The tech world is still reeling from the collapse of the crypto exchange FTX. Unlike in the cast of the fraudulent biotech company Theranos, FTX managed to hook lots of the supposedly most savvy investors in the space. So when venture investor and former hedge fund manager Rohit Krishnan offered to write a post about how venture capitalists can avoid being tricked by companies like FTX, I took him up on it. It’s a good sequel to Benn Eifert’s post on bullshit in the investing world.
Rohit usually blogs at Strange Loop Canon, where he once interviewed me. The opinions he expresses here do not necessarily reflect the opinions of Noah Smith or of Noahpinion.
We live in the golden age of technology fraud. When Theranos exploded, there was much hemming and hawing amongst the investing circles, mostly to note that the smart money on Sand Hill Road were not amongst those who lost their shirts. When WeWork put out its absolute sham of an IPO prospectus before getting cut by 80%, most folks said hey, it’s only the vision fund that was lacking vision.
But now there’s a third head on that mountain, and it’s the biggest. Theranos only burned $700 million of investors' money. Neumann at WeWork supposedly burned around $4 Billion, but that was mostly from Softbank. FTX puts these to shame, incinerating at least $2 Billion of investors' money and another $6-8 Billion of customers’ money in mere hours. Soon to be legendary, worse than Enron and faster than Lehman, there is the singular fraud of FTX and its CEO Sam Bankman-Fried.
There are multiple stories about what exactly transpired, and all the ways in which it was cuckoo, and I’d recommend Matt Levine, Trung Phan, Kyla Scanlon or maybe just search on twitter and read until your blood boils. The shortest version is that FTX had highly incestuous relations with its sister hedge fund, which lost absolute mind-boggling amounts of money, which SBF and gang tried to patch up through illegally transferring client funds and rendering everyone involved bankrupt. While this elides the more sexy aspects of polycules and account hacks and penthouses in Bahamas, this is still pretty bad.
But unlike those other crashes, this seems like it might take down multiple other firms, and create a 2008 moment for crypto, which used to be a $2 Trillion asset class. More importantly, to figure out how we can stop something like this from happening. Not fraud, since that’s part of the human OS, but at least having the smartest money around the table getting bamboozled by tousled hair and cargo shorts.
I. The problem: this is Dumb Enron
Temasek, not known to be a gunslinger in the venture world, released a statement after they lost $275 million with FTX. It’s carefully written and well worded, and is rather circumspect about what actually went wrong.
They mention how their exposure was tiny (0.09% of AUM) and that they did extensive due diligence which took approximately 8 months, audited financial statements, and undertook regulatory risk assessments.
But the most interesting part is here:
As we only had a ~1% stake in FTX, we did not have a board seat. However, we take corporate governance seriously, engage the boards and management of our investee companies regularly and hold them accountable for the activities of their companies.
Sequoia, when it lost $214 million across a couple of funds, also mentioned in their letter to LPs they did “extensive research and thorough due diligence”. A week later they apologized to the LPs on a call and said they'll do better, by maybe using the Big 4 to audit all startups. I suspect this is hyperbole because otherwise this is medicine sillier than the disease.
These are not isolated errors in judgement though. The list of investors in FTX is a who’s who of the investing world - Sequoia, Paradigm, Thoma Bravo, Multicoin, Softbank, Temasek, Lux, Insight, Tiger Global.
The funny thing is, when Theranos happened there was a furore of articles and indignant tweets about how there were almost no professional startup investors who got caught in the scam. And WeWork, the other poster child, wasn’t quite a fraud as much as a seduction of an old tech loving Japanese dude by a beautiful Israeli man.
Doug Leone made the reasonable point that I made above, that VCs don’t really do forensic accounting. They got some audited financials, and it looked good, but it's a snapshot at the end of a quarter, so why would they know shenanigans had taken place!
But honestly, if VCs had been snookered by Theranos, that would make more sense. Like what do VCs know about how much blood is needed to test something? Sure it doesn’t quite sound right (100s of tests from a single drop of blood!) and there were people saying this is impossible, but they say that kind of thing about everything! And Holmes’ professor from Stanford was on the Board! That would’ve been a good reason to lose money, and Sequoia’s letter would be 100% on point.
But an exchange? That’s not an unknown business model. Frankfurt exchange has been running for over 4 centuries. We know how this works. We know how brokerage works. When Matt Levine writes about how this is insane, he doesn’t need to, like, study up on esoteric secrets of cryptography. Whether you’re trading baseball cards or stocks or currencies or crypto, a margin loan is a margin loan and a fee is a fee.
What they should have known however are the basic red flags - does this $25 Billion company, going on a trillion by all accounts, have an actual accountant? Is there an actual management team in place? Do they have, like, a back office? Do they know how many employees they have? Do they engage professional services like lawyers to figure out how to construct the corporate structure maze? Do they routinely lend hundreds of millions of dollars to the CEO?
Sure Temasek didn’t get a Board seat, but did they know there was no Board at all? Or how exactly Alameda and FTX were intertwined, if not all the other 130 entities? It seems sensible to ask these things, even if you’re only risking 0.09% of your capital.
