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Whenever a new technology bubble emerges, the end result is always name-calling. A bifurcation of belief usually occurs as people are dazzled by the latest shiny object. For the zealots, incentivized to see the bubble grow ever larger, they will call the uninitiated “normies, haters, skeptics, losers, closed-minded” etc. For those who are too late to the trend to achieve the truly ridiculous returns of early adopters, the next most financially lucrative option is to do as Michael Jordan did, and join the dunk industry. “Bernie Madoff! Tulip bulb 2.0! Pyramid scheme! Charlatans!”
The current tech hullabaloo is NFTs. Non-fungible-tokens are, depending on if you are talking to a zealot or a skeptic, either the second coming of TechnoChrist or the biggest scam to be invented in Crypto since the scam of Crypto was invented. (The venn diagram of NFT haters are almost exact matches of Crypto haters).
Today I would like to straddle that very difficult middle ground of appreciating the promises of the technology while simultaneously pointing out the (very obvious) flaws of some of its current iterations. To do so, I’ve teamed up with the wonderful Kushaan Shah who writes a marketing-focused newsletter called Mind Meld which I’ve found valuable over the last year. We co-wrote the piece that follows.
We posit that the most prominent NFT projects, things like Bored Ape Yacht Club and Pudgy Penguins, hold such a remarkably similar structure to Multi-Level-Marketing companies (MLMs) that they will also suffer from the same failures. Investors should exercise extreme caution as they evaluate this emerging asset class.
To begin though, we must start with hot dog leggings.
LuLaRipped Off
When you peruse the aisles of most thrift stores in Middle America, the women’s section is all stuffed with similar products. Garishly bright neon colors are partnered with chevron patterns, a clashing cacophony neatly printed onto buttery soft pants.
Staring at these garments, it is tough to reconcile their sometimes eye-watering appearance with the success of the business producing them.
These are the leggings of LuLaRoe, the MLM that rose to $1.9B in sales before flaming out in spectacular fashion. It is the subject of the new Amazon documentary LuLaRich (which is excellent and you should watch).
If you are unfamiliar with the MLM industry, the structure is fairly simple. The originator of the scam *cough* business, comes up with some sort of retail good. It ranges from knives and essential oils, to in this case, clothing. A typical consumer goods company would find a retailer to display their wares with. In contrast with that, an MLM transforms regular consumers into retailers. Consumers buy X amount of inventory at wholesale prices and then sell those goods to their friends and neighbors.
Growth for MLMs can take two paths.
- They can empower local distributors with better product/marketing support and thus help them sell more goods, or
- They can recruit additional distributors.
The fastest and cheapest path to growth for a business will always be option 2.
MLMs incentivize recruiting behavior with what they call the “downline.” This is MLM gobbledygook meaning that when an existing distributor recruits a new distributor they receive some sort of financial compensation—typically a % of that person's earnings. And guess what? When that new recruit suckers an even newer person into becoming a distributor, the person at the top receives a % of that person's earnings, too. Thus the term “downline” — you get to keep a cut of all the revenue from all your children, grandchildren, and everyone down your “line.”
Note: This is exactly how the real-estate business works, too. Keller Williams pioneered it, and everyone else has copied it. Real Estate agents now get compensated based on recruiting other agents in addition to selling homes. And this is exactly why regulating MLMs is so damn difficult! They are just a few shades removed from legitimacy and are thus very difficult to build concrete regulation around. The line between solid growth strategy and unsustainable pyramid scheme is very, very thin.
This recruiting method is such an effective method of growth for the overall business that distributors will typically make more from creating new believers than they would by selling their own product.
According to the Amazon doc, 1% of salespeople take 50% of the money. Over 80% of salespeople have nobody below them and thus lose money. To explain it, we will need to do some Napkin Math. Let’s start with the recruitment of new people. Let’s assume that each salesperson recruits 4 fresh bodies every month.
1x4 = 4
4x4 = 16
16x4 = 64
64x4 = 256
256x4 = 1,024
1024x4 = 4,096
4096x4 = 16,384
16834x4 = 65,536
65,536 x 4 = 262,144
262144 x 4 = 1,048,576
Within 10 months you have recruited every man, woman, and child within the state of Montana to sell leggings.
