Solana Investment Memo - Pt. 2

Searching for signal amongst a sea of noise

January 4, 2023Michael Nadeau
Solana Investment Memo - Pt. 2

Hello readers,

We’re back for Pt. 2 of our Solana deep dive.

Disclaimer: Views expressed are the author's personal views and should not be taken as investment advice. The author is not an investment advisor.

The DeFi Report is an exploration of the emerging web3 tech stack and an ongoing analysis of where value could accrue. We provide easy-to-follow mental models, frameworks, and data-driven analysis of DeFi and web3 business models.

Let’s go.

A quick note as we jump in: I’ve been observing a lot of mob mentality on Twitter lately, and even on LinkedIn — where I spend most of my time. Crypto Twitter is quite toxic and I’m seeing what amounts to people practically rooting for Solana’s failure. The keyboard warriors seem to want to punch down on Solana right now. Most of this is coming from the Ethereum community. I find it quite fascinating because Ethereum has gone through several existential moments itself. In December 2018/early 2019, it was the Bitcoin Maxi’s that were piling on Ethereum, proclaiming it would go to zero. And now Ethereum supporters are doing the same to Solana. My research of the Solana ecosystem and observation of this mob/herd mentality in the markets is making me bullish about Solana — which we’ll get to later.

Founders & Core Team

Solana is led by Anatoly Yakovenko, or “Toly.” He’s the public face of Solana, wrote the white paper, invented the Proof of History consensus mechanism, and is the leader of the network’s developer ecosystem. Prior to founding Solana, Toly spent 15 years as a software engineer — primarily at Qualcomm. He comes across as less ideological and more pragmatic than most crypto leaders. His original goal was simply to build a more performant blockchain than Ethereum. This “business-like” approach tends to turn off the more emotional, ideologically driven crypto natives and is one of the reasons that Solana gets a lot of grief from the Ethereum community. We actually view this as a positive. Toly has been around the block. His pragmatic, realistic approach shows maturity and sound leadership.

As such, Solana has attracted a combination of web2 engineers along with web3 natives. As Chris Burniske (one of our favorite crypto analysts) puts it, “Solana devs understand the crypto bank-end but have the skills to produce front-ends that speak to the mainstream, which crypto needs more of.”

Raj Gokal is the co-founder and COO at Solana. Raj previously co-founded a firm called Sano that developed wearable health monitoring devices and was the Director of Product at Omada Health.

The remaining core team at Solana consists of engineers from Qualcomm that followed Anatoly. Specifically, Stephen Akridge and Greg Fitzgerald are the other two co-founders and the principal engineers.

Investors

As we covered in Part 1, Alameda Research was a big investor in Solana and currently has a claim on about 8.6% of the total token supply. These tokens are now a claim with the bankruptcy trustee. This is a stain on Solana right now, but we think it is creating unjust sell pressure. As investors, our job is to identify gaps in the market. We see a lot of market participants assuming that since Alameda/FTX was a fraud, Solana is also a fraud. This is short-sighted and could be creating a market dislocation — and a generational buying opportunity.

In defense of Solana, Alameda/FTX was not super well-known when they were making their initial investments in Solana. They were just a small market maker/trading firm and start-up crypto exchange. Furthermore, FTX had been a reliable and committed development partner for the Solana engineering team in the early days (per Toly interview). Of course, hindsight is 20/20 and so it’s easy to point now and assume that the Solana team somehow has blood on its hands. My sense is that they just thought FTX/Alameda would be good partners at the time. They were wrong. But this does not make them complicit in any fraudulent activity.

Crypto markets are extremely emotional and reflexive. I found this LinkedIn post (and commentary) from a well-followed account to be a good marker for investor sentiment regarding Solana. I looked hard to find some signal in there. I see mostly noise. This type of sentiment looks like a bottom to me. The crypto community *loves* to get involved with conspiracy theories. However, sometimes the truth is less salacious than we want to believe it is. When we see this type of herd behavior, we should get really curious. We get curious by zigging when everyone else is zagging.

It starts with doing the work.

Back to the investors. Here are Solana’s funding rounds:

  • April 2018 - $3.1m

  • June 2018 - $12.6m

  • July 2019 - $5.7m

  • Feb 2020 - $2.3m

  • March 2020 - $1.7m

  • June 2021 - $314m (when the token price was 3x what we see today)

Total funding = $339.4 million.

