Crypto scandals are shaking up the venture capital world. From the fall of prominent VC firms to the devaluation of crypto assets, the crypto crisis is having a profound impact on the way investors approach crypto investments. The strangest thing about sudden collapse of crypto exchange FTX in one of the
decade’s biggest scandals of the venture capital world, dwarfing Theranos (if only in purely
numerical terms), was how many major players failed to see what was, with all the
information available at the time, quite obviously a house of cards.
Many smaller quant funds, who are perhaps not so prone to rose-tinted vision as
human-led venture funds, had months ago woken up to the fact that Alameda Research
– effectively the proprietary trading arm of FTX, albeit its precise relationship was not
disclosed until too late – was the counter party to a freakishly large number of
cryptocurrency trades, far more than its reported activities would seem to require, and
indicative of circular transactions (between itself, FTX and other related parties) and
market manipulation, not for the purpose of making a profit per se, but of concealing
massive losses.
What exactly transpired will be revealed in the fullness of time, but what occurred in a
nutshell is that Sam Bankman-Fried, until recently perhaps the most feted tech founder
in the world, was using client funds to mask the catastrophic balance sheet impact of
the dual implosion of terraUSD and Luna.
Financial historians may indeed one day come to regard terraUSD/Luna’s crash, and
that of Alameda/FTX, as part of a single larger event, in the way that we now relate and
associate the end of Bear Stearns and Lehman Brothers.
The Alameda / FTX scandal
The Alameda/FTX scandal, just the latest in a long string of bankruptcies and
improprieties to hit the crypto world, has left many uncertain about the sector’s future.
But putting crypto to one side, what about the venture investors? Whilst they may not
have had the counter-party trading data available to certain quant funds, what they did
have was unrivalled access to FTX management.
How could such a massive fraud, with so many clear red flags, have passed right before the eyes of some of the world’s largest, most sophisticated and nominally successful venture capitalists, such as Sequoia, Tiger Global, BlackRock, Altimeter, SoftBank and Iconiq?
It is breathtaking to consider that these outfits, who have no shortage of analytical
resource, nevertheless piled into a business, about which its new boss – John Ray, who
oversaw Enron’s bankruptcy process – recently commented: “never in my career have I
seen such a complete failure of corporate controls.”
The mission of a VC firm is less about avoiding failure – which is expected in the
venture world, and to a large degree ‘baked in’ – than not missing out on the next big
thing. If nine investments are to fall over – not an unusual rate of attrition – then the
tenth investment must go to the moon. Every portfolio must therefore contain
moonshots. The problem in this case was one as old as capitalism: greed. The entrance of new investors like hedge funds and corporates drove up competition, fuelled the
FOMO, and stories of term sheets being signed in a matter of days (hours in some
cases) were increasingly common, and as valuations swelled to absurd multiples, so too
did the promised returns.
Patience and diligence are not rewarded when you know that if you walk away, a host of other funds are waiting in line to invest. Rival funds. Funds which are incentivised to
deploy capital at the earliest opportunity, and which rely on having high profile deals to
facilitate their next fundraise. (This is because with investment horizons of five to ten
years, a venture capital fund will tend to be investing its Fund II, and perhaps even Fund
III, before the Fund I positions are fully harvested.) And their target LPs (Limited
Partners, i.e. investors) are those might otherwise have come to you, had you only been
able to prove your ‘all access’ credentials by landing a ticket in the FTX series B…
All of this created – and continues to create – a dysfunctional ecosystem where the
balance of power lies with high profile, well-connected (perhaps even politically, as was
the case with Sam Bankman-Fried), messianic founders, and away from prudent,
analytical investors. And even those who made investments were motivated to be
passive, silent investors, since their cooperation with the founder was essential for
inclusion in future rounds. Rather than advocating for controls, for wisdom and
experience on the board, investors stayed quiet. The Emperor was naked, but nobody
dared say a thing.
Hopefully, the FTX collapse will be a wake-up call for the VC industry, albeit there seem
to be rather too many of these in recent years to believe that lessons are capable of
being learnt. The days of cheap money are gone, and are not going to be back any time
soon. It pays for a VC to be prudent, to be analytical, to be professional skeptical. Do
not flex your parameters to fit the case, and be prepared to say no. That is a lesson not
just for the initial due diligence, but the duration of any investment actually made.
In the words of one battle-scarred investor, who considered but declined to participate in
FTX’s Q2 2019 seed round: “it is better to walk away and miss your chance to ride the
bull than to be thrown off and gored by a bear.”
Do any similar lessons exist for founders?
The easy one is, don’t be a fraud! The harder one is something of a mirror image of the lesson for VCs, which is the beware of greed. In a parallel universe, perhaps there is a more conservative Sam Bankman-Fried, who instead of headline-grabbing to leverage the multiple of his next fundraising round (and thus his own on-paper wealth) is working on a tedious but all-important corporate governance proposal for investors, having just signed off a request-for-tender for an internal audit.
In the scramble for wealth and fame, Sam Bankman-Fried now faces poverty and
infamy. What cash he managed to extract from the business will be frozen and all in
likelihood seized and liquidated for the benefit of his many creditors. No VC will go near him again, in the event he does manage to steer clear of prison. His many contacts in
Hollywood and Capitol Hill will have deleted his messages and blocked his number.
It did not have to be this way.