1,048,576 x 4 = 4,194,304
4,194,304 x 4 = 16,777,216
16,777,216 x 4 = 67,108,864
67,108,864 x 4 = 268,435,456
A mere 4 months later, you have recruited the entire working population of the United States (~160M) plus every single resident of Egypt (102M).
268,435,456 x 4 = 1,073,741,824
The next month you have now successfully recruited every single person on the American continents. If you give it another 3 months or so beyond that and you are going to have to look to extraterrestrial sources for growth.
This is an exaggerated case but the point remains, most MLMs/Ponzi schemes are built off the assumption of an essentially unlimited market. There is just a certain point where there are too many people selling the product. Especially since the selling and recruiting are done with the same, local networks, there is going to be incredibly heavy cross-pollination/pyramidalization.
Additionally, to join this group of product evangelists you are required to have the inventory you need to sell to others. At LuLaRoe this was initially 5,000 dollars. Each of their pieces was 10 bucks on average so you were needing to sell 500 leggings. That is a lot! Especially when you factor in the amount of competition that recruiting brings in. Additionally, you’ll often see sellers need to continue buying inventory to maintain their downline. So they are still spending thousands every year buying new stuff to sell.
All this results in even more madness—the final form of pyramid schemery is cross-selling. Eventually, to maintain the necessary minimal order volumes, the sellers will start buying and selling to each other.
At LuLaRoe this looked like some early distributors having a downline of thousands of distributors. While they may only be doing $80k gross revenue a year selling leggings they would be doing $150k a month just by having recruited others.
The value of what they were building was entirely contingent on duping the masses into the belief that they could make that much too. Note: You will sense a theme here.
The language for these companies closely mirrors that of Cryptoland. LuLaRoe’s consistent slogan was “Part-Time Work, Full Time Pay” and “Own your own business from home.” The zeal of ownership, of entrepreneurship and self-reliance, was fed to these women. In my discussion with former MLM distributors, one often cited reason for joining was the “community.” By literally buying into the group, they joined a community of people trying to forge something new for themselves.
LuLaRoe also hit upon a much beloved trick of Crypto—product rarity. When they made a print they would say, “We only made 2,000 of these, we will never make them again.” It would result in a feeding frenzy where interested vendors/consumers would hunt down the thing they wanted, pushing prices higher. Note: To be fair, this is used by lots of other companies. Sneakers, Pokemon Cards, etc.
When the elements of financially incentivized community, exclusivity, ownership, and growth are mixed, MLMs produce spectacular flameouts. LuLaRoe is the subject of over 50 lawsuits and has shrunk to a fraction of its former size.
When we examine some of the more popular crypto projects, similar elements are eerily present.
What do NFTs stand for?
Once simply ridiculed as “overpriced jpegs” with a weak utilitarian benefit at best, the NFT movement has taken on a whole new shape in recent months.
Early 2021 saw NFTs become more mainstream (cue SNL skit in late March) but the benefit of digital ownership was still a struggle to define.
Yes, you could own a rare Luka Doncic TopShot or a GIF of planets revolving in high-definition - in return, you would spend almost double the time explaining to friends why this was not the equivalent of downloading a glorified Youtube video as an MP4. No matter how fast you scrambled to map out its future utility, the rest of the world struggled to keep up. Depending on where you were in the world, you could run into the street and yell about owning an NFT without receiving so much as a blink in return.
Note: It is important to note here that we think that NFTs as a technology hold incredible promise to help more evenly distribute financial outcomes to community users, not just community organizers. We are in the early days of exploring what digital ownership actually means and it is far too bearish to universally decry the technology. Our concern is with the following types of NFT applications.
Enter PFP collections.
PFP Collections aren’t new - Cryptopunks have been around since 2017 - but it was the second quarter of 2021 that saw these collections explode in the secondary market. Unlike many NFTs that existed as one-off digital artworks, PFP collections involved the drop of thousands of NFTs at once with a set of consistent elements: an alliterative theme, a scarce supply, and dedicated roadmaps. One of the biggest perks was full commercial rights to the NFTs, enabling buyers to sport their wares with profile pics (hence, PFP) on social media accounts. Owning one of these NFTs quickly became a sign of status as new PFP projects flooded sites like Twitter and Discord.
