Dialogue with a16z partner Chris Dixon: Investment principles, the crypto market in the history of technology, and outlook for the coming year

Original Title: 《a16z's Chris Dixon on the state of the crypto market》

Source: The Block

Translation by: Dong Yiming, ChainCatcher

So far, the Silicon Valley venture capital firm a16z has raised over $7.6 billion to invest in cryptocurrency and Web3. This article is translated from the latest episode of The Block's "The Scoop," where a16z partner Chris Dixon shares some guiding principles for a16z's investments in the crypto space and explains why the time has come for decentralized networks to replace centralized corporate networks. ChainCatcher has made appropriate edits to the content.

In this episode, Frank Chaparro and Chris Dixon also discussed the following topics:

• How venture capital firms manage risk in their portfolios
• The relationship between the internet and "networks"
• Why a16z has never invested in FTX
• The transformation of decentralized social networks

Frank Chaparro: Welcome to The Scoop. Today, we have Chris Dixon, founder and partner at a16z. We will discuss his views on the current crypto market, recent investments, and the outlook for the crypto market in 2023. Our first meeting was before the credit crisis, when the entire market was affected. Now, six months later, the crypto market has almost experienced what would typically happen in a decade. In such a turbulent environment, what is your perspective as a venture capitalist on the current market?

Chris Dixon: For venture capitalists, the time horizon is indeed different. Hedge funds may try to predict what will happen in three months or twelve months, but we have to think longer term. In my career, my general experience is that at any given time, two levels of things are happening: one level is the technical and entrepreneurial level, and the other is the capital market level. There is some relationship between the two, but it is certainly not a 1:1 relationship. For example, I started my entrepreneurial career in 2003, which was a downturn for the internet, with Amazon's stock price at only $6 a share. But looking back, that might have been one of the best times to build internet companies in the past few decades.

Just like during the global financial crisis in 2008, we began investing in mobile applications. Looking back, that was a great moment. Why? Because the iPhone came out. The iPhone was released in 2007, and the App Store launched in 2008. If you look at all the top apps, the vast majority were created between 2008 and 2011.

This is a common pattern throughout the history of technology. After that, I have been focused on three major trends: crypto and blockchain, AI, and virtual reality for the past ten years.

Historically, every 10 to 15 years, a major new technological trend emerges. I believe we are on the brink of all these significant changes, which is a very exciting time in the technological development process. This stands in stark contrast to the rather grim year we just had. This is something that happens in almost all high-growth tech companies, not just in the crypto capital markets.

The current internet crisis has spread to companies like Google and Facebook, which have already had layoffs, and some consumers have experienced bankruptcies. These are obviously very bad things for those affected. However, if you extend the time horizon and look at broader technological trends, I believe some very powerful things are happening, and overall, this trend is positive.

Frank Chaparro: In the context of the overall tech market downturn, the volatility in the cryptocurrency market has intensified, and many crypto companies have seen significant profit reductions. What reasons lead people to consider crypto companies and projects separately during market turbulence?

Chris Dixon: That's a good question. I think new technologies are a bit like a double-edged sword, so cryptocurrency has received positive attention for being reliable, interesting, and novel, while also being very controversial. I think large-scale controversy will also occur in the currently hot AI field; we can see what happens next year. So, this is just a natural tendency: people pay more attention to big, new, important things. Everything in the tech space is under a microscope; the newer something is, the more energy it attracts, whether it is supported or opposed, it will receive more attention. This will be a recurring pattern, not just in cryptocurrency, but in all major new technological trends.

A typical example is when the internet first emerged; there was a lot of controversy about how it would kill graphic design and print jobs. But if you look at the statistics, traditional jobs did decrease, but it actually created more jobs in web design, social media management, Uber driving, and so on. I think similar events will happen in the AI field; AI will not create blueprints and illustrations by itself. It will need human assistance; it will simply enhance what people can already do and help achieve automation. But I don't think it will reduce the number of creative jobs in any way. However, it will indeed put pressure on some who need to transition, and that brings up "political" issues. So, the crypto market is the same.

Frank Chaparro: The FTX incident raised an interesting question about the role and function of VC in society. In the past few weeks, I have seen discussions saying that VCs in the crypto space have not done well enough; they did not conduct proper due diligence, and some say VCs are involved in excessive hype and interference in project development. How do you view these doubts and criticisms? Is a16z's "dodging the bullet of FTX" a skill or luck?

Chris Dixon: First of all, I think having VCs is good. There are boards behind corporate governance, and there are dedicated financial departments; this oversight is important. We strongly encourage that. We did not participate in the investment in FTX, and I don't know what role its VCs played.

