FTX collapse exposes power imbalance between founders and investors
What exactly transpired has yet to be revealed, and may never come fully to light, but the broad strokes are that the company has a murky relationship—to say the least—with its trading firm, Alameda Research, whose heavy losses founder Sam Bankman-Fried tried to patch up with FTX client funds.
The scandal, just the latest in a long string of mishaps, bankruptcies and improprieties to hit the crypto world, has left many uncertain about the industry’s future. And—in ways that some of the other shocks to hit crypto have not—the FTX implosion has forced investors to confront the question of how such a massive fraud could seemingly pass right under the noses of some of the world’s most sophisticated venture capitalists.
Could the much-criticized backers of FTX have done better?
The short answer is yes. There were obvious issues with due diligence—new boss John Ray put it succinctly, saying “never in my career have I seen such a complete failure of corporate controls.” (And that’s from the man who oversaw Enron’s bankruptcy.) Backers including Sequoia have apologized and promised to do better next time around.
But context is important.
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The mission of a VC firm is less about avoiding failure—which is expected in the venture world—than not missing out on the next big thing.
In the last few years, as VC’s popularity soared, that philosophy became even more important. The entrance of new investors like hedge funds and corporates drove up competition and stories of term sheets being signed in a matter of days (hours in some cases) were all too common. The need for 3x returns remained even when valuations swelled to unsustainable levels.
The environment that fueled the outsized growth of companies like FTX was one of the Wild West. Patience and diligence are not rewarded when you know that if you walk away, 50 other investors are waiting in line, waving cash in a startup’s face.
All of this creates an ecosystem where the balance of power leans too heavily in favor of founders and away from investors.
Investors who dared suggest that it may be wise to include someone with a bit more experience to run the business or disagree with a founder’s decision would likely be excluded from future rounds and thus a larger payout. When your mission is to not miss out, asking questions can seem like an unnecessary risk.
Hopefully, the FTX collapse will be a wake-up call for the VC industry: Maybe asking questions isn’t the worst thing in the world. It’s easy to be skeptical the call will be heard—after all, it’s not the first time investors have been caught unawares by startup misconduct.
But unlike earlier periods when high-flying startups—such as Theranos, which later collapsed in scandal, or WeWork, which endured crisis and founder disgrace—met their downfall, the current startup environment is more sober. Gone are the days of cheap capital, and rationality shows signs of returning to the venture market. Times are, and likely will continue to be, tougher for startups—and a downturn may be what’s needed to shift the power balance in favor of VCs, giving them more leverage in negotiations and more time to spot red flags.
So what should VCs and other investors do to avoid a future fiasco?
Stop deifying founders. An investor’s decision to back a startup will depend on the quality of the founder, among other things, but they are still human and capable of mistakes—or outright fraud. Allowing a founder to rule as an autocrat necessarily leads to a culture of submission and their failures mean that they bring the whole house down with them. Also, pro tip: If they’re playing “League of Legends” during pitch meetings, maybe think about how seriously they’re taking their job and walk away.
It’s also important to base an investment decision on the whole of a company, not just its best attributes. Proper corporate governance is essential, as well as management cohesion, business model viability, strong financial metrics, product market fit and customer retention, to name a few.
Furthermore, due diligence can’t stop when the initial investment is closed. Routinely monitoring a startup’s performance and metrics, as well as internal processes, will help provide a clearer picture and opportunities for troubleshooting earlier on.
With all this said, the nature of VC means that investors have to operate with limited information, particularly in the early stages of a startup’s life. If you believe that innovation comes from companies exploring ideas that are somewhat off the beaten path, then risk cannot disappear from the market.
To make big leaps forward, you need to take big swings, which in some cases will result in heavy losses and potential embarrassment. And while the market has cooled off, it would be naive to assume that the culture of FOMO has disappeared from VC. Only time will tell if investors have really learned their lesson.
Featured image by Jenna O’Malley/PitchBook News
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