These are hardly deep detailed insane questions you skip in order to close the deal faster. Speaking as someone who’s lost deals because of that kind of silliness, this is a whole another level. I’ve had investments where we ask the company to get an audit done as part of the round requirements, and that’s at 1/10th the size! The answer to most of these combined will take like half an hour max.
This isn’t Enron, where you had extremely smart folk hide beautifully constructed fictions in their publicly released financial statements. This is Dumb Enron, where someone “trust me bro”-ed their way to a $32 Billion valuation.
II. Due Diligence Woes
One of the other constant arguments in the aftermath is the question of why the investors, the who’s who of the venture world, didn’t do enough due diligence. But note that the very framing of the debate around “did they do enough due diligence” is a bit of a psyop. It changes the emphasis from what they should’ve done to “have you done enough”, to which the answer can always be “sure, look at our reports, look at these thick, juicy binders”.
For one thing, nobody understands what “diligence” means here. Everyone in venture has a different interpretation of enough. There is some combination of information you ask for to make sure that the company kind of does what you think it should, and that the founders aren’t lying too much, but it's not forensic accounting nor any kind of seal of approval.
Venture investors invest in growth. Which means, necessarily, most of the diligence is to figure out if the growth is sustainable. Which means, most of the work would’ve been to check things like (in the case of FTX) trade volumes, and margins, and unit economics per trade, combined with maybe the types of customer base, trader personas, and institutional interest. All of which would’ve looked great, obviously. It’s a crypto exchange during a trade boom and insane volatility. Hence, as Dror Poleg says:
Given the opportunity, most of FTX's investors would do exactly the same thing tomorrow. Their job is not to avoid failure; it is to avoid missing out on the biggest success.
It is also their job to say they learned their lesson before they do it again.
What it wouldn’t include are like corporate governance deep dives, or even much legal diligences, at best which is outsourced after which you take a commercial call on what risk you’re willing to take, or at best financial diligence.
So we shouldn’t blame them for not knowing fraud was occurring, because that’s not something anyone would’ve known unless they had, like, a mole in the company. We might now even be able to conclude that they approved expenses via emojis, because holy hell who would know to even look for that!
And for the rest, like financial diligence or audited accounts or regulatory risks or even related inter-party transactions, they would’ve asked some law firm to have a look at their books or agreement to say “you shouldn’t do this”. Even there they might have gotten an Alameda exemption, because if FTX is making Sam filthy rich, they would probably (mostly rightly) conclude that he’s not gonna blow up the golden goose by doing dumb things.
III. So now what?
So … is this a fait accompli? That makes it sound like we’re living in a Panglossian best of all possible worlds, which isn’t true. Because the problem here wasn’t one of not playing poker well enough against an evil Annie Duke.
Here's where I get to differ with Matt Levine, who was much more sympathetic to the woes of VC due diligence.
I suppose FTX is a failure of venture capitalist due diligence, but it’s an odd kind. The usual VC due diligence failure is, like, you back an entrepreneur who promises a futuristic product, and the product doesn’t work. FTX worked fine: People liked its technology, and it seems to have made money. The problem was in its balance sheet, which was full of snakes, and its governance, which put all the snakes there. Ideally the venture capitalists would have spotted that in due diligence, but the typical VC company has a very simple balance sheet and terrible governance, so it is sort of understandable that they sailed right by those problems.
Well, no. If the failure had been Theranos, or even WeWork, that would make sense. It’s a moonshot we don’t understand at all, or a business we basically all understand, and we’re just hoping the CEO can run the company well. Those are understandable risks for someone to take, even if you don’t think they should’ve taken them.
But here the problems were barely skin deep. The gotcha questions here were of the grade-school variety, like “who holds most FTT coins?” or “what the hell is Serum?”. This isn’t a failure of forensic accounting, this is a failure of basic logic. Buying everyone $300 million of mansions in the Bahamas doesn’t sound like things hidden under the radar. Yes, he made $1 Billion in revenue the year before, the year of the insane pandemic fueled crypto growth, two years after he started the company, but a giant red flag nonetheless. In Matt Levine’s prose:
If you try to calculate the equity of a balance sheet with an entry for HIDDEN POORLY INTERNALLY LABELED ACCOUNT, Microsoft Clippy will appear before you in the flesh, bloodshot and staggering, with a knife in his little paper-clip hand, saying “just what do you think you’re doing Dave?” You cannot apply ordinary arithmetic to numbers in a cell labeled “HIDDEN POORLY INTERNALLY LABELED ACCOUNT.” The result of adding or subtracting those numbers with ordinary numbers is not a number; it is prison.
Or from Ray, the new CEO, who oversaw Enron, but was absolutely flabbergasted at what he saw:
Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.
The Debtors did not have the type of disbursement controls that I believe are appropriate for a business enterprise. For example, employees of the FTX Group submitted payment requests through an on-line ‘chat’ platform where a disparate group of supervisors approved disbursements by responding with personalized emojis.
