Highlights
- The collapse of FTX, a cryptocurrency exchange, has raised concerns about the safety of venture capital (VC) investment, particularly in the volatile world of crypto.
- FTX was started in 2019 and operated as a cryptocurrency exchange until bankruptcy in November 2022. It allowed users to trade various cryptocurrencies and complex derivatives.
- FTX had a partner firm, Alameda Research, which held a significant portion of its assets in FTT, FTX’s own cryptocurrency. This caused a surge in customer withdrawals that FTX was unable to meet, leading to its collapse.
- Many prominent VCs invested nearly $2 billion into FTX, valuing it at $32 billion. However, the lack of due diligence and transparency from FTX’s fiercely independent founder, Sam Bankman-Fried, should have been a warning sign for investors.
- While another FTX case could happen again, it is very unlikely since many conditions came together at just the right time to allow such an investment.
Introduction
Venture capital (VC) has long been a popular method for startups to secure funding and support for their businesses. Historically, VC has performed better than the S&P 500 by a few percentage points each year. However, the recent collapse of cryptocurrency exchange FTX has raised concerns about the safety of VC investment in the startup space. According to a report from investment-management firm Galaxy Digital, VC funding for crypto startups saw a dramatic drop of 80% to $5.5 billion in the 3rd quarter of 2022. This has led some to question whether VC is a reliable investment vehicle, particularly in the volatile world of crypto.
But what sets FTX apart from other ventures, and why did it ultimately fail? By taking a look at the company’s history and the broader VC trends, we hope to provide an understanding of the risks and rewards of VC investment and what happened that allowed for the FTX disaster.
Short History of FTX
FTX was started in 2019 by Sam Bankman-Fried and operated as a cryptocurrency exchange from 2019 until it declared bankruptcy in November 2022. The exchange was headquartered in the Bahamas and had over one million users at its peak in July 2021. The exchange allowed people to trade different cryptocurrencies as well as complex derivatives to bet on movements in the different cryptocurrencies.
Unlike other crypto-exchanges, FTX created its own cryptocurrency, FTT. This was used to incentivize traders to use their platform and reward early investors when the value rose. Additionally, FTX had a partner firm called Alameda Research, which acted as a hedge fund to speculate on cryptocurrency moves. However, in November 2022, a CoinDesk article revealed that Alameda Research held a significant portion of its assets in FTT, leading to a surge in customer withdrawals that FTX was unable to meet. Rival exchange Binance initially expressed interest in acquiring FTX, but ultimately withdrew its offer due to concerns about mishandled customer funds and ongoing investigations by US agencies.
As FTX began unraveling, many parts of FTX came to light that showed complete mismanagement of the firm. The current CEO of FTX, John J. Ray III, who was involved with unwinding the Enron scandal, has described the company’s previous management as exhibiting a “complete failure of corporate controls” and a lack of “trustworthy financial information.” In December 2022, Sam Bankman-Fried was arrested by the Bahamian authorities at the request of the US government for financial offenses.
Image of Sam Bankman-Fried
Source: Forbes, November 2022, “Who Is Sam Bankman-Fried?”
The Role of VC in FTX
There were many prominent VCs that invested into FTX including Tiger Global, Insight Partners, Sequoia Capital, SoftBank, Lightspeed Venture Partners, and BlackRock. Investors poured nearly $2 billion into the cryptocurrency exchange in just two years, valuing FTX at $32 billion.
These investors saw FTX as a promising opportunity in the emerging crypto sector with the potential of growing to be the largest crypto exchange in the world. Sequoia published a glowing profile of FTX’s founder, Sam Bankman-Fried, on its website. The problem, however, lay in the lack of due diligence these VCs were able to conduct. VCs are normally expected to conduct thorough due diligence for any investment and usually require board seats to oversee the company due to the high-risk nature of VC. In the case of FTX, Sam Bankman-Fried was known for being fiercely independent and not wanting any external oversight or interference in the running of his company. He made it clear to potential investors that they were not to get involved in the operations of FTX, but rather were expected to simply “support him and observe.” This lack of transparency and desire for complete control should have been a major warning sign for investors, as it meant they had no way of knowing what was really going on within the company. Many of the investing VCs have issued apologies to their investors for failing to conduct the due diligence that was necessary.
Why FTX was different
Many investors in VC are wondering if a case of FTX can happen again? In theory yes, but it is very unlikely as FTX was a combination of many factors that came together at just the right time.
First , the general VC environment in the post-COVID period was operating much faster and investing more haphazardly than normal. Due diligence had changed from months to weeks leading to much lower quality analysis. VCs began relying on their “gut feeling” instead of the classic due diligence.
Second, VCs had more money to spend than before. Between 2018 and early 2020, VCs raised on average $65B per quarter and closed around 6,500 deals. By the end of 2021, that number had risen to $178B and 9,800 deals! Money was being raised and deployed faster than ever,
Source: CB Insights, “The State of Venture: Q3 2022 Global Report”
Third, “hot” funding rounds, or investment opportunities where more investors want to be part of it than spots available, led to even faster rounds with less ability to do due diligence. Companies in “hot” rounds have the luxury to decide who can invest. This usually meant that VCs that took too long to decide would be left behind.
Fourth, crypto investments were seen as a very promising sector to invest in. Bitcoin had risen from about $6,000 at the start of 2020 to $60,000 by mid-2021. NFTs became popular and were selling at high prices. Investors wanted to find ways to profit on this momentum.
Together, FTX had the perfect opportunity to raise large amounts of money with close to no scrutiny. Sam Bankman-Fried was able to convince investors to invest due to FTX’s strong position in the cryptocurrency market and had features other exchanges did not. There were more large investors scrambling to join his funding rounds than space available that he was able to reject anyone that wanted to do due diligence on FTX. Investors used their “gut” to trust their investment and were initially rewarded with major increases in the company valuation. However, none of their returns materialized and the funds took major losses.
Conclusion
The collapse of FTX highlights the inherent risks of venture capital investment, particularly in the volatile world of cryptocurrency. While VC can generate lucrative returns from startups looking for funding and support, it is crucial for investors to thoroughly research and understand the risks and potential rewards of any investment. In the case of FTX, investors failed to properly conduct due diligence and were blinded by the promise of high returns in the emerging crypto sector. The lack of transparency and desire for complete control by FTX’s founder should have been a major red flag for investors, as it left them with no way of knowing what was happening within the company. This lack of oversight ultimately contributed to the company’s downfall.
While it is possible for another case of FTX to happen again, it is extremely unlikely since the VC environment has completely changed. The level of funding has decreased, and length of funding rounds has returned to normal so proper due diligence can be done. VC funds have learned their lessons and are unlikely to repeat such a mistake. Even though VC has large risks, it still remains one of the highest returning investment classes.
Sources:
Cambridge Associates, December 2017, “US Venture Capital Index and Selected Benchmark Statistics”
CB Insights, “The State of Venture: Q3 2022 Global Report”
Forbes, November 2022, “What Does FTX Tell Us About The State Of Venture Capital?”
Forbes, November 2022, “Who Is Sam Bankman-Fried?”
Investopedia, December 2022, “What Is FTX?”
The New York Times, November 2022, “Investors Who Put $2 Billion Into FTX Face Scrutiny, Too”
The Wall Street Journal, November 2022, “FTX’s Digital Coin Was at Heart of Crypto Exchange’s Fall”