Core Thesis #3: Web2.5 as a pragmatic approach to venture investing in web3

Web2.5 is an approach to venture investing that recognises the existence of a large whitespace for innovation and opportunity between web2 and web3

At Hashed Emergent, our investment thesis stands on three core pillars: (i) emerging markets; (ii) India and Indian founders; and (iii) web2.5. Our previous blogposts have explained our theses on emerging markets and Indian founders in detail. This blogpost will cover ‘web2.5’.

In recent months, there has been rising interest in the term ‘web2.5’. Although there isn't a universally agreed-upon definition the core idea is apparent - web2.5 is a more practical approach to integrating blockchain technology into a product’s tech stack. It is characterised by pragmatism that comes from deep consideration of specific environmental constraints – technological feasibility, market dynamics and regulatory frameworks. These considerations have an impact on one’s decision to build in web3 or invest in web3 startups. This strategic alignment of reality to the idea of ‘web3’ is web2.5.

Web2.5 is a strategic combination of onchain and offchain elements

The offchain components of web2.5 encompass the existing infrastructure and technologies that have shaped the modern 'web2' internet. This includes centralised databases and APIs which have been instrumental in building web applications and platforms. It also includes the ability to wrap web3 protocols in legal entities in order to facilitate frictionless interactions with real-world organisations via established legal frameworks. These 'traditional' components form the web2 bedrock of 'web2.5'. 

On the other hand, the onchain components of web2.5 represent a pragmatic embrace of the innovations inherent to blockchain technology: decentralised P2P cryptography-based network architecture, smart contracts, open-source code and immutable ledger systems. Integrating such components can introduce a new paradigm for trust, verifiability and transparency in tech products – constituting the web3 value-add.

Web2.5 is about building business models that use web3 technological primitives while prioritising scalability

Web3 is a movement driven by the belief that ‘decentralised world computers’ with smart contract functionality can provide significantly better alternatives to traditional systems of coordination and will eventually replace legacy institutions - much like email has largely replaced physical postmail. This sentiment is most evident from the moniker adopted by web3’s most popular podcast - ‘Bankless’.

We are firm believers that the shift from text to code (as a basis for public coordination) is a fundamental evolution that will unlock unimaginable growth. However, at the same time, we are looking for opportunities where blockchain technology can serve the current needs of a large TAM in emerging markets and hence we remain realistic when it comes to the timeline for this transformative growth to unfold.

We believe that the revolution begun by Satoshi Nakamoto’s Bitcoin whitepaper and accelerated by Vitalik Buterin’s imagination of Ethereum is systemic in magnitude and will take multiple market cycles to fully materialise. The infrastructure layer is still under development and refinement, and various protocols that offer novel primitives are still being developed. Consideration of this technological constraint is key to developing a web2.5 approach. 

Keeping this in mind we seek founders that are focused on integrating revolutionary and ready web3 primitives like NFTs with web2 primitives like APIs and cloud computing to create novel functionalities for consumers. These are founders who have a deep appreciation for the merits of blockchain technology, virtual digital assets and smart contracts, and are trying to build scalable business models around these new primitives. While such founders incorporate public blockchains and smart contracts in their design philosophy from the outset, their overarching focus remains on developing scalable business models. To put it simply - it is a business-model-first blockchain-later approach, as opposed to a blockchain-first, business-model-later approach. For such founders, the inclusion of blockchain elements into their tech stack is simply a matter of product optimization.

Consider Onboard as an example. Onboard is a P2P decentralised, escrow-based digital asset exchange for businesses in Africa. It integrates crypto payment rails to optimise cross-border transfers within Africa and solves the real and pressing problem of limited liquidity when it comes to exchanging two African currencies. Onboard’s utilisation of blockchain technology is the result of a decision to build a product optimised to solve a problem in a geography where traditional solutions have not made an impact.

Web2.5 is about approaching the market from a perspective that is firmly rooted in reality

One criticism of web3 is that it is ‘for the developers and by the developers’. This sentiment points to the fact that most web3 products today are not user friendly at all. We agree with this sentiment – in a world where the masses have gotten used to software products that are extremely intuitive and don’t pre-suppose any knowledge on the user’s part, it is unrealistic to expect mass adoption of web3 in its current – almost alien – form. Simultaneously, from a business strategy perspective, as investors we maintain sight of a fundamental lesson from the web2 era: seemingly impractical business models can become highly viable if scaled properly. 

Being mindful of these market realities, we want to target startups that display the ability to seamlessly integrate web3 features with software products whose shape and form remain largely familiar to the masses. This, combined with a strong focus and roadmap for achieving scale as well.

Furthermore – as expressed before – by maintaining a sense of realism about the timeline for the expected impact of web3 to materialise, we ensure that we remain cautious of creating situations like Webvan. We maintain a strong filter for seemingly promising ventures that are likely to falter because of incorrect timing and misalignment with market readiness, and actively avoid investing in startups that may be theoretically sound but are ahead of their time in practical terms. This realistic viewpoint on the market helps us strike a balance between theoretical potential and practical feasibility in our investments.