Notable investors include a16z, Polychain Capital, Multicoin Capital, CMS Holdings, Jump Trading, Tiger Global, Sino Global Capital, and Placeholder.VC. Solana is well-capitalized, which is critical to incentivizing developers to join the network. Their ability to channel funds into ecosystem development via hacker houses, hackathons, and incubator programs cannot be understated. Bootstrapping a developer network and community is not easy. Having the necessary resources is table stakes to compete.

Solana has several strong backers with strong networks, but what caught out attention was Placeholder’s investment, which was initiated in 2022 via public market purchases. Placeholder is run by Joel Monegro (formerly with USV and the author of the popular “fat protocol thesis,” and Chris Burniske (formerly an analyst with Ark). We view Placeholder as an honest actor that puts out some of the best data-driven analyses in the industry.

Multicoin is also well-connected and a huge proponent of Solana. They famously held their SOL position through the bull market of 2021 and recently wrote to their LPs that they are sticking with Solana through these rough times.

Tokenomics

SOL is the native token of the Solana network and is used to pay for transaction (data) fees and also to secure the network through proof-of-stake. Like any layer 1 network, the native token is designed to create a strong network effect by aligning the incentives of developers, users, service providers, and token holders to contribute to the growth and success of the network.

  • Circulating Token Supply: 367,801,169

  • Total Supply: 537,635,632

  • % Circulating: 68%

  • % of Tokens Staked/Validating Transactions: 70.97% (note that some tokens controlled by the foundation that are not circulating are held in staking contracts)

  • Protocol Inflation Rate: 8% at launch (March 2020) with a 15% disinflation rate

  • Token Burns: 50% of transaction fees are burned

Insider Unlock Schedule:

Source: https://medium.com/solana-labs/solana-foundation-transparency-report-1-b267fe8595c0

*Please note that the insider vesting schedule is not 100% known. The data we’ve used here is taken directly from Solana Foundation disclosures as well as Messari Research. The Solana Foundation indicates that all tokens issued in SAFT rounds, core team, founders, and validators are fully vested. With that said, as we noted in Part 1 — the Solana Foundation also indicates that most of the tokens sold to Alameda are currently unvested. So, it’s possible that additional tokens issued in private rounds remain unvested as well. We believe this relates to the “strategic sale” allocation in the chart below. Solana Compass has the full breakdown of upcoming unlocks, which includes staking contract unlock periods.

Solana has been criticized by the crypto community for its large allocation to insiders. We think this is a fair criticism, but ultimately don’t see it as a barrier to adoption.

KPIs vs Alternative L1s

Solana’s ranking across usage KPIs:

  1. Daily New Addresses: #2

  2. Daily Active Users: #2

  3. Daily Transactions (non-vote): #1

  4. Active Devs: #5

  5. TVL: #5 (depressed due to FTX entanglement)

  6. Market Cap: #5

  7. Market Cap/TVL: #7

Solana stacks up pretty well across the top L1s, yet has been excessively punished by investors in the bear market. We think this is due to the ties to FTX/Alameda and could be a significant dislocation as a result. Furthermore, investors punished Solana as the network experienced several up-time issues last year. We think those challenges have been solved, which we’ll get to later in the report.

ETH Jan. 2019 vs SOL Jan. 2023

Since we are currently in the first crypto bear market with alternative layer 1 protocols to Ethereum, it’s helpful to look back at Ethereum in the late 2018/2019 period. ETH also saw a parabolic run in its first few years before crashing back to reality. It’s interesting to see that the KPIs look pretty similar across the board. Back then the Bitcoin Maxi’s were dancing on Ethereum’s grave. Today it’s the Ethereum community doing the same to Solana. But if you had the conviction to buy ETH at the bottom, you would have seen a 60x (with lots of volatility) over a few short years.

Risk Analysis

Core Team: As noted, we like the core team. We think the founders have been extremely focused from day 1 and are playing long-term games. Solana tends to attract a combination of web2 and web3 talent — which we think is a nice differentiator from other networks.

Investors: Solana has a strong investor base. These investors have lots of experience, work with several teams across crypto, and have strong networks that help attract talent and capital.

Product/Market Fit: Solana seeks to be the most performant blockchain in crypto and solve scalability challenges related to Ethereum. The trade-off to achieving this is that their hardware servers/validators are more complex to run than other networks. For example, Ethereum makes it fairly easy to run a node, which allows the network to be more decentralized. Because the nodes are less complex, Ethereum cannot process 50k TPS like Solana. Instead, Ethereum introduces complexity at the software layer, by scaling with layer two solutions in a modular framework. It’s really just about trade-offs. We have yet to see the “killer app” explode on a blockchain just yet but there are green shoots across transactions/stablecoins, DeFi, NFTs, games, physical hardware networks, social media, etc. Due to Solana’s robust developer and user network, we think there is a strong case to be made that as demand for block space increases in the years to come, Solana will be well-positioned as one of the primary networks. In particular, we will be looking for DeFi use cases to come back to Solana in 2023/2024.

