Value. It’s what every company strives for and every investor seeks. For traditional businesses, we may argue around the edges, but it’s not too hard to define — create a product or service that generates sustainable cash flows in excess of costs.

However, when analyzing the value of blockchain protocols, DeFi applications or anything else novel within Web3, the analysis is much less clear. This is part of the reason why many investors and institutions still won’t touch the industry with a ten-foot pole.

See Polygon (an Ethereum scaling solution) as an example, which received $450 million in a venture funding round last year that valued the company at ~$13 billion at the time. I have so many questions as it concerns how the VCs participating in this round analyzed and structured the deal — for example, how much expected return is attributable to those VCs being allocated a portion of Polygon’s massive $MATIC treasury (which is in aggregate worth over $2 billion as of writing)? As we know, tokens in treasury do not equal revenue and mean nothing should price collapse for whatever reason (see FTX). Additionally, what proportion of any revenue do these VCs receive from the various protocols Polygon spent hundreds of millions acquiring over the past couple years (e.g., Mir)? And how is Polygon otherwise forecasting revenue to justify its billion-dollar valuation? Not to pick on Polygon, but it is the unclarity with respect to this line of questioning that has investors who are focused on fundamental valuation largely baffled with the industry as a whole.

The Fat Protocol Thesis

The notion that all Web3 protocols should be evaluated similarly to traditional businesses is part of the reason why there is so much confusion with respect to valuation in Web3. In reality, the comparison is not always apples to apples, and as a result we’re often looking through the wrong lens which is contributing to the issue. This idea was famously touched on by Joel Monegro in 2016 in what has famously become known as the “Fat Protocol Thesis.”

For illustration, let’s compare certain companies in the tech industry today with those in blockchain. Think of Google, Amazon, Meta (Facebook) and other large, internet-based tech companies. These businesses and their products/services are applications built on top of shared protocols like TCP/IP, HTTP and SMTP. Despite the obvious importance of the latter in serving as required infrastructure for the Amazon’s and Google’s of the world to operate, almost all of the value capture occurs at the “application layer” and not the “protocol layer.” For example, Google has over a trillion-dollar valuation, but no layperson knows what TCP/IP even stands for.

This relationship between protocols and applications is largely turned on its head in the blockchain stack. Here, think of prominent Layer 1s like Ethereum, Cardano and the like. These are protocols serving similar roles as HTTP, but intended for Web3-related applications / companies to build upon. However, Ethereum today is commanding over a $150 billion token market cap, whereas Web3 applications of significant value ($1 billion+) built on top of this infrastructure are very few and far between. The relationship is therefore flipped and largely due to the introduction of protocol-level tokens able to command value at the protocol level, which leads to some interesting positive feedback loops resulting in protocols often growing faster than the combined value of any applications built on top (since the success of the application layer drives further speculation at the protocol layer).

So, when looking at protocols like Polygon within Web3, it’s not really an adequate comparison to view them with the same eye as traditional companies and to expect cash flow, recurring revenue streams, tangible products/services, etc. Value is created, but in an entirely different way that needs to be analyzed in its own right (e.g., token value increasing from expected network effects due to protocol efficiencies, staking / tokenomics, etc.). Whether protocols like these therefore warrant “traditional” funding rounds is still an open question in my mind, as it has yet to really be seen how value can be returned to investors beyond maintaining a stable or appreciating token price (which is a dangerous game to play). Given the rapid pace of development which might lead to new concepts of “value” emerging, this line of thinking can change very quickly though.

Lastly, a brief note on the staying power of the Fat Protocol thesis. Some will be quick to point out that times are changing and the continued validation of the thesis may soon be called into question. They are not wrong. As we continue to move toward a more modular world, the very concept of a blockchain and what it comprises has evolved away from initial conceptions of large, monolithic blockchains processing everything under the sun in Web3. As this evolution continues it is likely that protocol layers will become increasingly less bloated. Further, as on-chain applications continue to develop and mature, we will surely see more value start accruing at the Web3 application layer as well. All of this being said, the Fat Protocol thesis still illustrates and brings to light an important aspect of Web3 valuation that is generally misunderstood, and it is important to have perspective on no matter how far the pendulum swings back.

More on Application-Layer Valuation

With the above context in mind, I can’t help but extend more specifically to valuation at the application layer and zero in on a recent trend that has emerged within DeFi — finding “real yield.”

