Conversation with former managing director of Redpoint Ventures: The evolution and prospects of Web3 venture capital from capital expansion to global layout

Tomasz believes that as the industry develops, companies that can provide stable cash flow and sustainable business will stand out.

Edited & Compiled by: DeepTechFlow

Guest: Tomasz Tunguz, General Partner at Theory Ventures & former Managing Director at Redpoint Ventures

Hosts: Saurabh Deshpande; Siddharth

Podcast Source: Decentralised.co

Original Title: On The Evolution of VC in Web3

Broadcast Date: August 20, 2024

Background

In the latest episode, we delved into the thoughts of Tomasz Tunguz. He is a venture capitalist who has been working in this field for over 15 years. As a General Partner at Theory Ventures and former Managing Director at Redpoint Ventures, Tomasz has witnessed the development of venture capital. From his early attempts at Google to profit from social media to his current focus on data-driven investments, Tomasz provides a nuanced perspective on the industry. (DeepTechFlow note: Theory Ventures is an early-stage venture capital firm with investments ranging from $1 million to $25 million, focusing on software companies that leverage technological change to gain a competitive edge in the market.)

In our conversation, his insights resonated deeply with me. What is his key idea? The only enduring moat is the brand!

He juxtaposes private equity, venture capital, and the growth of Web3. Tomasz predicts that Web3 will follow a similar path. For example, during the frenzy in 2021, capital sources such as private equity funds and hedge funds surged from 8% to 81%. In terms of deployed capital, venture capital firms played a small but crucial role.

A key highlight of our conversation is Theory Ventures' investment in Allium, a company providing Web3 data solutions for financial institutions. As the U.S. venture capital ecosystem expands from deploying $8 billion annually to $175 billion, the demand for Web3-compatible financial infrastructure has never been greater. Allium fills this gap today.

Today's episode with Tomasz Tunguz provides a deep discussion on the development of venture capital and presents a compelling case for why the future of finance may be built on blockchain.

Tomasz's Career Background and Writing Habits

Tomasz shared his writing experience over the past decade. He initially started blogging to curate news and prepare agendas, publishing a series of news articles every Monday. Over time, he realized that entrepreneurs often posed similar questions, leading him to write content related to these questions, such as "What metrics do startups need to raise Series A funding?" and "How do public market investors evaluate companies?" Despite slow initial progress, his blog gradually gained attention.
Tomasz recalled how he entered the venture capital industry. Moving to California in 2005, he first encountered a venture capitalist at a gathering, which surprised him to learn about the existence of this profession. He likened the work of venture capital to academic research, requiring continuous learning and understanding of different fields.
Regarding the work of venture capital, Tomasz mentioned that his initial understanding was to help portfolio companies develop strategies, but he later discovered that this was only part of the job. The role of venture capital also includes building connections within companies and limited partners, providing expertise and resources to help entrepreneurs secure funding.
Tomasz further discussed the importance of writing for his career development. Initially not passionate about writing, he considered himself more inclined towards mathematics, but over time, he found that writing helped him clarify his thoughts and facilitate learning and communication with others. He emphasized that writing is not only a process of self-reflection but also builds trust with readers and records his learning journey. Tomasz's passion and perseverance for writing have enabled him to continuously grow in the venture capital field and contribute his insights to the ecosystem.

Evolution of the Venture Capital Industry: Overview of Industry Development

Tomasz discussed the evolution of the venture capital industry, noting that when he joined, the annual capital entering the venture capital industry in the U.S. was about $8 billion, reaching a peak of $300 billion in 2021, and currently around $175 billion. He mentioned that the industry's growth is primarily due to regulatory policies making it increasingly difficult for companies to go public, leading to longer times for companies to achieve initial public offerings (IPOs). For example, the average time from founding to IPO is now about 12 years, compared to 4 years in the 90s.

Changes in Capital Sources

During the peak period, 81% of venture capital funding came from non-traditional venture investors, such as hedge funds and corporate venture capital. With the emergence of early growth funds, many investors began to focus on companies that require additional funding support before going public, a model that has been significantly successful over the past decade.

Industry Breadth and Diversity

Tomasz also mentioned that the investment scope of venture capital has expanded from its initial focus on semiconductors and networking to consumer internet and B2B fields, and now even covers heavy industries such as manufacturing and robotics. This evolution is similar to that of the private equity industry, which initially focused on leveraged buyouts and gradually expanded into other categories, becoming large asset management firms for public trading.

Feedback Loop and Decision-Making Process

Regarding the decision-making process of investors, Tomasz emphasized that the feedback cycle of venture capital is long, with the primary measure of success being the multiple of invested capital returned (DPI). Although investors can obtain some feedback in the early stages of investment through subsequent financings (such as Series B, C, D rounds), overall, investors need to remain patient and continuously improve their investment process.

