Coinbase Ventures Q2 Analysis: What are the investment opportunities in the bear market?

Translation|Wu Zhuocheng Wu said blockchain

Foreword: The market has entered a period of turmoil. A large number of VCs that have completed fundraising are holding back, and project valuations have begun to decline. But VCs who have really experienced bulls and bears know that high-quality projects with a hundred times, a thousand times or even ten thousand times of high quality often come from opportunities when the bear market price has not yet been discovered. As Coinbase Venture, the most active VC in the market, their analysis and outlook for the second quarter deserves attention.

Original link:

https://blog.coinbase.com/coinbase-ventures-q2-investment-memo-857dd8ec7627

• Deal activity at Coinbase Ventures mirrored the overall pace of the venture capital space, falling 34% quarter-over-quarter. Business activity increased 68% year-over-year, reflecting the solid growth of our venture business over the past year.
• Among the major trends observed, we believe that Web3 games will lead the next wave of crypto, with experienced founders from Web2 games continuing to flood the space.
• We're excited that Web3 User Apps can upend Web2's captive model, giving users control over their users and communities.
• The Solana ecosystem continues to demonstrate impressive momentum and traction.
• Encryption is undergoing a massive UX improvement that will remove complexity and provide the same experience as Web2
• The US continues to be home to the majority of companies in our portfolio, with impressive innovation centers established in Singapore, the UK, Germany and India.
• CeFi lending institutions have performed poorly this year, while DeFi lending platforms have been resilient.
• Current price action aside, we still believe that the crypto and Web3 opportunity is much bigger than most realize.

The first half of 2022 will be volatile for all markets. The Dow and S&P had their worst first-half performances since 1962 and 1970. The Nasdaq had its worst quarter since 2008. Bitcoin experienced its worst quarter since 2011, DeFi TVL fell 70% from its highs, and NFT sales in June fell to levels not seen in a year.

The collapse of the $60 billion Terra ecosystem in May was a central part of the crypto market turmoil. This led to the collapse of a $10 billion crypto token fund (Three Arrows Capital), which had leveraged trades on Terra and some other unfavorable trades (GBTC, stETH). Next, news emerged that Three Arrows Capital had borrowed large sums of money from some of the largest crypto token centralized lenders, and several of them were forced to go bankrupt due to their inability to recoup these loans.

The downturn in the macro market has also affected the venture capital field.

Venture capital field

The overall venture capital market began to show signs of cooling in the first quarter, with total funding falling for the first time since the second quarter of 2019. The trend continued in the second quarter, with total venture capital funding down 23%, the largest drop in a decade. In a further sign of the times, late-stage companies such as Klarna also raised down rounds during the quarter.

Crypto VC investment still hit records in the first quarter, but as we wrote in our last letter, we are already starting to see signs of a slowdown, expected in the second quarter. Sure enough, data from The Block’s John Dantoni shows that crypto venture capital funding fell 22%, the first decline in two years.

In the second quarter, Coinbase Ventures continued to rank among the most active crypto token investors, but the number of transactions also slowed, with the total number of transactions falling from 71 to 47, a drop of 34%. Despite a slowdown from the fiery pace of late '21 and 1Q'22, our second quarter activity was still up 68% year-over-year, demonstrating overall growth in our venture capital business.

Much of this decline reflects overall market conditions — as the market fluctuates, we see many founders rethink or pause their funding rounds, especially at later stages. We see many companies foregoing funding unless absolutely necessary, and even then, if they are confident they can show the growth necessary to justify a new round of funding.

Depressed macro conditions aside, there are still plenty of high-quality founders raising funding at our most active seed stages. Looking at the price action, the areas we invest in show the real utility range of continuous construction and paint a promising future picture: a vibrant array of Web3 user applications, improved user experience, robust DeFi market, scalable L1/L2 ecosystem, and all the tools developers need to build the next killer app.

This is our layout for the second quarter.

Now, let's look at some prominent themes.

The Coming Era of Blockchain Gaming

With the meteoric rise and subsequent decline of Axie Infinity, many pundits are happy to think that blockchain gaming is just a flash in the pan. As we wrote back in September, Axie is going through a positive feedback loop that can turn negative when the enthusiasm for pushing the game fades. Regardless, Axie generated nearly $1 billion in sales in one month and attracted 2 million DAUs with little to no marketing budget, drawing the entire gaming world to the power of this new vertical.

With an estimated over 320 million gamers worldwide, we firmly believe that Web3 gaming will be the platform for the next wave of crypto users. Web3 gaming remained a heavy investment area in Q2, with The Block estimating that more than $2.6 billion has been raised. Our activities over the past few quarters have strengthened our conviction.

As we saw in Q1, founders with a strong track record in Web2 gaming will continue to embrace the category. Azra games, for example, was created by the creators of the $1.4 billion+ mobile game Star Wars Galaxy of Heroes with the goal of creating a combat RPG with a strong in-game economy that would appeal to mainstream players. The space has also attracted Justin Kan, co-founder of game-streaming platform Twitch, which was acquired by Amazon for $1 billion. Kan's new company, Fractal, is building a marketplace for NFT game assets.

Companies like Venly will add fuel to the fire by giving Web2 game developers a set of tools to seamlessly make the leap to Web3. Established game companies are also starting to get involved, with Epic Games, the developer of Fortnite, now allowing non-mainstream games into its game store.

It will take a while for this field to mature, but it is becoming increasingly clear that blockchain games will be a huge category in the future. We look forward to an increased focus on sustainable economics and gameplay, merging NFTs with more familiar Web2 gaming experiences.