Utility Token Limits

When it comes to looking at your favorite gaming or other application-level tokens for yield, let’s not forget — holding tokens do not equal equity (or stock) value. The latter represents ownership in a company, which often entitles shareholders to a fraction of a company’s earnings (e.g., dividends), a residual claim on assets in the event of liquidation, voting power as well participation in upside through share price appreciation. Tokens, on the other hand, are usually only meant for utility, with no associated rights concerning value. For speculators, it’s a bet on the underlying popularity and rising use case of a product rubbing off on the related token’s price. There are always exceptions, but generally speaking.

So, key point — a token for a project can fail, but that same business’ equity owners and operations can live on and thrive should they have other revenue streams and strategy aside from reliance on the popularity of a specific token.

For holders of utility tokens, this is important perspective to keep in mind.

Finding Yield Elsewhere (DeFi)

Where else might speculators look within Web3 to earn a return? DeFi is one such place, with novel tooling and structures offering tons of innovation and opportunity. However, there’s a famous saying in crypto:

“If you don’t know where the yield is coming from, you are the yield.”

Many of us learned this lesson the hard way with protocols like Olympus DAO and the subsequent rise of rebase token economies (read here for background). In contrast to pure-play utility tokens, are DeFi protocols able to provide users with anything concrete as it concerns yield? Contractually, not really, but DeFi can offer something of more traditional substance.

For example, consider everyday consumer banking, which at a high level might promise X% to those depositing money with a bank. This yield is paid by banks through interest received from the subsequent pooling of loans made to others. DeFi allows for something similar. Take, for example, decentralized lending protocols like Aave, which depend on others to supply liquidity to lending pools to facilitate the collateralized borrowing of others. These suppliers of capital are incentivized through sharing in the receipt of interest paid by borrowers, which represents actual return (paid from a counterparty) on the underlying crypto asset supplied.

Aave’s set up and others like it are not entirely dissimilar from traditional consumer banking — i.e., depositors lock up capital, and in return receive X% back paid out through a higher loan % charged. I won’t otherwise be getting into the specific benefits/risks of centralized vs. decentralized lending in this article, but just want to make clear that DeFi is sometimes similar to that of what we see in the real world in terms of structuring yield for retail.

The Emergence of “Real Yield”

This leads us nicely into a recent trend to be aware of in DeFi — that of “real yield.” When touting yield as being real, it’s mainly in reference to the sustainability of a project’s emissions versus actual revenue. For example, if over a month, project X has distributed 10,000 of its tokens at an average price of $10 (emissions value of $100,000), but over the same period has only made $50,000 in revenue, there’s a real yield deficit of $50,000. If analyzing the sustainability of a protocol like this, it could warrant a closer look to see if the deficit might be a precursor to perpetual dilution in an effort to incentivize TVL and users. But all this fancy language aside, real yield merely presents an argument that a protocol actually makes money and is not a ponzi scheme.

A variety of projects have jumped on this concept and structured their protocols around achieving sustainable real yield for users. One such project I’ve followed for awhile is Redacted ($BTRFLY), which actually has its origins as an Olympus fork with the goal of positioning itself as a key player in DeFi’s liquidity wars (i.e., the “Curve wars”), which warrants an entire article for itself. Since its founding, Redacted has made a transition away from a bond-centric, dilutive token model to one focused on producing real yield for its holders.

At a very high level, BTRFLY can be staked and locked away for 16-week periods in return for revenue-locked BTRFLY (rlBTRFLY). This token rewards holders with a share of revenue from the Redacted treasury and product ecosystem (Hidden Hand and Pirex), paid in ETH, plus a certain amount of BTRFLY emissions. Time will tell whether the model and its revenue sources prove sustainable, but if you have time to dig into Redacted’s ecosystem, it’s a fun rabbit hole to go down.

At the same time, the real yield narrative also has its pitfalls, and Redacted’s pseudonymous co-founder 0xSami highlights some of the dangers well in this piece. In short, offering incentives like real yield are no shortcut to natural protocol adoption which should be the top priority for projects, most of which are barely a year old but yet still promising real yield to users. Soon enough, these projects might find themselves in a negative feedback loop where every operational dollar is now out the door with no way to pay for the glue that is supposedly keeping them together (i.e., sustainable, revenue-producing operations).

The concept of real yield makes sense and it’s obvious how it might stand out and attract attention in an industry that has been plagued by dilutive schemes in the past. However, it would be wrong to say that striving for real yield is objectively better than other models, at least in the early stages of a protocol, if it comes at the expense of building an actual product with a sustainable use case.

In the end, this is just one more trend to keep an eye on and remain intelligently skeptical of should you encounter it in the future.