But why did FTX's headquarters end up in the Bahamas? Mainly for regulatory reasons. Because a16z invested in Coinbase, I have a judgment standard for centralized exchanges based on years of experience working with Coinbase. In Coinbase's board, 70% are advisors on finance, security, and compliance; it is a company that is heavily regulated. And centralized crypto exchanges should be regulated.

I think what is truly innovative is DeFi, which allows users' assets to be held on-chain, where you can trust the software rather than relying on someone else to safeguard the assets. Most of our investments in the crypto space are centered around on-chain activities, but we also need some intermediary bridges, like Coinbase, to help people enter a fully custodial world through fiat rails. And these companies cannot simply rely on on-chain guarantees; they must be regulated.

Our investment approach over the past 10 years has been "must choose one," either everything must be on-chain, like Uniswap; or be regulated in a country, having audited financial data, with 1:1 customer assets, and highly secure custody. If a project or company is offshore, falling between the two, there are some risks.

But fundamentally, this should be the job of regulators; regulation should clearly define the system, requiring companies to choose one of the two; if not on-chain, there must be appropriate financial security and compliance, and if on-chain, there must be appropriate code audits to ensure safety, rather than trying to do both.

So, some offshore exchanges may seem more innovative and flexible than Coinbase, but in my view, these advantages come from cutting out 70% of the business related to security, compliance, and finance. The reason we did not invest in FTX is not purely luck; it is also due to the diligence of the past decade. It is not to say that there won't be mistakes in our portfolio, but we work very hard to identify whether a project is truly achieving technological innovation. If a project has neither on-chain trust nor off-chain regulated trust, I would not consider putting money there.

Frank Chaparro: What investment directions are you currently focusing on? I know you used to focus on payments and decentralized finance; are there any new changes now?

Chris Dixon: Our investment areas are mainly divided into two large directions: one is infrastructure layer investments, and the other is application layer investments. Infrastructure investments include layer 1 blockchains and layer 2 cross-chain bridges, wallets, and everything needed to build applications.

I believe that this may be the first time in crypto history that we have infrastructure applications capable of supporting tens of millions or even hundreds of millions of users; this is exciting. As for the application layer, that includes DeFi, payments, and so on. Payments have always been a frequently discussed area in crypto, dating back to Bitcoin. This year, we invested in the Bitcoin Lightning Network company Lightspark, founded by David Marcus, who is the former CEO of PayPal and previously led the Facebook Diem project; he has done something very interesting based on the Bitcoin network.

Additionally, the current web3 gaming space is also very interesting. We currently have about 15 game projects in our investment portfolio, but only one or two games have officially launched so far. Therefore, a large batch of games will be released in the next 12 months. The people who entered the Web3 crypto gaming space three years ago are typical crypto enthusiasts; the 15 companies mentioned earlier are all from top gaming teams like Blizzard, Riot, and Valve.

Speaking of NFTs, I believe NFTs have brought cryptocurrency out of the financial world and into a larger world, the media world. Clearly, more people in the world are interested in media than in finance. I think the path to getting a billion people actively involved in crypto may be through media in some way. There are a bunch of interesting new social networks being built, such as the decentralized social protocol Farcaster, which establishes a trusted neutral protocol that allows users to build direct relationships with their audiences and enables developers to freely build new clients without permission; I think this is a very interesting new architecture.

Frank Chaparro: How would you describe the benefits of decentralized social networks?

Chris Dixon: Mainly in terms of money and power. First, let's look at the take rates. The take rate is a very important concept, referring to the percentage of money flowing through a network that the network operator takes for themselves. This is prevalent in social networks like Facebook, TikTok, or YouTube; the take rate on YouTube is 45%, so creators get 55%; Twitter's take rate is 100%, and Facebook is also 100%.

What does this mean? Take Zinger as an example; they built an active gaming platform on Facebook, and then Facebook took all the money. We live in an era where social networks are owned by platforms. They have extremely high take rates, which creates a lack of incentive for people to create content. This kind of network is a bit like a theme park; they are centralized and top-down managed. No one wants to build on that foundation. That's the money part.

Then there's the power part. Is it a good thing to buy Twitter and then decide to change all the rules? Whether you like Elon Musk or not, no one person should have that kind of power.

Looking back at the history of the internet, you will find that initially, email was not owned by any platform; it was community-owned. The community of software developers building email clients and access points decided on the changes to the protocols.

Decentralized social networks are beneficial for creators and developers because they can earn more money and build real businesses. But at the same time, there are broader social implications—how should we manage these networks to make them core infrastructure and key parts of our lives?

