, making them more capital efficient than web2 companies.

4. Liquidity

Traditional VC investing is highly illiquid. When investing in traditional startups, VCs usually zero their mind on cashing out their investments only during an acquisition or IPO. Exiting an investment is difficult even if you lose faith in the project. However, the use of tokens in web3 makes investment liquid for VCs. In the case of an investment raking in profit or going north, they can quickly adjust their portfolio and optimise their returns.

For example, if a token's value increases to a particular target within a few months of investing, VCs can quickly cash out their investments on exchanges - provided there is no vesting period.

5. Compounding Profits

In web3, investors can leverage their initial investment in a startup to unlock other avenues for profits. Unlike equity in the private markets, tokens come with utility baked into them. While waiting for their investments to peak, VCs can earn passive income by leveraging their tokens for new opportunities like yield farming, staking, liquidity mining, no-loss lotteries, etc. The yield from these opportunities in most projects ranges from 1-20%, with an extra layer of daily compounding. As a result, VCs want to hold onto their positions in the long term and help the project grow to improve their profits potential.

6. Transparency

Traditional VC investing requires several documents and auditing to prove the honesty of startups and their founders. In a bid to get investment, some founders lie about their revenue, balance sheet, equity distribution, debts, etc. However, the relationship often ends sourly when the truth comes to light.

Unlike the private markets, web3 projects boast high transparency due to their on-chain presence.

The business information and activities of most web3 start-ups are visible on-chain. From protocol upgrades, capital allocation, financial health, total users, etc. Investors can use tools like Etherscan, Dune Analytics, and DappRadar to see a detailed overview of any startup they wish to invest in. Hence, reducing the need for trust and the possibility of shady deals.

7. Early Stage

Web3 is in the early stages of development. The current solutions are only a scratch on the surface compared to the immense potential of web3 technologies. This means there's more room for growth and innovation in the space. On top of that, the web3 ecosystem allows for permissionless creativity. Thousands of talents are dumping web2 companies and migrating to web3 to build where there's less restriction to their creativity. Even web2 firms are beginning to realise the turning tide and are setting up arms dedicated to crypto and web3. Also, most market predictions expect web3 to have a compound annual growth rate (CAGR) close to 50%. All these indicate that web3 has a bright future. And VCs are looking to secure their share of that future by investing in promising web3 teams.

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