Bored Ape Yacht Club, iterations of a melancholy cartoon ape, sold all ten thousand of their images within 24 hours. Pudgy Penguins surpassed that, selling out within 20 minutes. Five different collections in the last few months have done more than $200 million each in transaction volume. If phase one was the first to address the issue of access, this new phase brought a new revelation: speed. It took Facebook almost five years to make a dime - it took Bored Ape Yacht Club two months to hit $100k in the secondary market, with $100m within four months of launching the Mutant Ape drop.
Artists who would previously struggle to scrape the barrel for a piece of art suddenly saw their art grabbing record amounts in quick liquidity. Trades stacked up by the hour, mysterious ethereum wallets gobbling up trending projects with all the verve of a ravenous Pac Man.
What’s more, the incentives suddenly changed. Instead of owning a piece of art in isolation, collections enabled a new promise: community. *Que the LuLaRoe theme song*
Creating at the corner of crypto and community meant you could bypass any skepticism that this was purely speculation or recreational gambling. Discord servers, Telegram chats, exclusive events, and shared twitter avatars erupted in popularity. NFTs now brought an acute sense of belonging, a whole layer of Maslow’s hierarchy delivered from digital art.
So what’s the catch?
There is a floor price, of course. For many trending projects, the floor price can often skyrocket to 1 ETH in a day - close to $3,000 USD. If you’re reading this and not a millionaire, you have likely already missed the yacht on the bored apes. The cheapest one is going for almost $115K at time of publication. This Ape sold for $2.3M (769 ETH) last night.
But you can still hunt for the next big collection, right?
Let’s look at the math - in the past 30 days, the top 25 collections have done more than $2.3B in transactions. Out of this, 60% of that volume comes from just five collections - Cryptopunks, Mutant Apes, Art Blocks, Bored Apes, and Loot. If you extend it to the top 50 collections, we’re looking at closer to $2.8B - but still almost 50% of that comes from those same five collections.
In fact, the difference between the fifth (Bored Apes) and sixth (Cool Cats) highest selling collection is almost $145m dollars. For many PFP collections, you might pay more in gas fees when buying on a platform like OpenSea than you’ll see in returns.
Now, this is not to say that buying an NFT is pointless if it doesn’t net you hundreds of dollars immediately.
According to a tweet from NathanCRoch, only 0.009% of internet users own an NFT. Twitter is even looking to add NFT verification as a native feature within its app. All of this points to a directionally positive trend - there is certainly a justification that it pays to be a part of something esoteric that is only going to increase in recognition.
Sure, the benefit can be a bit of an abstraction. “Community” can mean different things in the context of different projects. But we’ve seen evidence from lots of these projects that involvement can lead to new mentors and genuine friendships.
It’s easy to make a larger financial argument that MLMs and NFTs could be similar in terms of who they benefit - but ultimately how similar are they?
Same But Different
It's possible that these PFP collections will retain their value long into the future. But MLMs like LuLaRoe also seemed extremely promising at one point. A key characteristic of projects with this structure is they start by growing fast and ultimately flame out. So, to guess at the future of NFT PFP projects, we're going to see how similar they actually are to MLMs.
Earlier, we identified a few key components of MLMs:
- Recruiting New Believers is Key to Growth: MLMs growth rely on existing sellers telling/convincing new people that this product is the future.
- Sell A Community, Attach a Product: To help do so, they convince them they will receive unique social capital within a group of similar people. For LuLaRoe it was stay at home moms.
- Convince Them They are Owning Something: The language of ownership is seductive (especially to Americans). Rather then working for the man, MLMs allowed you to build your own company.
- The Downline: By convincing people they were owners in this new community, you would share in their financial success.
NFT PFP projects hold remarkable similarities to the list above.
- Recruiting New Believers is Key to Growth: These pictures only have the value that others say they have. In espousing the doctrine of cryptopunks, you push the value of your own asset higher. This is especially helpful when the person stanning your project is a tech celebrity. Note: A good example of this is a major tech CEO calling his Cryptopunk the “digital Mona Lisa” and going on podcasts to talk about it.
- Sell A Community, Attach a Product: You’ll often hear anecdotes of “when I put my [PFP project of choice] as my profile pic, I added hundreds of followers. I love interacting with people on the Discord and learning from them.” Having a PFP makes you feel like you are a part of something.
- Convince Them They are Owning Something: This language is part of the core value proposition of NFTs. You own the JPEG! It is unclear if that matters or not in the real world, but for the viability of these projects it does.