Uniqueness of Web3 Investment: Different Perspectives on the Investment Process

Tomasz emphasized the need for a different perspective when investing in Web3 companies. He pointed out that Web3's liquidity is earlier, making it more important to understand the dynamics of the public market, valuation multiples, and capital flows. The capital structure of Web3 companies is significantly different from traditional software companies, especially at the Series A financing stage. For token companies, the ownership stake is usually lower, as larger shareholders may impact the market when selling.

Globalization Feature

He also mentioned that Web3 is a more international phenomenon, especially with usage in regions such as Asia often surpassing that in the U.S. Therefore, the environment for Web3 investment is vastly different from traditional venture capital.

Developer Acquisition and Retention

In Web3 projects, acquiring and retaining developers is crucial. While Web3 companies have similarities with companies like Stripe, Twilio, and Hashicorp in customer acquisition methods, their use of tokens as financial instruments is a novel experiment.

Changes in Risk Curve

Tomasz pointed out that due to short-term liquidity and extremely high valuation volatility, Web3 investors are venturing further down the risk curve. He believes that while the structure of building software code and sales team in the early stages is not clear, the software ecosystem is gradually mechanizing over time. In contrast, Web3 is still in its early stages and has not yet formed a mature pattern.

Capital Efficiency Challenges

He mentioned that an analysis conducted 18 months ago showed that the capital efficiency of acquiring developers using tokens is much lower than using traditional venture capital funds. This indicates that the operational mechanism of Web3 is still relatively inefficient, and different teams will need to explore how to effectively utilize tokens and airdrops to acquire customers in the future.

Current State and Future Prospects of Web3

Early Stage of Web3

Tomasz pointed out that Web3 is still in its early stages, and despite its potential applications, the number of Web3 developers is still relatively small compared to traditional Web2 developers. According to a report by Electric Capital, the current number of Web3 developers is between 15,000 and 25,000, while the total number of software engineers globally is approximately 27 million. Therefore, bridging this gap is necessary to attract more developers to the Web3 space.

Balance of Infrastructure and Applications

Tomasz emphasized that the rapid development of Web3 infrastructure will make it more familiar to Web2 developers. He believes that the next generation of virtual machines will be able to support multiple programming languages, which will be a significant driver. He envisions that in the future, developers will be able to write code in any language and connect it to container or serverless infrastructure, managed automatically by the system. This abstraction will lower the barrier for developers to enter and enable them to build blockchain-based applications more easily.

Investment Strategy and Market Changes

When discussing fundraising strategies, Tomasz shared their experience of successfully raising a $230 million fund during challenging times. They established a business model that uses historical venture capital data for multivariate simulations to optimize portfolio construction. This strategy set them apart in a competitive environment.
He also mentioned that the current funding approach in the venture capital industry has shifted from demand-based to market-based, making the fundraising process more like an auction. This change reflects the intensifying competition in the venture capital industry, where investors need to have a deeper understanding of portfolio structure and potential returns.

Future Prospects of Web3

Tomasz is optimistic about the future of Web3, believing that the industry is still young and full of potential, and blockchain technology will play a crucial role in most software applications. He pointed out that the increasing compliance costs are driving more and more companies to seek blockchain solutions to meet data storage and privacy regulations. Additionally, the transformation of stablecoins in the realm of fund flows will also drive the development of Web3.
He noted that with the reduction in costs, Web3 blockchains will become an effective alternative to compliance costs, while the experience for developers is significantly improving.
Tomasz mentioned that they have invested in two companies, one of which is a publicly traded company, and the other is about to be announced. Their investment strategy focuses on integrating blockchain technology into Web2 and improving the user experience for developers.

Dynamics of Infrastructure and Applications

Tomasz pointed out that industry development is a swinging process, sometimes limited by infrastructure and sometimes by applications. Currently, the rapid progress of infrastructure provides a solid foundation for the development of Web3, but more developers need to recognize the advantages of Web3 protocols for broader market applications to be realized.

Structure and Strategy of Venture Capital Funds

Establishment and Operation of Funds

Tomasz shared the process and strategy of creating Theory Ventures. He mentioned that the venture capital industry has experienced different waves of innovation, and Carlota Perez's theory divides these waves into two stages: installation and commercialization. In the installation stage, a large amount of capital is needed for the construction of internet infrastructure, and Web3 investments are also laying the foundation for sustainable future applications.

Differentiation in Competition

In venture capital, Tomasz emphasized the importance of achieving differentiation in competition through in-depth research and building customer relationships. He mentioned that while many infrastructure projects may seem similar, investors' expectations of their future potential often influence their valuation. He cited Twilio as an example, illustrating how infrastructure companies can achieve significant market value by finding key applications.
He also pointed out that in an environment of abundant capital, investors are more inclined to adopt a strategy of "wrong omission" rather than "wrong commission," meaning they are more willing to invest in projects that could become great companies rather than miss out on potential successful opportunities.

Current State of Web3 Investments

Tomasz mentioned that a quarter of their current investment portfolio is focused on the Web3 space. He believes that most of the innovation in the past 12 months has been primarily focused on stablecoins, and they are exploring how to gain more investment opportunities in this area. He noted that the high valuations in the market make seed stage investments more challenging, especially in a soft public market.