I’ve asked before on the controversial question of how much should one lie in corporate life. The conclusion was something to the order of lying somewhat is inevitable, but the art is to do it well, not make dumb mistakes. And there is a belief that those like Holmes or SBF are hyper-intelligent and that a $32 Billion fraud has to be the result of careful collusion amongst a bunch of evil geniuses. Most often though, it’s barely a napkin covering a “I’m Stealing” sign that nobody bothered to look under. This was a fairly straightforward wake up call to not do dumb things! And so there are three lessons I’d recommend we learn from this saga so as to not get completely snookered.
First, focus on the basics: if you're looking at a large financial company where there is no HR team, no accountant and no Board, try not to write multi hundred million dollar cheques. If the founder is regularly taking out absolute mountains of cash from the company to buy properties, donate to charity or blow it on burning a bit of capital for seemingly silly deals, that feels like bad governance.
See the fact is that VCs are in the business of funding companies that look like they’ll do well in the future, knowing that many won’t. They’re also the Venn intersection of the most interesting parts of finance and most boring parts of entrepreneurship. They’re in the “dream business”, as Doug Leone said above, and we regularly see. The reason this is hard is because the job is to invest in narratives, because the thing they’re investing in hasn’t been built yet, and narratives are always lies. They can’t predict the future by doing due diligence just a little bit harder.
Second, don’t fall in love more than necessary: Try to internalise the following: “human ability is normally distributed but the outcomes are power law distributed”. What this means is that just because someone builds a company that produces extraordinary outcomes, 10000x the average, doesn’t mean that they were 10000x as capable. Achievements are created from multiplicative outcomes of many different variables. So if you’re investing in a “10x founder” it doesn’t mean that they themselves are 10x the capability of everyone else, but what it means is that their advantage, combined with everyone else’s advantage, can get you to a 10000x outcome.
Which means the adulation we pour on top of some folks creates its own gravitational field, and makes others susceptible to falling in love. The most difficult task is to not let someone else control your decision making for you, which is what you give up. If your job is to get seduced by the right narrative by the right-seeming person, guess what you’ll get seduced by anyone who can tell a compelling narrative.
Do NOT make decisions thinking surely someone else has done their part. As the names get bigger, a new investor thinks “hey, surely Sequoia and Temasek and all these big guys would have done their diligence, this makes me comfortable”, which just isn’t true.
Three, zeitgeist investing can go explosively wrong. One of the weird benefits of the large decade of crazy bull market is the emergence of zeitgeist farming, which I described as "do no work, throw money blindly, and get rich". In the past several years the venture capital investing model, investing smaller sums of primary capital to make the future come true, climbed much higher up the capital stack with them competing with pension funds and hedge funds and sovereign wealth funds.
The problem here is culture contagion. Because Sequoia is in the business of losing money on bets going wrong, we forgot that Temasek perhaps shouldn't be doing the same thing just because the cheque size went up.
The problem with playing this long enough is that it's musical chairs. If you don't sell out at the market top and get out, you're dead in the water. Especially for businesses where since the beginning people have questioned how it could ever work - like grocery delivery or buy now pay later or various lending models or marketplaces with razor thin margins.
FTX isn't an example of crazy overextension, like WeWork, or outright fraud, like Theranos, but sheer unadulterated incompetence and hubris. The first two are understandable mistakes to overlook because investors are in the risk taking business, and are not detectives. The third is a failure of seeing things right in front of one’s eyes.
(There’s an interesting fight to disavow FTX with crypto folks pointing to it and saying its finance and almost everyone else pointing to it and saying its technology, but refereeing this battle is beyond the scope of this essay. A crash is still a crash.)
As larger sums of money come into the primary capital funding game, where the investment by definition is in the future, the way those investments are made also changes. Just because the cheque sizes from KKR and Sequoia are the same doesn’t mean the diligence or indeed the outcome is expected to be the same.
Failure is common. Losing money on investments like Fast or Volt or Katerra or Quibi or CommonBond or Reali are par for the course - you invest hoping for a particular future that turns out to not be real. And while those can be criticised for being obviously silly, or only viable in low interest rate environments, that’s the risk that VCs are paid to take. The job is to take risks, but not all risks are built the same. The risk you shouldn’t take is to ignore the pile of rubble strewn about you while dreaming about building Arcadia.
I feel like the commentariat want to make the FTX implosion more legible by slapping the fraud label on and putting them in the same bucket as familiar stories like Enron and Theranos. But there are some critical differences that are getting glossed over. FTX was genuinely a highly profitable firm with a great and differentiated product. While the story is still getting written, it seems likely that the actual fraud started rather late, after taking big trading losses (perhaps from the Terra/Luna meltdown in May), and was basically a case of gambling for resurrection. If that's the case you can hardly blame VCs for missing a fraud that hadn't yet started when they invested.
Excellent. Is there also the flaw of not assuming fraud is always on the table? That it is always a possibility? The point of due diligence is that trust is not enough. Snookering happens. Has happened throughout history. Is wariness somehow aligned with lack of bravery?