Charges have been filed by the U.S. Securities and Exchange Commission (SEC) against three top FTX executives, including Sam Bankman-Fried, but this is certainly not the end of the SEC’s probe. Earlier this month Reuters reported the SEC is also seeking information from financial firms (yet to be named) that made significant investments in FTX regarding their due diligence processes used prior to investing in FTX.
Tal Elyashiv is the co-founder and managing partner of SPiCE VC.
While this particular area of the investigation is not necessarily an indication of any wrongdoing, the abundance of venture capital funds associated with, and deeply invested in, FTX raises some questions. Specifically, the SEC is focusing on details about what policies and procedures venture firms had in place when they chose to invest in FTX, and whether they were followed.
Jumping on the FTX bandwagon (despite red flags)
The list of FTX investors who in aggregate invested over $2 billion, and subsequently had to write it all off, spans an impressive “who’s who” of well-known investment firms, including NEA, IVP, Third Point Ventures, Tiger Global, Insight Partners, Sequoia Capital, SoftBank, Lightspeed Venture Partners, Temasek Holdings and BlackRock.
It also includes the Ontario Teachers' pension fund, one of Canada's largest pension funds, with nearly $250 billion in assets under management. It will write down the entirety of its $95 million investment in FTX.
That’s quite a lot of money flowing into an organization that had an accounting firm in the metaverse, no board of directors, a questionable corporate domicile and was highly leveraged from the very beginning, among a list of other “red flags.” So, what gives?
See also: Who's Who in the FTX Inner Circle
Each of the VC funds that invested in FTX said it conducted an appropriate amount of due diligence. That includes Temasek Holdings, which stated it spent eight months of due diligence without identifying a single red flag.
While I’m not in a position to Monday-morning quarterback the VC/FTX bandwagoning, it’s undeniable that serious questions are being raised by the SEC and others. Were the funds acting responsibly on behalf of their own investors when they poured money into FTX as part of their fiduciary duties? How is it possible that not one of FTX’s investors noticed anything amiss? And is VC groupthink what led to all of this?
While these questions about due diligence deserve answers, the issue is also about oversight. Did these investors exercise any oversight on how these funds were being deployed at FTX?
When it comes to FTX, (and many others, including Terraform Labs, Celsius Network, BlockFi, CoinDesk sister company Genesis, etc.) the stopgaps and oversight failed. We expect regulators to protect investors from fraud and mismanagement of their investment, while investors expect and rely on investment managers to do proper due diligence on investment and make risk-reward decisions as part of their fiduciary duty.
This delicate balance of oversight, trust and accountability failed because, let’s face it, FTX was the cool thing to invest in.
This isn’t the first-time venture capital and private equity money followed the shiny object, throwing caution to the wind and betting the house. Remember the dot-com bubble? Apparently, investors in FTX forgot because a cool kid who wore wrinkled shorts, never made his bed and lived in a Bahamian penthouse wooed them. While Sam Bankman-Fried’s rap sheet of fraud continues to grow, his single greatest fraudulent accomplishment, in my opinion, was the massive heist of the global VC market. The “Crypto Kid” gave VCs a reason to swoon, and many of them fell in line without seemingly questioning a thing.
What’s next for VC investing?
According to Politico, to potentially avoid another VC groupthink fail, the SEC is working on a rule that would preclude private funds from seeking indemnification for simple negligence, effectively making it easier for limited partners (LP) in such funds to sue these funds. This will, presumably drive higher accountability and will, hopefully, result in deeper due diligence and oversight on the part of fund managers. However, this issue has implications that go beyond just direct investors and often impact institutional investors, pension funds, etc.
Sounds good, right? But not so simple.
While I strongly believe VC funds and their managers carry significant responsibility to their LPs and must do their best to make investment decisions based on solid due diligence and according to fund policies, my prediction is the FTX-related VC probe is unlikely to amount to much from a regulatory perspective.
Even if some VC fund managers did little more than blindly follow Sequoia Capital in investing in FTX, it will be very hard to justify regulatory change from a singular event and a relatively small number of VC funds. In essence, LPs are rarely promised specific due diligence procedures, or requirements related to corporate governance, etc. LPs know this is a high-risk asset class, and that general partners often have little time to access the most popular deals. If they're dissatisfied with the fund’s performance, they can (and do) vote with their feet during follow-on fundraising.
Also, LPs are already allowed to sue for gross negligence, which covers reckless or purposeful acts. However, expanding liability to simple negligence would effectively enable LPs to sue every time a deal goes bad, which would add a significant amount of unruly risk and cost to the VC business, which will be passed on to investors and portfolio companies alike. Furthermore, most LPs will not take advantage of such rights because earning a reputation as being overly litigious will preclude them from participating in future deals . No one wants to work with a tattletale.
Take risk, but don’t be reckless
To quote Taylor Swift (no, I’m not a Swifty), VCs need to “keep their side of the street clean.” As mentioned before, participating in the venture-capital ecosystem is inherently risky. VCs make bets on early-stage companies, but those bets should be educated, informed and researched. Furthermore, once the decision to invest in a startup is made, there should be an adult in the VC room making sure that whatever investment was made is being used wisely and for the right reasons.
There’s no scenario in which a VC fund can guarantee a unicorn (a privately held startup company with a value of over $1 billion) or even modest positive returns – and that’s OK. Investors who are not comfortable with those odds shouldn’t be in the VC market. There will always be winners and losers, just like with the stock market. So instead of opening the litigation floodgates, let’s hold the fraudsters accountable and allow responsible VC funds to continue to invest in innovation.