29 Comments
Nov 27, 2022·edited Nov 27, 2022

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.

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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?

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Honestly I feel like there's just a basic rule here that you don't invest in a company at 8 figure and above valuations without a board in place? I know this businesses moves fast and good companies might grow faster than they're able to put these sorts of things in place, but isn't Sequioa in a position to just pitch this as one of their value adds? People take their calls, they can help you put a board together with some legitimate independent directors fairly quickly, surely. If a founder doesn't take that offer it's a pretty big red flag.

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I subscribe here for Noah Smith's unique voice. So usually, I don't even bother to read "guest" posts. This was worthwhile.

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FTX is very peculiar, per crunchbase the first Venture financing was $8M in Aug 2019, and the next major infusion was $1B in July 2021 then $420 M in Oct 2021. Per Mr. Krishnan FTX generated $1B in revenue in 2021 that is pretty incredible growth. An $8M investment in mid-2019 leads to $1B revenue for the year 2021? In addition FTX had around 300 employees, payroll costs would have been, what around $120M, potential for profitability seems huge. If the revenue is generated by fees then did FTX have $25B plus in trades in 2021? You can see why venture capital invested $1.8B in 2021 if this is what the income statement was showing.

FTX had to have some sort of accounting function, payroll and bills were paid, taxes returns had to be filed etc. There are financial roles listed for FTX on linkedin. What role did the auditors play; did they just compile the financial statements, no real audit or internal control review? Without being able to see full financial statements who knows. Investor’s way smarter than me reviewed and thought they were ok.

If the only loss was the $2B venture investors put in maybe this is not such a big deal, but if there is another $5B - $10B of crypto (or whatever it is) lost that was being held in the FTX exchange that is real pain to a lot of people. Summary: 1) Don’t put your money in unregulated entities in the Bahamas (even if Tom Brady says it the smart thing to do). 2) We have no idea what the truth is but it will be interesting to see how this all unfolds.

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Kind of funny to read this piece, it does not even grapple yet with that FTX is an obvious feeder fund for Tether. So it calls out VC for not seeing the obvious scams, but misses itself the way bigger scam of Tether that it is part of.

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Good piece; a few thoughts. First, this is going to be one of many examples where Covid had a catastrophic effect on the nature and magnitude of professional diligence. Anybody working with the legal or financial or business world saw an immense drop in focus and acuity during the pandemic. It has persisted. Do not underestimate this as a major factor in this debacle. Second, debacles are absolutely part of our economic system. I missed the memo on when things like this were not supposed to happen. They always have and will. But, as the author suggests, there are things that humans can do to contain the consequences and reduce the occurrence. Third, although it useful to focus on how and where improvement may occur (though there is ever the underlying tone of "fixing" something that is "broken," as if we have finally figured out how to engineer around human nature and frailties), it is also useful to underscore what works and what makes it work.

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As I read I kept thinking this seems to be a series of pump-&-dump variations as Pachelbel's Canon in D played softly in the background.

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Are the number of frauds large compared to the number of venture investments?

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This ignores the obvious question of why should they care? It's not their money. Their investors expect them to back a certain number of losers in hopes of getting a few big winners. There is tons of venture capital money out there, and the win rate is incredibly low. Obviously, they don't want to be tricked by every last charlatan with a spiel, but so much of their decision making revolves around feelings instead of reasoning that they often back obvious tricksters. Sometimes they even make money backing them.

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A couple of thoughts on this excellent post: First, let's do FTX. If you check the latest numbers, I think this will be close to a 100% recovery for creditors in less than 12 months. Funds were located and recovered and some investments like Anthropic are home runs. I am not defending FTX or Bankman-Freid, but I am taking a shot at the board and its advisors for rushing the company into bankruptcy. They could have kicked out the the management team, suspended withdrawals, taken a breath, and then figured out the right move. Note that overly conflicted Sullivan and Cromwell "advised" the board on its actions and then Ray spent six months saying anything to tell the world how hard his job was so he is a hero with the 100% recovery that was not really his doing. Second, on Theranos, the investor FOMO needs to include a discussion of Walgreen's. How can a Fortune 500 company do this investment with no audited financials statements and no true testing of the science? When looking at these crash and burn situations, I think the answers are many times in the periphery and not obvious to our world of SMS and headlines.

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No FTX Executive Board. Only FTX Executive Polycule.

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Weird that you don't mention Proof of Reserve...

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A great checklist for red flags from Bill Gurley, which echoes some of the points above (lack of a board, counsel, insane corporate structure, and huge secondaries) - https://abovethecrowd.com/2022/11/28/venture-capital-red-flag-checklist/

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Exceptional. TY.

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If FTC is dumb Enron, that really says something.

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