Given this perspective, we look for founders who display a nuanced adoption of web3 – as opposed to those who reflect a dogmatic and wholesale adoption of the tech and the political ethos. Such characteristics become evident upon reflecting on the founder’s business plan. Does the plan presuppose operations in a completely decentralised economy? Is there a proactive vision for creating symbiosis between onchain and offchain components of the business plan? Does the plan for generating supercharged growth stem from web2 elements or web3 elements or both?

One startup that is facilitating symbiosis between onchain and offchain institutions is KALI. It is a no-code, no-lawyer framework that allows users to deploy DAOs that are interlinked with real-world legal entities through a pragmatic approach of legal & technical engineering. Kali's web2.5 vision involves a combination of different offerings: legal and code integration, strategic containment of legal risks, legal recognition for DAOs, an innovative DAO-LLC product, a convenient and accessible limited liability solution, a high level of community involvement and a strong open-source ethos.

Satisfactory answers to these questions help us understand if a founder is aligned with our web2.5 thesis. A basic threshold to satisfy in this regard is a vision for using web2 products as a wedge into the market. This strategy captures market share by delivering and quickly scaling a web2 product that addresses an immediate and pressing need and follows that up with the delivery of superior web3 products in the same vertical. This strategy uses web2 as a stepping stone to web3. It reflects an appreciation of the transformative potential of web3, but at the same time remains pragmatic by aiming to gradually transition towards web3 once the broader ecosystem matures. This dual perspective enables startups to seize current market opportunities while laying the groundwork for a seamless transition to web3.

Mayhem Studios has taken this approach towards building Underworld Gang Wars (UGW) - a ‘localised’ battle-royale game rooted in India and inspired from real events focusing on the Indian market. They have implemented a Free-to-Play-to-Earn (F2P2E) strategy allowing players to primarily engage with the game in a similar manner to other web2 battle-royale games via in-app purchases. Later on, they introduce in-game assets in the form of digital assets through lootboxes which players can purchase using in-game points. These digital assets can be traded and used to craft even more valuable assets that can be traded on the marketplace for the game, enabling users to capture additional value.

This combination of the familiar web2 free-to-play model with web3’s play-to-earn model is web2.5.

Web2.5 is about finding certainty in an unpredictable market environment 

There is uncertainty in the private market for web3 startups at the moment because of two factors: (i) the global regulatory response to crypto is still taking concrete shape; and (ii) the infrastructure layer is still being developed and refined. Despite these uncertainties, in a venture context, the opportunity to create generational wealth by leveraging new technological primitives is clear and unmissable. 

Faced with this practical reality, a web2.5 approach balances the promise of the future with the reality of the present by proactively trying to factor out uncertainties in the market. 

On the regulatory front, a web2.5 approach mandates strict checks for compliance with relevant local laws and maintains a strong filter for startups whose business plan indicates a collision course with regulatory interests. On the proactive side of things, in line with the need of the hour, a web2.5 approach requires concentrated effort to move the needle forward when it comes to the development of clear policies and regulations for this industry. In the context of the ever-evolving infrastructure layer, a web2.5 approach looks for nimble startups that can - and are not afraid to - migrate from one infrastructure stack to another with relative ease. 

Keeping this practicality in mind, we seek founders who have a strong aim of minimising legal ambiguity associated with their products. Such founders proactively try to establish a symbiotic relationship between their ‘crypto startup’ and legacy institutions. There is a strong focus on compliance and regulation - all with the motivation to generate trust with the consumer base. 

Certain business models are exceptionally well-suited to capture the web2.5 whitespace

Integrating features from the web3 tech stack can bring significant benefits to certain business models even without embracing complete decentralisation from the outset. These business models are prominent in the Entertainment, Finance, and Social sectors - which are all core focus sectors for us.  We believe these sectors are ideal for disruption by web3 because they largely operate in virtual environments. 

1. Category #1: Business models that already have in-app virtual economies in their products
   
   It is commonplace to find coin-based virtual economies in many mobile applications these days - especially in games. But being built on the web2 tech stack, coins in these virtual economies remain siloed and can lose value or significance over time.

   A web2.5 approach tries to generate more utility for these virtual ‘coins’ by creating open liquid markets for them. Converting ‘coins’ to blockchain-based ‘tokens’ breaks the silo of the application and opens new avenues for value generation. Liquid markets for these ‘tokens’, when supported by robust and prudent tokenomics, can unlock value for users by creating novel incentive systems and gamified experiences. 

   Sweatcoin is a great example of this phenomenon. The fitness app rewards users for physical activity in the form of Sweatcoins (web2) and SWEAT tokens (web3). These coins and tokens are redeemable for branded products, digital services and charitable donations, and users can choose whether they want to hold the coins or the tokens.

