FTX benefited from venture capitalists’ suspension of disbelief

By Judy J. Beasley Last updated Dec 5, 2022

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The narrative that emerged in the days following the collapse of FTX, the $32.5 billion exchange at the center of Sam Bankman-Fried’s crypto trading empire, was that it must be the result of a highly sophisticated and nefarious scheme that only came to light after a series of unfortunate events. After all, some of the smartest minds in the financial world have been sucked in: Sequoia Capital, Tiger Global Management and the Ontario Teachers’ Pension Plan, to name a few.

And that’s what the venture capitalists and pension funds that created FTX surely want you to believe. That they were the unwitting victims of an unfortunate and complex saga that no one could have foreseen. Do not fall into the trap. Although we don’t know all the facts yet, they shouldn’t be beyond reproach. Without their continued funding, approval, and lack of questions, FTX would never have grown as big as it has. Their negligence means that FTX customers are short on billions of dollars that they will probably never be able to recover.

Interviews with Bankman-Fried in recent days suggest that FTX’s failure is down to sheer incompetence. It was a doomed enterprise. Exhibit A: In a company where risk management is the #1 priority, Bankman-Fried now says there was no one in the company responsible for risk management. “It’s quite embarrassing,” he told the New York Times DealBook Summit audience on Wednesday. And that’s not all. FTX seems to have lacked anything remotely resembling a conventional board and subcommittees. Bloomberg News reports that it’s unclear how many compliance employees — or even employees — FTX actually had. In a filing for bankruptcy, court-appointed CEO John J. Ray III said FTX was unable to provide a complete list of who worked for it and in what capacity, adding that the responsibilities were unclear.

So how did venture capitalists and other supposedly sophisticated investors not see this coming? The little they said leaves more questions than answers. Top partners at Sequoia, the most reputable of all venture capital firms for seed companies such as Apple Inc., Google, Cisco Systems Inc. and Airbnb Inc. since its inception in 1972, have championed due diligence reasonable on their $214 million investment in FTX and related entities. They told investors on a recent conference call that staff repeatedly reviewed financials and asked questions about FTX’s relationship with Alameda Research, a trading firm Bankman-Fried also founded that allegedly borrowed. and lost FTX customers’ money. In the future, they assured investors, Sequoia could push startups to use Big Four accounting firms.

Expect! Sequoia invested in a company valued at over $30 billion and did not require the company’s finances to be audited by a reputable accounting firm? Regarding the allegation that FTX funds were used to finance Alameda’s business, Sequoia’s partners said they were confident that this was not happening and that the two were separate entities. Again, even a cursory audit by any chartered accounting firm, let alone one of the Big Four, would have concluded otherwise.

It’s not like there aren’t any red flags, as my Bloomberg News colleague Layan Odeh reported. The potential for conflicts of interest between FTX and Bankman-Fried’s Alameda, and the lack of a proper board of directors were only the most obvious. The Ontario Teachers’ Pension Fund, which has written off its $95 million investment in FTX, called its due diligence “robust” and said “no due diligence process can uncover all risks , especially in the context of an emerging technology company”. True, but the effort cannot simply be to ask a question and then take the Founder at his word. Trust but verify. Even basic scrutiny would have revealed glaring flaws in how FTX works.

The obvious question is if they missed the red flags at FTX, what else are they missing? That’s a good question to ask. As much as anyone, the private capital industry has been a major beneficiary of the easy money era. Funds have been flooded with more money than they can deploy, fueling complacency, which then fueled bets on risky start-ups that would have disappeared in “normal” times.

The best form of accountability is the market. Venture capitalists who have lost their clients’ money on FTX should be required to make an exceptional case for new inflows – even the mighty Sequoia. This means demonstrating specific and robust due diligence processes that go beyond a partner’s hunch after being struck by an entrepreneur or an idea. Insist that every venture capital investment be kicked off by an independent consulting firm that must vouch for its work, just like a CEO of a public company or a firm audit should vouch for reported financial results, would be a good start. And how about charging the vendor due diligence fee separately to the end investor, to make it clear who the business is meant to serve? (Bloomberg News reported that Bankman-Fried’s oversight of a vast network of FTX-related entities was one of the risks highlighted during the due diligence Bain & Co. conducted for Tiger Global, but the fund manager still thought it was a good investment at the time.)

Of course, not all start-ups will succeed. For every Apple, there’s a Pets.com. But there’s a difference between a startup failing due to changing market conditions or old-fashioned bad luck, and failing due to terrible governance, like us. saw it with FTX. You can’t beat venture capitalists for the former, but you definitely should for the latter. And those who suffer are not just the wealthy who invest in venture capitalists, but also retirees and regular workers who participate in the pension schemes that fund venture capitalists.

Venture capitalists were not directly responsible for FTX’s collapse, but they certainly share the blame.