Evaluating a Network: Internal vs External Value
I've been having a lot of discussions lately around Web3. I think there are a lot of really interesting aspects of Web3, but I do think there is a fatal flaw in the design.
In order to see the flaw, we need to start by understanding what the value of a network is, the difference between external and internal values, and how to understand the value of a network.
What's the Value of a Network?
In order to understand the value of a network, it's helpful to look at existing network structures and examine how they are valued. Let's begin by looking at an educational network.
In the US, there is a fairly set path for you to be traditionally "successful". You graduate high school, go to college, get a degree, and go on to your career.
You likely don't worry too much about your network in high school. It's probably based on where you live, so that determines your high school experience. But then, you decide you want to achieve more. So you start looking to colleges that can enhance your existing network. You find competitive colleges, where the applicants that are admitted have similar work ethics and ambitions. Ideally, this value is higher than a degree from an average college. It fosters a level of competition at the academic level that should hopefully filter out the people who can't cut it right?
So you get your degree and now you've got a network of people around you, classmates that you possibly built relationships with, alumni with connections, all sorts of possibilities. And they are all tied together by a bond: they put in the work, they know what it takes, they finished. So they value this bond pretty highly, within the network. That's the first type of value. Perceived value to participants of the network. That's the internal value of the network.
But there's another value: perceived value external to the network. In our example, there is a distinct internal value. But going to a competitive college sends a certain signal to recruiters. That makes you a more attractive candidate for employment.
There's also value measured in things like college rankings, accreditations, etc. This demonstrates that there are a number of external values that can be applied to a given network, making it important to understand who the viewing party is and how they are evaluating the network.
How To Understand The Value of a Network
So now that you see what the value of a network is, let's talk about how to understand it. There are a number of ways to do so, but the first thing we have to decide: are we a member of the network? Or are we external to the network?
Let's examine how companies work, because they provide a great example for internal vs external valuations.
For example, let's say we have Acme Co. They just started building a product and are looking for investors. The founders want to raise $100K at a $1M valuation.
That's the internal value that the founders set. They believe that their network (of employees, customers, community members, whoever) is currently worth $1M, so they are willing to part with 10% of their company for $100K. As an investor, you have to look at it from an external perspective. Who are the employees? How good is the product? What traction exists? As we can see, they are actually evaluating the network from several perspectives. From the perspective of the customer, how does this product look? What's the perception of the company, if one exists? From the perspective of a prospective employee: would I want to work there? Is this company going to be able to attract a good team?
From an investor's perspective: what do the financials look like? Do they tell a story that I believe can grow to more than my initial investment? Is it a better investment opportunity than other companies?
Mat Sherman from Seedscout has a really great blog on how investors use what he calls vanity filters: https://words.seedscout.com/p/do-you-know-what-a-vanity-filter/comments?token=eyJ1c2VyX2lkIjo3NDgxNDk2LCJwb3N0X2lkIjo1MTQ2OTU1NSwiXyI6InVXQVVHIiwiaWF0IjoxNjQ5MDIxMzU4LCJleHAiOjE2NDkwMjQ5NTgsImlzcyI6InB1Yi0xNDczNSIsInN1YiI6InBvc3QtcmVhY3Rpb24ifQ.dB5xNwp4clMSna8KLQW-_isztfrLvgB86fff_dTbXJA&s=r
They use these filters as a way to save themselves some work. For reasons they determine important enough, they have filters set up that some networks are sufficient to get through and others aren't.
Ideally, the company will grow enough to do an Initial Public Offering (IPO), where the public will be able to buy ownership in the company, allowing the investor to exit the network.
This creates some interesting dynamics because an investor has to put a price on becoming part of a network that will hopefully give them a chance to leave it at a higher price. They have to think about the growth rate of a company, which means they put pressure on a company to grow. This means the company has to grow quickly in terms of several subnetworks: customers, employees, community members, partners, vendors, etc. They have to do this at the behest of someone who wants to leave the network.
This creates a lot of problems that could be avoided. There are a lot of pressures exerted on these networks that tend to cause side effects. Companies grow faster than they learn, so they deploy machine learning algorithms to give them insights into the data they generated. But they don't always know what that end state looks like, so you end up with large networks that tend to have major issues. But they are large enough that they can be monetized inefficiently.
The interesting thing about tech is that it's evolving so rapidly that people will come to appreciate suboptimal solutions because they don't know what's possible.
Most people haven't been exposed to social networks of 1000s or 10000s pre-internet. Now anybody can suddenly create networks of 1000000s. This means that bad actors can take advantage of the networks they create. That's why understanding how networks are valued is really important when evaluating a network. Here's what you should ask yourself when evaluating a potential network to join:
- What is the dynamic between the internal value and the external value?
- Are the creators of the network exploiting a lack of knowledge?
- Who benefits the most when the network increases in value?
- Do the benefits of network memberships outweigh the costs of membership?
So this brings us to the main problem with Crypto/Web3. They try to make the price equal to the internal value. But whose internal value?
The internal value of a network is very specific to the person in the network. With cryptocurrencies, the internal value depends on how many coins someone owns. But this misaligns the incentives of the network, because the largest holders can do things out of alignment with the many smaller holders.
Happens all the time with Web3 projects.
I think there is a solution that lies between a coin and stock options. Unfortunately, it's a battle between too many regulations and not enough. I am hopeful that the lack of regulations will bring a balance to the existing regulations and make things friendlier for small communities who want to leverage capital to enhance their communities.
I view the future as a ton of small gated communities. These will be more likely to succeed than giant communities of 10000s. The average effort of a given network participant drops because their average stake drops. But small communities can do some incredible things.