2. Category #2: Business models that eliminate intermediaries - specifically, intermediaries who are primarily focused on generating systemic transparency and legitimacy

   
   The reduction in the number of middlemen in a value chain by virtue of integrating blockchain technology not only lowers costs but also increases the revenue share for participants within the network. For instance, startups like Royal.io are enabling creators to directly build channels with their consumers (fans). This approach reduces reliance on intermediaries who have traditionally played a significant and powerful role. Reducing processing costs by reducing intermediaries creates a win-win situation. Decentralised lending protocols like Goldfinch (details below) and JIA are good examples here. They aim to reduce the transaction cost of credit generation by leveraging smart contracts.

3. Category #3: Businesses that rely heavily on user data as a crucial component of their business model. 
   
   By integrating web3 features like open social graphs and decentralised identities, these businesses can enhance the trustworthiness of their user data management policies. Such businesses grant users some control over the terms on which their content will be monetised by the platform. An open social graph means users ‘own’ their ‘online network’ and can port it from one app to another, without fear of loss of contacts. Decentralised social media application Lenster is a good example. It is built on decentralised and open social graphs  maintained by the Lens protocol.

It is also noteworthy that some startups are proactively building infrastructure that seeks to enable seamless integration of web2 and web3. One class of such companies make it easy for developers to integrate web3 features into web2 applications by providing tools that can abstract away complexities like wallets and private keys. ‘Social login’ as a web3 product is an example. Another class of such companies are attempting to create new web3 primitives that can simplify how users interact with blockchains and smart contracts. A good example here is 0xPass.

We are already seeing prominent examples of web2.5 products at scale in the market

Goldfinch is a decentralised global credit protocol. It is a great example of taking a web2.5 approach to building with the web3 tech stack. 

To start with, Goldfinch adopts a fundamentally useful character trait from web2 apps: ease of useability. The Goldfinch UX is simplified (compared to web3 alternatives like Aave) and has social login as an option. Given that Goldfinch is offering a financial product to consumers, their pragmatism is also apparent in their approach to legal compliance. Users of the Goldfinch platform are required to verify their identity and cannot operate anonymously on the platform. 

Additionally, given the need to develop a moat as a business, Goldfinch adopts a pragmatic stance again and has a hybrid code base (open and closed source) with centralised storage. When it comes to governance and decision-making, unlike the standard web3 practice of community-driven decision making, Goldfinch maintains a centralised decision-making process at present, with a path to decentralisation via its tokens. Most crucially of course, Goldfinch does all this while still integrating a core web3 primitive: onchain stablecoin liquidity. This makes it a classic web2.5 example.

Chainlink solves the connectivity problem for blockchains by giving developers seamless access to external data, offchain computation, and cross-chain interoperability.

Chainlink does so by providing reliable, secure, and decentralised data feeds and acts as an "oracle" that can be used by blockchain-based applications to interact with real-world data, thereby bridging the gap between centralised and decentralised systems. Chainlink allows smart contracts on different blockchains to securely and seamlessly interact with offchain web2 data sources and APIs. The connection facilitated between the real-world and the blockchain world by Chainlink expands the realm of available data pools in web3 and enables widespread usage of such data.

At the same time, Chainlink also embodies the web3 ethos of decentralisation where unlike fully centralised services, Chainlink relies on a network of independent node operators to provide data. This reduces the risk of a single point of failure and ensures the integrity of the data provided to smart contracts. At the same time, Chainlink's system of tokenized incentives and penalties, along with its reputation framework, ensures that node operators act in the best interest of the network, balancing the decentralisation of web3 with the accountability of web2. 

The significance of web2.5 has also come into focus in light of the actions taken by two leading traditional organisations: Starbucks and Reddit.

Last year, Starbucks announced and launched its Odyssey Experience - an extension of its popular Rewards programme that integrates NFTs. In a nutshell, the programme allows customers to participate in a series of interactive activities called ‘Journeys’ which, once completed, entitle the customer to earn collectible NFTs called ‘Journey Stamps’. These NFTs in turn are meant to unlock access to new immersive experiences that cannot be availed by any other means - helping build brand loyalty in a new way. The adoption of NFTs by Starbucks is a classic example of a pragmatic and selective integration of web3 features that generates better outcomes.

Reddit’s Collectible Avatar Program launched last year is similar to Starbucks in its approach to web3. The program allowed Reddit users to mint NFTs to use as their profile pictures without having to navigate traditional web3 primitives such as wallets and buying/spending tokens. This ease of access and usage has resulted in exponential growth in adoption.

The story of Starbucks and Reddit tells us that web2 incumbents are realising that they are faced with the innovator’s dilemma and that integrating the web3 tech stack is essential for them in order to preserve their own self-interest and future prospects.

Web2.5 sets us apart as a fund

Web2.5 represents a pragmatic approach to venture investing in the web3 space. It balances exposure to the transformative potential of web3 with present-day realities. This strategic approach strikes a balance between the theoretical potential of web3 and the practical feasibility of blockchain-based primitives like NFTs. It is a compelling and attractive investment thesis for venture investments. At Hashed Emergent, we believe that web2.5 is most appropriate for us as a firm. It allows us to navigate current market opportunities and capitalise on an untapped whitespace, while also keeping an eye on the transformative potential of web3.