By Leigh Drogen and Dennis Qian of Starkiller Capital
In the late 1990’s, as the tech bubble was inflating, many questioned whether the internet would ever produce applications that drove sustainable businesses. Yes there were a limited number of early successes, but most of the profitable businesses in Web1 were basically physical infrastructure companies and ISPs. There was a lot of hand wringing over the chicken and egg issue for why applications couldn’t find a critical mass of users/customers. Was it simply that these businesses needed a larger number of users to make the numbers work, or was it that the products weren’t fast/cheap/extensive enough? There’s a famous interview with Marc Andreesen where he notes the fact that almost all of the future Web2 successes were known ideas in Web1, many of which were tried and failed in the 90’s, pitched to VCs, or were posted on a famous Silicon Valley message board.
But by the end of the decade, as the tech bubble was bursting, something happened. Bandwidth and speed increased massively, and entrepreneurs recognized that they were able to build products that might suffice user requirements for real adoption. A few years later we got the explosion in e-commerce with Amazon and Ebay, payments with PayPal, social media, and the rest of Web2. Application businesses built on the internet thrived, and we never looked back. At the same time, the infrastructure businesses basically died, the fiber optic companies, the ISPs, most of the browsers.
We believe there's an almost perfect corollary between the transition from Web1 to Web2 and what we are seeing take place right now in crypto. To set the stage, here is how we see the current state of affairs across the ecosystem.
Bitcoin has consolidated its place as a quasi store of value and has some “moneyness” to it in the minds of investors, and maybe, at some point, central banks. Its market cap is roughly 10% that of gold, and it now has a physical ETF seeing solid and steady inflows. BTC represents roughly 57% of the total crypto market capitalization, below its 2020 bear market high of 74% and above its 2022 bull market low of 39%. The developer community has mostly abandoned the concept of the Bitcoin protocol being anything other than a store of value while a handful of teams believe they can make DeFi and other apps happen on Bitcoin L2s, so far unsuccessfully. Some crypto-libertarians still hold out the hope that BTC can be a dominant currency separate from the sovereign system, but while BTC has almost no traction in terms of payments USD stablecoins, and the companies that produce them, are surging in use and success. The success of BTC as an investable asset, which sits within spitting distance of all time high prices despite massive supply overhangs from bankruptcies and government selling, has been eye opening compared to the vast majority of other tokens and arguably driven by the idea that BTC is not a protocol, it is an application, and that application is store of value.
Meanwhile, if you read anything in crypto media, Twitter, listen to any industry podcasts, or look at the relative performance of ETH, you might come to the conclusion that the Ethereum community is in full meltdown. Ethereum mainnet is dead in terms of transaction volume, NFTs are dead and meme coin trading all moved to Solana. Most coins native to the Ethereum ecosystem are trading at or below their 2022 bear market lows save for a few memes, some RWA coins, and a smattering of AI associated apps and protocols.
The federation of the Ethereum ecosystem into over 100 L2s and L3s has caused a lack of focus amongst investor demand for “the internet computer”, leading to the poor performance of these assets. For god sake Sony, yes the television maker, is launching a L2 soon. Ethereum’s founder Vitalik has even questioned the sustainability of DeFi as a concept. Ethereum mainnet fees have trended down considerably leaving investors to question how they should value the protocol that had previously had footing on the basis of those fees.
And yet, some of those Ethereum L2s are flourishing. Base is growing like a weed. Others have focused on supporting specific application verticals. The cost of transacting within the Ethereum ecosystem has fallen, in some cases to sub .01c rates. Speed is almost instantaneous. And the capacity of the network has expanded so much that blockspace is now abundant and will likely remain so as users scale.
The stark divide between the success of ETH as an asset and the success of the Ethereum ecosystem as a technology is nothing short of epic. The chasm is so wide that many longtime developers and holders of ecosystem assets have very publicly questioned whether transacting in the ecosystem is now too cheap!
Too cheap!!!
Look, it’s hard to simply hand wave away the financial pain felt by many in the ecosystem since early 2022, especially as they’ve had to watch Solana take meme coins and SOL come roaring back. Worse, the illegal regulation by enforcement regime being perpetrated by Gary Gensler and the SEC has taken direct aim at many of the core applications within the ecosystem, namely DeFi. This regime has cut off a path for application developers to imbue their governance tokens with the actual equity value in their projects (think UNI fee switch), which has put a clamp on both developers who want to launch actual applications and the valuations they receive.
One more thing to set the stage. Much of the history of VC investing in crypto has focused on the protocol layer. For a long time, this made logical sense. Outside of BTC’s store of value, the real prize in crypto is the protocol which will eventually consolidate users and be the place where the world transfers value, the place all applications are built on top of. It made sense to spread out your bets given none of the competing technologies had solved the cost/speed/capacity trifecta. Given the valuation that BTC and ETH traded at, betting that other protocols with new tech would potentially dethrone the king was reasonable at 2-5% of their FDVs. VCs made great money investing early in these protocols from ‘17-’21 at sub $100M valuations, watching the tokens trade at multi-billion dollar FDVs while attracting basically no users. Cardano, a chain no one uses, still trades at roughly $16B. The same concept attracted VCs to Ethereum L2s. And against that backdrop, applications built on these networks were given vastly lower valuations. Why would you bid up an app token that theoretically represents a real business of somewhat finite size when you can bet on the Nth Ethereum killer that could be infinitely large. It made sense.