Web2 Reimagined

Beyond games, the next generation of Web3 user applications is working to upend the Web2 captive model, giving users control over their users and communities. One company we're particularly interested in is Farcaster: a decentralized social network founded by former Coinbase employees Dan Romero and Varun Srinivasan. Their early product was similar to Twitter, but the key difference was letting users own a relationship with their audience.

Farcaster is an open protocol, similar to email (SMTP). While Farcaster built the first social app based on the protocol, other developers could build competing clients, just like we have Gmail and Apple's iCloud. While you can't bring your Twitter followers to TikTok, someone can build a similar TikTok on top of the Farcaster protocol, and Farcaster users can bring their followers to a new, differentiated platform. Not only can users better maintain ownership of their users, but they can also earn more consistent monetization. Most ad spend goes directly to platforms like Twitter and Instagram, and Farcaster users with large followings can make money directly from their audience through the platform.

Another investment we're excited about is Highlight.xyz, which sits at the burgeoning intersection of Web3 and music. Highlight will let musicians create their own Web3-enabled fan clubs/communities (no coding required), including Token gating, using NFT airdrops, merchandise, and more. Highlight joins other CBV portcos such as Audius, Sound.xyz, Mint Songs and Royal, all of which offer musicians new avenues to connect with fans and monetize.

All in all, we remain excited about the potential of Web3 to reimagine established Web2 models for social media, music, and more, and ultimately return power to creators.

Rise of Solana

Amidst our Q2 activity, it was worth noting the continued momentum behind the Solana ecosystem. While Ethereum and the EVM are still king for developers and compatible applications, we've noticed a clear trend towards Solana being taken seriously by early teams. All in all, we closed 10 Solana-based deals in the second quarter.

Given that Solana smart contracts are coded in Rust, rather than the EVM's Solidity, the founding team often had to choose between the two. We're seeing more and more teams choose to support both EVM and Solana from the start -- such as the recent additions of Coherent and Moralis. We've seen other companies start with EVM and choose to transition completely to Solana, while Fractal, mentioned above, chose to build on Solana from the start.

Additionally, several large funds have publicly expressed their support for the ecosystem, suggesting that Solana's staying power is real. However, chain liveness (the ability to keep Solana online) remains a top priority for the Solana team.

user experience

The overall clunky and disjointed crypto user experience has long been a barrier to crypto token adoption. Consider what a user has to do to perform a typical transaction: convert fiat currency to a crypto token, transfer the crypto token to a wallet, bridge the crypto token to the network of their choice, and finally execute the transaction.

In Q2, we've invested in multiple teams (not yet announced) working on simplifying and verticalizing the entire retail transaction process. Soon, crypto and Web3 developers will be able to deploy entire transaction stacks with a few simple lines of code and a standard set of APIs.

The end result will be, for example, that users can perform DEX transactions in one click. In the background, the fiat currency will be converted into encrypted tokens, moved to the wallet, bridged to L1/L2, and then the swap will be performed, and the assets will be kept in the wallet of their choice. All complexity will be blurred and we will have the same user experience as Web2 - a massive unlock.

where is the builder

This quarter, let's take a look at where the founding teams we invest in are. While crypto tokens are a global industry, the largest concentration of our founding teams is in the United States—unsurprisingly, 64% of the 356 companies we invest in are from the United States. All the more reason, therefore, for regulators to foster, rather than suppress, this fast-growing industry.

Singapore has become a base for many Asian teams to build. Meanwhile, the UK and Germany are growing financial centers where policymakers are actively working on regulatory transparency. We're impressed with the founding team in India and we hope they play a big role in future adoption of crypto (CBV portfolio company Frontier, with 30 engineers in India, has built a great mobile-first DeFi aggregator, Supports 20+ chains and 45+ protocols).

This quarter, we were also pleased to support 5 teams founded by former Coinbase employees, including the aforementioned Coherent and Farcaster, as well as 3 other teams that have yet to be announced. We're proud to continue supporting the employees who receive a world-class crypto education at Coinbase and continue to build world-class companies and projects.

epilogue

While there is much to be excited about in the future, there are also many lessons to be learned now. The current crypto crisis is similar to what we’ve seen in traditional finance, where centralized lenders and the opacity of Three Arrows Capital’s operations prevent lenders from properly assessing their counterparty’s risk. Lenders don't know how much money others have lent to 3AC, nor how much leverage and risk 3AC has taken on. Investors don't know how much risk they are facing in total. When the market is bad for both the lender and the 3ACs, a huge hole is left in the lender's balance sheet, and investors are the scapegoats.

However, compared to the centralized lenders facing bankruptcy, it is worth noting that the blue chip DeFi lenders Aave, Compound and MakerDAO are running smoothly. Every loan and its terms remain transparent on-chain for all to see. When collateral levels fall below a threshold, the collateral is sold via automated code and lenders are repaid. The same code also stipulates that Celsius was forced to repay $400 million in loans to Aave, Compound, and MakerDAO — no court order required (although overcollateralization played a role). All in all, a strong testament to decentralized finance.

It's just that it can be easy to get overwhelmed by the current price action and forget how far we've come in the short term. The last time the bear market hit, the most popular user app was Crypto Kitties. Today, there are more profound and impactful innovations than we can count. DeFi, NFTs, a rich DAO ecosystem, all emerged in the last two years, and even came together to make a real impact on the world stage. Meanwhile, Layer 2 scaling solutions are finally here that can take us from dial-up to broadband, capable of supporting a rich array of user applications, and bootstrapped with a simple UX.

As in previous recessions, critics have once again confidently declared the death of crypto tokens. However, from where we are in the industry, we are heartened by the incredible founders we see tirelessly pushing this technology forward. With the digitization of the entire financial system and the world itself, we continue to believe that the opportunity for encryption and Web3 is much greater than most realize.