What Does FTX Tell Us About The State Of Venture Capital?

Much has been written about the implications of FTX’s collapse for the future of cryptocurrency and the broader financial system. Commentators have not focused much on what the debacle may be saying about the state of venture capital investing. Maybe they should.

VC notable Chamath Palihapitiya reports that when he was invited to participate in an FTX fundraising round, his team made a few recommendations. They were standard safeguards for venture investors, such as creating a board of directors and providing some reps and warranties. The response from FTX’s employee was “F—- you!”

This suggests that the A-list VC investors who did fund Samuel Bankman-Fried failed to demand certain protections that Palihapitiya’s Social Capital fund, based on experience, deemed essential. Historically, such deterioration in standards has typically arisen from the condition of too much money chasing too few deals. In recent years, excess demand could have arisen from institutional investors stepping up their allocations to venture capital as they realized that prospective returns in equities and fixed income were insufficient for meeting their future obligations.

We do not know for certain whether FTX was an isolated case of VC gatekeepers becoming besotted with a beguiling entrepreneur. If that is what happened, it was not the only case of recent years. Reeves Wiedeman’s Billion Dollar Loser: The Epic Rise and Spectacular Fall of Adam Neumann and WeWork (2020) documents how a charismatic CEO secured a wildly inappropriate super-tech valuation for a company in the mundane business of renting office space.

My former colleague Jeff Stambovsky offers a possible explanation of FTX’s success in getting VCs to lower their defenses:

Don’t forget the role that SBF’s prominence in the Effective Altruism movement played in all this. SBF knew which buttons he had to push in order to make large investors feel good about themselves.

Venture capitalists’ misjudgment can have a deleterious effect on markets. Risk Fabric’s Rick Bookstaber, another former colleague, recently made a serious point on this subject in a satirical way. Here is how he said it was possible to create a $50 billion company almost overnight: Issue one billion shares, then sell 100 shares at $50 each to one of your children, who pays for it with money borrowed from you. “Do the math,” says Bookstaber.

It is no laughing matter that an unrealistic total enterprise value can be conjured up for a private company through the purchase of a small percentage of its shares by an investor whose judgment is clouded for some reason. Disparities between hypothetical values and values grounded in reality can have severe consequences. For example, some VC funds are currently coming under fire for not taking larger markdowns on their holdings in the face of this year’s steep drops in the indexes of public stocks. Institutional investors in those funds may consequently have inflated notions of their portfolios’ worth.

In short, it could prove costly to assume that the huge and sudden wipeouts of value observed in the crypto ecosystem are purely a function of flaws in the concept of alternative currencies. Any market sector that experiences growth as explosive as crypto has will inevitably attract some entrepreneurs who are either too inexperienced or not sufficiently honest to merit financial backing. If providers of capital are enabling the mishandling of the funds entrusted to them, problems may well surface in industries and asset classes other than the one on which attention happens to be focused at the moment.