Until it didn’t.
After mostly failing to liquidate their tokens in the 2021 bull market, VCs took a massive drawdown in 2022 and got wise to the fact that they should be selling their position at these somewhat ridiculous valuations into unlocks. That selling has been constant for several years now as VCs (who aren’t dumb) realize that the vast majority of these protocols are ghost towns going nowhere and are effectively worthless. If a VC can liquidate a position completely after 5 years at valuations in the hundreds of millions or billions knowing the protocol has no future, of course they are going to. Same goes for the founders and team members. Early stage investing is a power law game, most things will fail, if 90% of teams and investors who will fail anyway can cash out they absolutely will. VC investments made since the beginning of 2021 have largely been a disaster given the valuations they were struck at after founders got wise to this game, and while most have yet to write down these investments, a rare few will break even in the end. But the advance in technology these alternative L1s and L2s represent is very real, and in a sense you can think about all that VC money as the cost of R&D that would eventually be folded into the Ethereum ecosystem. Why we had to pay founders hundreds of millions of dollars for this R&D in the form of their native tokens is beyond me, but that’s for another day.
When people look around the crypto ecosystem and bemoan the fact that there aren’t many apps or “uses cases” for crypto, we look directly at the economic incentives for teams to develop apps vs protocols, and up until now it simply hasn’t been there. Yes, stablecoins are now a massively successful application built on top of decentralized blockchains, and more centralized blockchains for that matter. Tether makes $4B a year in profit for doing basically nothing besides issuing the collateral used to trade on CeFi exchanges (this is a little tongue in cheek, but only somewhat). Treasury backed stablecoins are now one of the largest global buyers of US debt and offer everyone around the world an opportunity to earn safe US treasury yield while preserving the value of the money (yes that’s what I said you Fed hating anti-American ghouls). Our bet is that native yield bearing USD stablecoins will eventually become the primary collateral and transmission of value for the global economy, and yes you will pay for your coffee with one.
The other successful use case in crypto has been speculation (the casino). And while you might bemoan this, like Vitalik did this week as an ouroboros, we believe that’s misguided. Speculation was always going to be at the heart of any new system of value transfer. It is central to the idea that protocols can bootstrap their growth by allowing consumers to bet on that growth through use and earning equity in the project. We now have rapidly growing prediction markets (Polymarket) which isn’t just a new form of entertainment everyone can participate in (though that’s fine too!), but a way for investors to manage risk around important global events. Decentralized exchanges are well on their way to being the place where AI agents trade tokenized assets of all types in the blink of an eye. And maybe most importantly, DeFi lending markets significantly cut the spread paid to banks when loans are taken, from roughly 300bps to less than 50. It was natural that the casino would be the first application for crypto because it didn’t require non crypto native companies to play ball inside a new system.
But eventually we do need to move beyond these small handful of successful applications. And had the economic incentives not been so incredibly tilted towards building protocols instead of applications this past decade given where the VC money flowed to, we may now have a flourishing application ecosystem. It’s going to take a lot of trial and error to probe for the utility in applying cheap blockspace to the rest of the economy, many teams will fail in that pursuit, but that is the nature of being an entrepreneur on the bleeding edge of technology.
With all of the above in mind, we believe we are at the precipice of a massive shift. We are about to enter the Web2 era for crypto. The meltdown taking place within the Ethereum ecosystem is an incredible sign that we have crossed an important threshold in cost/speed/capacity of the network, and the era of crypto apps is neigh. Despite the massive roadblock that is the US crypto regulatory regime, application developers are pushing forward (many overseas) on ideas that only now can be made real given their technical and user experience requirements. It will take time for these applications to get to market, perhaps another 6-9 months, and it will take some time for the first real user adoption breakthrough. But we are confident that it will only take one large example to light the fire and cause a large shift in how applications are valued by the market (look at the literal billions of dollars crypto VCs poured into gaming shortly after Axie Infinity caught fire).
The other side of that coin is how protocols will be valued in the age of abundant blockspace. Years ago, the idea was that protocols would accrue all the value (the fat protocol thesis), not the applications, because protocols are where users pay for the security of the network and applications were just pieces of easily copyable code. That may have made sense in the age of blockspace scarcity, in fact at Starkiller we pay(ed) close attention to the cost of blockspace as a signal of demand. We found that, up to a point, the increasing cost of blockspace was a bullish variable, but only up to a point, because when the cost rose too much it basically shut off demand for transacting on the network and asset prices fell as a result. We saw this happen to Ethereum in 2021.
But in the age of abundant blockspace, what is the value of protocols? It’s anyone’s guess, but we believe we are entering the age of the fat app thesis, where cheap blockspace enables apps to accrue real value. And yes, some of the core DeFi apps may end up being public goods, worth not much. But an entire world of applications which are able to bootstrap their growth and liquidity by giving equity like tokens to users will eventually reach sustainability and become massive global businesses built on real demand.
We will eventually see a regulatory path which enables this, because even if it has to be done overseas first, it is inevitable. We are big long term believers in DeFi, tokenization of real world assets, gaming, DePin, enabling AI agents to transact on-chain, amongst other use cases we can think of, what we are most excited about are all the use cases we can’t yet think of. When you give entrepreneurs cheap abundant blockspace on public permissionless blockchains that have the ability to reach everyone on earth, it is inevitable that they will build some incredible and incredibly valuable things used by hundreds of millions if not billions of people.
At Starkiller Capital we’re here for it.
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