By Henry Ang, blockchain investor at BACKED VC | Published 20th August 2024

This year has seen significant milestones for cryptocurrency: the launch of Bitcoin and Ethereum ETFs, the bipartisan nature of crypto in the U.S., and Circle’s expansion into new currencies, beginning with EURC. Despite these advancements, a sense of unease remains as to where the next major inflection point will emerge and how we (capital allocators) can position ourselves accordingly.

Walking into some of the events at EthCC, we saw many teams working on infrastructure, each with minimal differences over one and other. There was the odd application developer going booth to booth speaking to these teams, thinking where best they should build on. Our view is that this fragmentation has led to a diluted focus, with application developers left navigating a confusing array of options on where to build. Despite the abundance of infrastructure, there is a lack of cohesive, impactful application development. To borrow a phrase we have heard too often, we are in the situation where “we have built a bunch of highways with no cars on it”.

This is where capital allocators (us included) have a huge responsibility in shaping the industry. While funding infrastructure is not fundamentally bad, the potential returns made from late-stage, minimally differentiated projects is distorting the market, posing a dilemma for builders: should you attempt to build an application where product market fit is a lot harder to achieve and risk failure to raise a round if market conditions are bad? Or would it be much easier to build an infrastructure project with some differentiation over other competitors with a higher likelihood of closing a round, securing sufficient runway for years? This trend of investing heavily in infrastructure discourages innovation in application development, where the next major breakthroughs are most likely to occur. So how can we reverse this?

Shifting the Tide: From Infrastructure to Applications

The good news is that the market tends to self-correct, albeit over a period of time. Our view is that the current vintage of funds that are still blindly copying the infrastructure playbook from the last cycle will begin to see underperformance which then limits their ability to raise a new fund. Extrapolate this across the industry and we should see a healthy reset of the funding landscape. Ahead of this transition, we hope to share some internal insights that have shaped our own thesis.

First, it isn’t clear that private infrastructure investments represent better opportunities than their public counterparts. One common investment heuristic is that infrastructure has a larger TAM and can afford a longer time to find product market fit, and as a result capital is willing to price them according to existing benchmarks. For example, Monad (a parallelised EVM layer 1 blockchain) latest valuation of $3B can be argued as “fair” given Sei is trading at $2.6B as a parallelised EVM competitor, while Aptos & Sui trade at $6.8B and $8.6B respectively as alternate L1 competitors. If you are in the camp that Monad has “better” community and tech with alignment to ETH which grants greater access to liquidity, you could potentially underwrite a base case of ~$10-$20B FDV in the right market conditions, representing a 3–6x return. However, these opportunities do not support early-stage venture economics: should you deploy $3M into the round, a 3–6x return translates into a TVPI impact of just 6–15%, assuming you run a $100m fund.

Second, when compared to liquid market opportunities, the risk / reward to do this as a private venture deal is not very favourable. Rather than underwriting a 3–6x return on Monad, you could have taken on a similar return profile (with liquidity preference) in Solana around $80 when it broke out of a year long resistance, with much clearer metrics (no. of users, TVL, transaction volumes etc.). You would also have had the flexibility of sizing up your investment with a shorter repayment period, translating to better IRR for the fund. With all that being said, how should we approach early-stage venture within crypto?

Focus on the App Layer

At BACKED, our approach is to look at infrastructure deals opportunistically and spend most of our time assessing projects on the application layer.

The decision stems from our hypothesis that the application layer is grossly undervalued and under invested. For example, Aave commands over $11.5B in TVL, generates $302.5M in annualised fees and trades at a valuation of $2.1B FDV. Aptos commands a valuation of $6.8B FDV but only has $378M in TVL and does only $0.85M in annualised fees. Is Aave undervalued? Or is Aptos overvalued? Either way, our belief is markets should price value accrual more accurately over time, and the applications that serve the most users and possess the strongest financial metrics will come out on top.

The encouraging thing is we are starting to observe the early signs of this. For example, applications like Jito, Raydium and pump.fun on Solana are starting to do more fees (and revenue) than the blockchain infrastructure they live on. What’s left is for valuations to start reflecting these fundamentals more accurately.

Therefore, our investment thesis is to back founders who deeply understand and actively leverage blockchain and crypto economics as a way to deliver better applications.

We think that there are two broad categories of applications — crypto-native and crypto-enabled and they each have different target user groups. Most applications we see today fall under crypto-native: think DeFi or Web3 Gaming where users are mainly on-chain. These applications drive permissionless, fully on-chain economies and areas of immediate interest to us include:

• Perp Dexes — drives majority of CEX volumes but on-chain volumes remain small
• Decentralised Social — enables new way of consuming content
• Insurance — important primitive but many challenges for risk assessment

However, there are many more applications under the bucket of crypto-enabled where users need not be on-chain. Some areas of immediate interest to us include:

• Payments — enabled by blockchain rails for faster settlement and global reach
• DePIN — enabled by token emissions and ownership tracking through NFTs
• Advertising & Attribution Markets — enabled by on-chain social graphs
• Asset Tokenisation — enabled by on-chain transparency and smart contract automation

Capital allocators play a pivotal role in steering the blockchain industry

As we look towards the future, it’s clear that we all must play a pivotal role in steering the blockchain industry towards sustainable growth and genuine innovation. By refocusing our efforts on supporting application developers who deliver real value and utility, we can catalyse the next wave of breakthroughs in the space.