- The Downline: Here the analogy is more difficult to see. PFP founding teams hold downline structures by skimming a % of the revenue off the top. However, the individual JPEG holders do not actually receive direct compensation from recruiting a new believer. Ironically, the right MLM will probably generate better returns for early believers than a PFP project will because of the lack of a downline.
To be fair, the analogy isn’t perfect! The losers in MLMs are the people who join late and who buy in more than they can earn, but that's kinda different than the losers in NFTs who buy-in at the top and have to sell at a loss. In either scenario, someone less knowledgeable is left holding the bag.
Should We Actually Be Concerned?
In a recent piece for Divinations, Nathan Baschez talks about the reasons people effectively get seduced into supporting new paradigms - there’s one part in particular that stands out:
The more you learn about a new paradigm, the more likely you are to believe in it (thanks to the “mere-exposure effect” and “consistency bias”).
As soon as we put one foot in the door, we slowly lose the urge to pull it out. Commitment is embroiled in our psyche. It’s a tactic psychologist Robert Cialdini mentions in his flagship persuasion principles and one of the biggest levers for longevity with retailers for companies like LuLaRoe.
With LuLaRoe and other similar MLMs, it isn’t entirely the belief in the product that pushes dozens of consumers to continue selling leggings amidst an onslaught of lawsuits. It’s also a deep aversion to failure.
What’s more, the message pushed by leadership is that it’s your fault. When leggings don’t sell, it’s very clear by the leaders that people aren’t trying hard enough. Mark Stidham, LulaRoe Cofounder, says it best: “I’ve heard some whining lately also about how well my inventory’s stale. No, you’re stale.”
It’s a dissonance that transcends simple financial loss - when you admit to yourself that what you’re doing is wrong, you risk a blow to your basic sense of self. When we feel any idea about the self is threatened, our evolutionarily-linked fight mechanism is activated; we fight against every instinct that we might be wrong. The price to pay for admitting one is wrong, the reputational effect, is almost perceived as greater than the price to pay for simply losing money while holding on to a conviction.
With crypto, we see a similar pattern: people who dip their toes in the water won’t easily tap in and tap out. You rarely see tweets or proclamations about people who are “done with crypto” - there can be a reputational cost for doing so. You risk external criticism for losing faith early, for giving up on a single project, for choosing incorrectly - it’s your decision, not the actual system, that’s faulty.
It’s easy to get recruited into MLMs: it’s much harder to leave. The promise of financial gain is seductive. When the incentives laid out also include community and ownership, it becomes an easy cost to justify.
But these justifications often never come true. Similar to MLMs only profiting a chosen few, it’s often the Ethereum Whales or early adopters that capitalize on new trends first and stand to benefit off the Loots and Apes of the world.
The story of the average person getting rich on a lucrative NFT project carries the same benefit as the story of the lady who could barely afford a $5 box of cereal and then brought a dream home with LuLaRoe - both paradigms benefit from an illusion that meritocracy prevails. It’s hard to hope in a world without that illusion.
But if there is any solace, there is a silver lining for NFTs: With MLMs, your entire “community” rests on a singular goal behind financial independence by selling a product - within the world of Web3, there’s a belief in a larger movement around decentralization and peer networks that connects people.
In some cases, it doesn’t matter what NFT you own or even how much ETH you own - if you simply believe in the future of that world, you can be part of the in-group. As projects expand to include more benefits, the ones left behind may not be the ones that lose the most money by overbidding - but simply the ones that fail to believe in the first place.
💸 The Best Jobs at the Intersection of Tech and Finance
Today the Napkin Math job board is being taken over by Spark Advisors.
Spark is a pretty cool business—the short story is that they help seniors get covered by Medicare. The long story is that they do this by partnering with the local independent agents who enroll millions of seniors into Medicare each year but who’ve historically had little support. Spark gives independent agents a technology stack, a concierge team, and a unified brand to better support seniors, and gives seniors a much better, more simplified experience when signing up for Medicare.
Corporate Development Lead
Spark is looking for a Corporate Development lead to architect their inorganic growth strategy, including processes for developing deal sourcing channels, deal structuring options, financing, integration, and more.
Requirements: 4-6 years of M&A transactional experience, in investment banking, private equity, or within the corporate development function of an operating company.
Thanks again to today’s sponsor, Launch House. If you’re building a fintech startup, you should apply ASAP. Their Fintech residency kicks off next month.