Research and Resources

Tomasz also mentioned that Theory Ventures invests a significant amount of effort in research and encourages the audience to learn more through LinkedIn and their official website. They regularly publish content on market dynamics and research findings to help investors and entrepreneurs better understand Web3 and its potential applications.

Intersection of Cryptocurrency and AI

Potential of Decentralized Computing Resources

Tomasz mentioned that the data ecosystem is an area worth investing in because analyzing data requires a large amount of computing resources. He pointed out that data volume will only continue to increase, and the creation of data products and insights always depends on the quality and context of the data. The key is how to intelligently combine data from Web2 and Web3 to achieve greater advantages.
Tomasz also mentioned that while there are many attempts to build decentralized GPU clouds primarily for training models rather than inference, this model faces challenges due to security and trust issues. He emphasized that current GPUs have security vulnerabilities that could lead to sensitive data leaks, making it unsafe to run sensitive training tasks on decentralized networks.

Data Privacy and Compliance

In terms of data management, Tomasz believes that Web3 can play a role in ensuring the computational integrity of training data and data usage licenses. He cited the music industry as an example, mentioning organizations similar to ASCAP that can provide licenses and management for training data, which could have applications in Web3.
Tomasz stated that there are currently no decentralized GPU projects that have made breakthroughs in the AI field. He believes that while there are some innovations, most companies still prefer to use Web2 cloud computing resources because large tech companies like Google, Microsoft, and Amazon are heavily investing in data centers, providing more stable and secure services.
When discussing latency issues, Tomasz pointed out that for companies training large models, the efficiency of data transfer is crucial. Spending a significant amount of time on data transfer during training leads to inefficiency. Therefore, while decentralized solutions may present arbitrage opportunities, enterprises tend to use traditional cloud services due to security and data control.

Investment Strategy and Market Observations

Investment Strategy in the Web3 Space

Tomasz mentioned that Theory Ventures is particularly interested in projects like Helium. He believes that consumer-oriented network projects have great potential, but overall, they are still focused on areas such as data and stablecoins. He pointed out that when evaluating crypto companies, they can be viewed as market companies, usually valued based on Gross Merchandise Value (GMV), or as classic software companies, valued based on revenue or EBITDA.
Tomasz also mentioned that Ethereum's cash flow performance is outstanding, even ranking at the top among some publicly traded software companies. He believes that more Web3 companies will show this kind of potential in the future.

Market Trends and Impact of Technological Upgrades

Regarding the impact of technological upgrades (such as Ethereum's upgrade) on costs, Tomasz mentioned that historically, AWS reduced prices up to 111 times in the first five years, providing a good precedent for future cost reductions and usage growth. He believes that although the costs in the crypto market are still higher than alternative solutions, once a certain price advantage is reached, there will be a significant shift in market share.

Resource Allocation and Geographic Diversity

Tomasz stated that Theory Ventures allocates approximately one-third to forty percent of their time to the Web3 space, a ratio that has remained unchanged since the fund was established. He emphasized that with changes in the regulatory environment, the investment portfolio of Web3 may be more geographically diverse than that of Web2. They pay attention to regulatory restrictions in different countries to avoid legal risks.

Central Bank Digital Currencies (CBDC) and Global Financial Centers

Tomasz expressed concern about whether the United States will adopt Central Bank Digital Currencies (CBDC). He believes that if the US embraces CBDC, it could potentially become the center of blockchain innovation again. He also mentioned the potential of regions like Singapore and Dubai in adopting CBDC, suggesting that the regulatory frameworks in these areas may attract more innovation and investment.

Conclusion and Future Prospects

Outstanding Crypto Content Creators

When discussing outstanding content in the crypto space, Tomasz mentioned the "Electric Capital Developer Report," which provides a comprehensive overview of ecosystem activities. He emphasized the importance of crypto Twitter and Telegram, stating that these platforms play a crucial role in shaping project attention and fund flows.

Double-Edged Sword for Investors

Tomasz discussed the pros and cons of tokens as investment tools, acknowledging the risk of "dumping" behavior in the crypto market. He pointed out that while the risk exists, if the entire industry can focus on creating lasting value and real applications, it can change the way financial markets and entrepreneurial ecosystems operate. He hopes to see more companies with long-term value emerge, creating better returns for investors and employees.

Advice for Founders

For Web3 founders seeking funding, Tomasz advised them to focus on creating long-term value and build their business from a 5 to 10-year perspective. He believes that patience and focus are key to success, especially in asset categories with high volatility. He cited Linear as an example, praising their patience and focus on value creation when building the company.

Future Prospects

Tomasz is optimistic about the future of Web3, emphasizing the importance of creating lasting value. He believes that as the industry develops, companies that can provide stable cash flow and sustainable businesses will stand out. He hopes that the Web3 ecosystem can reduce volatility, create longer-lasting projects, and inspire teams to continue innovating after token issuance.

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