Part 1: Broken Unit Economics — Everywhere
Understanding why none of these businesses make sense
Introduction
As we progress deeper into the bear market over the next few months, any assets that investors hold will ask the same question — “is this asset worth holding or is it hot trash”? Because if not, they’re going to sell it for something safer/less volatile.
Now the question of whether an asset is worth holding is particularly complex but when we strip away all the speculation it’ll come down to whether the asset has a sustainable product which will ultimately be answered by the underlying unit economics.
The problem is though, no one actually knows the underlying unit economics. Let’s take the simple example of a lending protocol like MakerDAO. If we wanted to know how much the average user brings in revenue to Maker, we’d have a lot of difficulty computing that data. To make matters even harder, what if we wanted to find out how much MakerDAO paid to acquire that user through its marketing channels? Well now we’re truly asking for something really hard. Now if we want to take it a step further, what if MakerDAO paid incentives in MKR tokens to MakerDAO? The problem becomes extremely hard to reason and solve.
Out of sight, out of mind
So what do we do as an industry since we can’t get this data? A few things:
We pretend that everything is okay and purely look at revenue without factoring in any other nuance
We hope that magical new users come to a protocol without any clear strategies of how capital can be used for growth
We pray the token will go up based on fundamentals
Quite literally, the strategy for the entire industry is pretend, hope and pray. I think though, deep down everyone knows that most of the protocols out there have unprofitable unit economics where trying to find out the truth would cause nothing but agony to confront. Why spend a lot of time finding an answer that will make you so uncomfortable and invalidate any valid thesis you have?
The importance of unit economics
This sounds like a sarcastic title but I think many in this industry don’t have the experience to understand why this matters, or haven’t realised how critical it is to the underpinnings of a real, high-growth business.
To put it simply, when you’re flying blind about your numbers you can’t really make intelligent capital allocation decisions. Some of these pertain to very large financial decisions such as:
How much money should we spend on growth?
At what point should we transition our capital allocation strategy from growth to profitability?
What margins do we need on our profitability to repay the amount spent on growth?
At what cost should we take on dilute equity or debt financing based on our cost of growth?
These aren’t hard questions for any Series A/B startup to answer, but in crypto not a single protocol can answer these with the bar of professionalism that we’re used to in mature traditional businesses.
What’s even more insane is that capital allocators are willing to pay multi-billion valuations for questionable businesses rather than trying to find the truth behind these questions.
Until next time
Why is everything broken? If I were to describe it in one word: incentives. The competing interests of multiple players create a web of lies that is ugly to see when it all comes crashing down. I’ll cover this in more detail in Part 2 of this article series.