We do not interact directly with the internet; we interact with networks built on top of the internet. Therefore, email is a network, YouTube is a network, Twitter is a network, and Facebook is a network. Networks are what we do with the internet. In my view, there are basically three main ways to build networks: one is traditional protocol networks, like email systems, which are community-managed; the second is corporate networks, and the networks we are building on the blockchain belong to corporate networks, such as Ethereum, which combines the best features of corporate networks and protocol networks, distributing token power to the community in an email and web-like manner. Because of airdrops, the community has ownership and builds a real base of believers.

This is a better architecture; it is open and can use crypto as a secure method rather than hiding things behind firewalls. From a financial and control perspective, it is more inclusive; people can own a part of the network through tokens while also having some control and community governance rights.

But we are still exploring; I don't think we have found the best way to govern. There should be a discussion about how to conduct decentralized governance, but unfortunately, this dialogue only happens within the cryptocurrency community. I don't understand why it hasn't happened more broadly, but it is indeed a more urgent issue.

Regarding the power of ownership, I think of the examples of Uber and Airbnb. If you were an early Uber driver, you helped build the Uber network; if you were an early Airbnb host, you helped build the Airbnb network. If you were an early Twitter user, what did you get? You got nothing. This may be the appeal of Dogecoin. It is a silly product that does nothing. But this feeling of ownership gives it a lot of supporters; it is a very powerful force.

Although the current crypto market is relatively negative, I can share some good news. I spend most of my time meeting with entrepreneurs, and what I see is that the crypto infrastructure has truly improved, and a bunch of very interesting applications are being funded; the market may be cooling down, but these interesting things are being built. In our portfolio, about half of the products have not yet launched; many investments were made recently, but product development does take a long time.

In other words, there will be many products released in the next 12-18 months. This can also represent a broader market to some extent. So, I am excited about next year.

Frank Chaparro: How much capital has a16z deployed so far? Is it 50%?

Chris Dixon: The $4.5 billion crypto fund Crypto Fund 4 has deployed less than 50%, with most of the funds still unallocated. Most of the recently raised funds have not yet been deployed; I don't know the exact numbers.

a16z has a venture capital fund, but we have never raised a hedge fund; the two are very different. Perhaps I can give a simple explanation: both types of funds raise money from so-called LPs (limited partners), but the difference is that venture funds have a minimum lock-up period, which means that if you want to invest in our fund, your money is locked up for at least 10 years. And to be honest, it is usually 15 years, and we may extend that period. During this time, you cannot redeem your money.

But because of this, we invest that money in assets that need to be held for the long term. Additionally, compared to hedge funds, our profits (carry) as GPs (general partners) are also delayed significantly. Because of the different payment structures, hedge funds can make money in the second year, while venture funds typically take 5-7 years to realize returns. So if we are raising a venture fund, we will have a longer time to deploy capital.

By the way, I see many people speculating whether a16z will dump the tokens in its portfolio during a bear market; in fact, a16z's crypto fund still holds 95% of its investments. Many people misunderstand our model. If you have read about venture capital, you must have seen something called the J-curve, which describes the return characteristics of venture capital: it goes down first but then rises, resembling the letter J. All our data shows that most of the investment returns come in the later stages of the fund. And in venture capital, the worst thing is to sell good assets too early. I sympathize with those who have lost their jobs; I understand the pain, but it hasn't really affected our model.

Frank Chaparro: Can you talk about this issue? For example, if you invested in Uniswap and are really optimistic about it, do you have the right or ability to buy more tokens from that project?

Chris Dixon: We have that power, and we have done it many times; I can't specify which projects, but it is possible.

Frank Chaparro: How do you manage risk in this regard? For example, if you invested in a company early on and its token has multiplied many times, wouldn't it be unrealistic not to take some profits or not to do the best risk management?

Chris Dixon: In the past 15 years, from my experience as an angel investor in Silicon Valley, there have been too many investors who sold various hot companies at too low a price; such stories are countless. Therefore, it is essential to look at issues from a venture capital perspective; in the long run, we must design a relatively precise evaluation model, for example, inferring their valuation from the growth of the protocol and the cash flow generated by the protocol. We have a dedicated data science team doing professional valuation analysis.

We do not care too much about a project’s performance over the past three months and those momentum effect trading data points; instead, we look at the long-term value appreciation potential of the investment. If what the project is doing aligns with our understanding, we will believe in it. I truly view this world from the perspective of product and technological innovation; we like those open-source developers or hackers. I think a key reason is that they have deep expertise in their relevant fields, so we do not expect them to have experience in managing businesses or building teams; those are precisely the areas where we can help them.

a16z strives to invest in founders of technological products and then help them with other things. Venture capital is a talent business; we bet on people. Although we spend a lot of time on markets, technology, and other aspects, all of this is just to help us evaluate and assist entrepreneurs more intelligently. It is like searching for truffles; what you are looking for are very special people who have unique views of the world and the ability to build something special, and investors need to be smart enough to recognize them when they appear.