a16z Crypto Startup School: How Crypto Projects Achieve Progressive Decentralization

The author of this article is Jesse Walden, compiled by Chain Catcher Echo

At the beginning of 2020, the well-known venture capital firm a16z held an online video course called "Crypto Startup School," covering the basics of cryptocurrency technology and important considerations for building a crypto company.

To help domestic crypto market entrepreneurs gain more cutting-edge industry information, Chain Catcher translated the series of courses and made edits that do not affect the original meaning. The speaker of this article is Jesse Walden, the product manager of this series of courses and founder of Variant Fund, who previously served as a partner at a16z. He mainly shared considerations and methodologies for how a crypto project can achieve progressive decentralization.

Cryptocurrency founders face unique challenges. In addition to building products that people want, they also need to consider how the product can successfully operate in a decentralized manner, meaning it is owned and operated by the user community as a protocol.

This is a daunting challenge because building a successful product from the start takes a lot of time, such as product leadership, rapid iteration, and market development, complicating the path to community ownership and regulatory compliance, thus ensuring long-term health.

I have spoken with some cryptocurrency project founders dedicated to solving this complex situation. Here, I will propose a three-step process and a guide to achieving this goal through progressive decentralization.

In this process, the founding team will gradually relinquish control over time, allowing the team to focus and create a regulatory-compliant path, including issuing tokens that hope not to violate securities regulations.

Keep in mind that this process is applicable to certain cryptocurrency startups building applications on smart contract platforms. It is not very useful for the blockchain computing platform itself, as sufficient decentralization is needed from the start to be useful.

Given the uncertain regulatory framework surrounding community-owned networks, the final stage of this manual only addresses potential solutions rather than established successful strategies.

1. Background and Reasons

Open decentralized protocols like IMAP, POP, and IP are the foundation of many network services, and today many of the world's most valuable companies are built on these neutral protocols, which extend the functionality of internet protocols and provide rich experiences such as search, email, and social media.

These types of internet companies typically follow a predictable pattern when they start up; they do everything possible to recruit users, developers, and businesses to join the platform, with each member of the participating community forming the basis of a multi-sided network effect, making the platform more valuable and defensible.

As the platform grows, they gradually change their behavior, starting to extract value from the community rather than collaborating with it. Many Web 2.0 platforms have demonstrated the potential for this misalignment by stifling the innovative application ecosystem built on their APIs or profiting at the expense of user privacy or well-being.

For example, Twitter once received more traffic from third-party clients than from their own official app. However, to gain more value, Twitter changed the rules and restricted API functionality. This was a bait for users and developers, and the rich ecosystem initially brought by collaboration was ultimately stifled, leading to a lack of innovation.

Unlike enterprise-owned centralized networks, crypto networks offer a new model for building internet platforms. Crypto networks aspire to decentralization, attempting to become community-operated and owned network platforms. Cryptocurrencies can facilitate value flow at the cost of information, with nearly zero marginal costs. Crypto networks can have a more economical operating model, rewarding contributions from independent users around the world rather than needing to extract value from users to return to shareholders.

Well-designed crypto networks can directly pass value to contributors, which in turn signifies that crypto networks may be very similar to early internet protocols, and they can scale to a larger usage while achieving a sustainable innovation ecosystem at the top level. This is why decentralization is so important.

Next, let’s look at a framework that addresses this as a process, aiming to build sustainable, compliant, and community-owned products.

I assume that any successful application running on a blockchain computer will have three components: product/market fit, community engagement, and sufficient decentralization (community ownership).

2. First Step: Product/Market Fit

In the first step of building a crypto application, all conditions for a normal launch are needed: a great team, lean development, strict execution, and rapid learning. At this stage, the only thing that matters is product/market fit.

To find it quickly, it is important to avoid design by committee or community. The product needs decisive leadership to test hypotheses and quickly update them. Therefore, in practice, this may mean having administrative privileges over smart contracts, allowing for rapid iteration and product management, including upgrades or shutting down the application.

At this stage, there should be no pretense of decentralization, and it is not advisable to launch tokens at this stage, as it may derail the compliance path.

The idea that the core team controls all aspects of the project may surprise some early users, but founders should not be wary of this. If users complain about your control, that is actually a good problem, as it means someone cares about what you are building.

It is important to clearly state where control lies. If the project pretends to be decentralized, it will quickly undermine user trust, and transparency is one way to build trust.

Therefore, in the early stages when the product attracts users, founders should start spending more time shifting from thinking about the product to thinking about how to maintain harmony between the core product team and the community. This is the second step.

3. Second Step: Community Engagement

First, the founding team may need to invest more effort in best practices for running the product, similar to open-source projects, such as building open-source documentation, offering bounties and grants for third-party developers, hiring community leaders to help guide open development, and even further considering how to eliminate the project's dependence on the core team to build more trust with the community.

For example, a Compound manager delayed an upgrade of the smart contract by 48 hours, giving the community time to review and respond to the upgrade, thus relinquishing some control and creating an opportunity to invite community participation.

For the core team, relinquishing control presents an opportunity to start transferring responsibility to the community. However, it is important to reconsider incentives when interacting with community members; the question is why community members would continue to contribute to the product?

Economic incentives are one way to promote community contributions. But where does the economic model come from? A practical and familiar crypto service business model is pay-per-use, similar to API microservices like Twilio or Stripe, distributing fees to active contributors can help coordinate the community around the project's success.

That said, charging at the start of the project is not always reasonable. Given that crypto services are open-source, fees should only be charged when network effects are strong, thus enhancing defensibility through high switching costs.

