VC funding model fails web3 projects

Venture capital funding is the most sought-after form of backing amongst founders looking for capital to bootstrap their operations, offering a percentage of equity in exchange. The problem is, despite a few exceptions of funds like Sigma Capital, web3 VC funding is the most difficult to obtain at the early stages of the founder journey. In spite of a slight increase in funding in Q1 of 2024, VC backing for web3 startups continues to decline, dropping by 82% year to year.

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This exclusivity of opportunity continues to sideline many potential contributors and limits the diversity of ideas that receive funding. It’s a long-standing issue in the startup ecosystem that has persisted in the web3 space, despite blockchain’s promise of decentralization.

Why the traditional VC model fails web3

Web3 projects often struggle within the constraints of traditional VC funding because of the fundamental mismatch of incentives. VCs tend to prioritize profit and short-term growth, which doesn’t often align with the experimentation and collaboration-driven nature of web3 projects aiming to create public good and build for social impact. Public good projects also lack the incentive of lucrative exits associated with for-profit businesses.

Another factor that goes against the principles guiding web3 founders is decision-making. The most popular VC funds centralize their decision-making process when it comes to funding decisions, leaving the destiny of web3 start-ups in the hands of a select few. This structure is in direct opposition to the ethos of decentralization and community-led decision-making encouraged in the web3 ecosystem.

Moreover, VC funding flows mostly to organizations that launch a token, which infrastructure tools and L2s are more likely to do in comparison to apps. That means apps are much less likely to receive funding, even though they are just as, if not more important, to gaining user adoption.

The real question the ecosystem players should be asking themselves is, can startups survive with the current decline of funding? And what role can we play in shifting this trajectory?

Blockchain-powered funding models

Blockchain technology introduces a new realm of opportunities for funding in the web3 space, particularly for those building ambitious public goods projects, such as open-source software.

Retroactive Public Good Funding, or RetroPGF, offers a great alternative to traditional funding by rewarding projects based on their proven impact rather than their speculative potential. In this context, exit incentives get reimagined as rewards for creators delivering measurable outcomes to ecosystems or society at large. A recent success story for RetroPGF is Optimism, which has generated over $2 billion in impact-based funding. RetroPGF pools funded by DAOs or ecosystem contributors create a consistent approach to funding public goods.

Another successful funding mechanism option for founders building in web3 is fractional investing through NTFs. They can tokenize the value of their public good projects, such as governance rights, and allow a broader pool of supporters to contribute via micro-investments. This creates a diverse pool of passionate investors who believe in the project’s mission and growth trajectory.

A people’s VC

Quadratic funding, a mathematical formula for funding distribution based on donor numbers, has gained traction in web3 thanks to its ability to tap into community support, amplifying smaller contributions from a broad base of supporters by matching these funds with a larger pool. This ensures that projects with widespread grassroots support receive the most funding, evening out the playing field in a way traditional funding models prioritizing large investments from a few players never can.

One example of how powerful such a funding option can be is Tornado Cash. Projects like Tornado Cash that investors may not gravitate towards but users love have received significant funding through quadratic funding.

By focusing on collective intelligence, this model fosters innovation in areas like decentralized finance, social impact DAOs, and NFT ecosystems that traditional VCs might overlook.

On-chain ownership

At the heart of this new wave of capital allocation lies on-chain ownership. Blockchain allows creators and builders to tokenize their work, providing novel ways to monetize and engage with supporters. A case in point is creator tokens, enabling subscription-based models whereby fans pay a recurring fee to access premium content. Mechanisms like those create more stable, recurring revenue streams welcomed in a space that thrives on volatility.

The added benefit of on-chain transactions is that they make funding flows visible and auditable, reducing fraud and fostering trust, and by eliminating intermediaries, creators can build direct relationships with their audiences, ensuring that value flows back to those who believed in them from the beginning.

New capital allocation category

This new capital allocation layer consisting of funding mechanisms like community grants and quadratic funding, has the potential to replace or complement traditional venture capital in the web3 ecosystem, increasing the likelihood of launching the next web3 unicorn.

Adopting and propagating the availability of these funding options are important first steps on the path to ensuring that web3’s promise of decentralization and equity becomes a reality, not just a vision.

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