Competition: Solana is doing what it set out to do: separate itself from Ethereum as a more performant blockchain in a monolithic architecture. They will continue to compete against the other L1 chains for developers, users, and businesses to build on top of their platform. Because Solana has over $330m in funding, we think they have a good chance at separating themselves in the bear market.

Addressable Market: This is a tough one. Blockchains could have many use cases and are open data structures for the internet. This is an entirely new concept we have yet to fully wrap our heads around. That said, global finance is a trillion-dollar business. NFTs could be a $10 trillion dollar wrapper on many, many assets and consumer goods. Social media is a trillion-dollar business if we include digital entertainment. Physical infrastructure is a $5 trillion dollar market. Gaming is a $200 billion dollar market. Large investment banks such as Goldman Sachs and JP Morgan are projecting the metaverse as a $10 trillion annual opportunity. Of course, blockchains could open up business models for products and services that we cannot even imagine today.

Another way to think about this could be to simply look at the market caps of the Layer 1 chains we compared Solana to above. These projects reached a combined market cap of $900 billion in 2021. Nobody can predict the future, but we think this number will be exceeded in the next bull market. If Solana were to get back to its prior high, that’s a 25x from here.

Tokenomics: Similar model to Ethereum, with 50% of the transaction fees burned. 68% of the coins are currently in circulation. We believe the vast majority of insider allocations are circulating, with the exception of the Alameda coins that will be locked in the FTX/Alameda bankruptcy process for years to come.

Security Audits: Solana has a number of auditors, including Kudelski — a “fortune 500 preferred vendor.” More information on audits here. We’ll add a quick note about Solana’s up-time issues over the last year: from what we understand, the network went down due to high usage in each case — primarily due to bots related to NFT mints. This is certainly not good, but it could also be viewed as a good problem to have because it’s due to high usage. This could also be related to low transaction fees, which create an environment where bots can spam the network. Here is a good thread on the topic. We think it’s pretty common to see these issues arise with any new tech. People often forget that Ethereum had numerous existential moments in its earlier years, including a hard fork of the chain in 2016 due to The DAO hack. In the long run, it’s probably a good thing to run into these issues and solve them now before the network gets much larger.

Crypto Presence: Solana has a strong presence across the crypto developer community, investor community, and on social media (Twitter, Discord). It’s worth noting that Bitcoin has by far the strongest community in crypto. When we think about the number of podcasts, youtube channels, writers, content creators, and businesses devoted to Bitcoin, it trumps all other networks. We’ve seen Ethereum build out a considerable #2 position over the last 4 years or so — across podcasts (Bankless, Blockworks, etc), devs, crypto Twitter, etc. We’ll be looking for Solana to see a similar grassroots movement in the coming years. Keep in mind that Solana is still pretty new, having launched in March 2020.

Treasury Management: We don’t have a direct line of sight into Solana’s treasury, but we do know that they raised $339 million, with the bulk of that coming in June of 2021. The Foundation also controls a large % of the native tokens. We think Solana is well-capitalized and may be in a better financial position than any of its competitors.

Narratives: The narratives are not good right now. This is true across crypto, but in particular for Solana due to its association with FTX/Alameda and the flight of capital out of DeFi. As is a core theme of this report, we think this is creating a market dislocation. One can make an argument that Solana is in a much better position now than they were just one year ago when its token price was 25x higher.

Trading Volume/Liquidity: SOL was doing over $5b in daily trading volume at its peak, and today is doing about $200 million in volume.

Conclusion

We’ve done an immense amount of research on the Solana ecosystem in this bear market. We’re impressed with the founders, core team, dev ecosystem, progress, and tech. As such, we recently initiated a position and will continue to monitor the network throughout the bear market.

We believe that when it’s all said and done, there will be 4-5 large layer 1 blockchains that serve slightly different use cases. This would follow similar computing movements such as cloud computing, mobile providers, computing architectures, etc. We are using the bear market to identify the networks we believe will have the best chance to make it in the long run.

That’s it for Part 2 of the Solana deep dive. We’ll continue to share updates as things progress.

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Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice.

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