Uniswap is an example of leveraging the power of its network effects to protect paid crypto applications. In Uniswap, the more users contribute liquidity to the exchange, the better the pricing for traders. To offer the same pricing in a fork, new project teams need to coordinate with all liquidity providers and third-party services integrated with the original currency to start using the said fork. The cost of coordinating all of this is the switching cost.

Tokens are an effective tool for allocating the fundamental value of the project. While token distribution can incentivize participation and help build defensibility, it is important to consider how to build a fair and effective distribution mechanism.

Many past ICOs and airdrop projects have not fared well because many communities were dominated by speculators, and significant regulatory scrutiny distracted project teams. By distributing tokens to already active user groups, crypto applications focused on product/market fit have the opportunity to perform better.

First, the team can allocate and manage tokens to users who contribute value, helping to eliminate the community's dependence on the founding team's work.

Second, the team needs to plan how to fairly distribute the remaining tokens to participants, taking into account past contributions while effectively incentivizing future ongoing participants. Doing this correctly is challenging, but some common questions to consider are: what percentage of tokens should be allocated to the initial team and the cap table? How to reward different types of contributors to products or services? How will technical leaders be rewarded in the future?

To answer these questions, it is necessary to analyze community behavior, model reasonable outcomes, and discuss proposals with community members.

4. Third Step: Sufficient Decentralization

If you are a cryptocurrency founder and are ready to enter this stage, it means you have achieved early product/market fit, built a strong community capable of successfully maintaining the application, and developed a model that appropriately incentivizes sustainable operations.

Now is the final step to achieve sufficient decentralization: widespread token distribution. In fact, I envision the team airdropping tokens to users and contributors based on the planning from previous goals, thus achieving an "exit to the community." This will occur when the smart contract is triggered to mint and distribute tokens. Ideally, once this function is triggered, many things will happen:

First, the core team will transfer control of the product from the company to the community, so the product is thereafter controlled and owned by the community, reducing the risk of the platform violating rules.

Second, the company can find a sustainable business model, such as retaining enough tokens and benefiting from the future growth of the product. Similarly, community members, now part owners of the product, will also begin to receive economic rewards for their contributions, and as the cooperative economy of the product develops, they will see scaling benefits continuously increase.

Finally, because the product no longer relies on the core team, tokens are not considered securities, thus eliminating the regulatory costs imposed by the SEC.

This goal actually commemorates a specific moment when users call this smart contract, the crypto product completes its transition from a traditional product company to a sustainable community owned and operated by users.

5. Q&A Session

Next, I invite Robert Leshner, founder and CEO of Compound, to share their experience of achieving progressive decentralization in real-time. Compound is a currency market for lending digital assets, operating as a smart contract on Ethereum, and the company has been executing a progressive decentralization plan since its establishment in 2018.

Q1: Can you talk about how you collaborate with the developer community? What is the relationship between the company and the community?

Robert Leshner: This relates to the second goal stage of decentralization—building a community. We view developers as content users and focus 100% of our energy on enabling developers to build content for us, which means treating the product as a whole and everything developers need.

What we first consider is what the product of the protocol is and the ability to build on that basis, so we spend a lot of time building developer documentation and creating a developer community, bringing everyone together in various ways.

When we discuss how to interact with Compound, we focus on developers and create an environment where everyone can ask questions, compare notes, share code, exchange ideas, etc. Everyone is very active. This is a way to bring everyone together to enhance the cohesion of each developer.

Q2: Why is community ownership so important for Compound and cryptocurrency?

Robert Leshner: We believe that having a decentralized protocol has two important advantages: first, it allows the protocol to exist forever, letting developers and users know that the rules will not change; second, it enables a broader audience to upgrade and contribute to the protocol.

Our team is small, based in California, and we can only do so much to upgrade the protocol, but we can open it up to the entire developer community, allowing them to make upgrades and improvements to the protocol, which can accelerate the development speed of Compound.

Q3: You already have a community and are trying to figure out how to transfer ownership to them. I wonder how you discuss this plan with community members and how to ensure everyone is working in the same direction?

Robert Leshner: From day one, we have been communicating with the community, with the ultimate goal of becoming a decentralized protocol. Since then, we have taken a series of measures, such as limiting the ability to make sudden changes to the protocol and creating a lot of public pages around governance transparency.

The decentralization of Compound is divided into three phases. The first phase is that the team responsible for the protocol still controls code changes, but they are done publicly; the second phase shifts to decentralized sandbox experiments, where we test with decentralized blockchain networks. This is an intermediate step for testing decentralization, gradually expanding the testing group from limited stakeholders to the entire user community; once we can ensure that the variables and parameters set are correct, we will move into the third phase—fully handing it over to the community, at which point the project will achieve complete decentralization.

Q4: Have you found certain jurisdictions to be more friendly regarding the regulation of decentralized products?

Robert Leshner: The U.S. may be more difficult than many other jurisdictions. The regulatory landscape in this country is such that people just want entrepreneurs to create products that can protect users' safety and comply with established rules, and these rules do not stifle innovation. Everything we have done so far has been within the bounds of regulation.

But in reality, I like the ecosystem that exists here because we follow the principle of decentralization, allowing us to build what people want without having to conduct public token sales, without violating securities laws, and using venture capital funding to achieve uncontroversial profits, then building a community that operates well within the existing regulatory framework.

I believe the era of wild ICOs is over due to many irregularities, and regulators have done an excellent job cracking down on some bad behaviors. I think this is a conservative and cautious approach, but it allows users to know that only excellent teams with quality products can perform well.