Topics: Risk Management,Strategy
Topics: Risk Management,Strategy
January 5, 2023
January 5, 2023
Cryptocurrency exchange FTX has fallen. News outlets point mainly to rival cryptocurrency exchange Binance first announcing that it would sell off its holdings of FTX’s primary token, FTT, then later backing out of an offer to acquire FTX as the point of no return that resulted in FTX and more than 130 affiliated companies filing for bankruptcy on Nov. 11.
This occurred after CoinDesk reported on FTX sister company Alameda Research’s unusual balance sheet on Nov. 2. A large portion of Alameda’s balance sheet purportedly consisted of FTT assets and liabilities, the coin that FTX itself created. Allegedly, Alameda Research also secretly borrowed billions of dollars’ worth of FTX customer funds, leading to insufficient money on hand for FTX users to cash out should they have desired to.
The cryptocurrency exchange, based in the Bahamas, was once estimated to be worth $32 billion. Binance and its cofounder and CEO, Changpeng Zhao, saw red flags at FTX that it could not ignore. Yet many other well-known investors gave money to FTX and seemingly did not uncover the same red flags. These investors also did not install a formal, global board to oversee former CEO Sam Bankman-Fried and the company.
In Bankman-Fried’s own words at the New York Times’ DealBook Summit on Nov. 30, what happened was a “massive failure of oversight, of risk management.” With the failings of due diligence and risk oversight processes on display, there are some important discussion points for boards and business leaders.
Companies of all stages and sizes can benefit from a board and formal governance oversight. Investment firms have a responsibility to their fund investors and limited partners to ensure proper oversight of the companies they invest in. FTX investors claim that they performed due diligence assessments, which evidently missed some important red flags.
In addition, no official board was established to oversee Bankman-Fried and the main FTX entity. Axios reported on Nov. 29 that Bankman-Fried believes “proper oversight” could have helped FTX from its downfall. He also said at the DealBook Summit that with “more than a dozen boards when you look at all the entities put together” there was no one person or centralized entity that was responsible for global customer risk management.
“In this case, there wasn’t a true management team and [there] wasn’t regulatory oversight per se, so that left the investors as the only group that could require proper governance. I suppose that the investors didn’t want to miss the opportunity to get on the cap table or they just got caught up in all the hype and didn’t force the issue,” said Leslie Goldman Tepper, general partner and cofounder at The Artemis Fund and a board member of various companies.
While FTX said that it had been audited by two firms, an audit by a more established and better-known third party—shepherded by a board—may have discovered FTX’s issues earlier. A separation of responsibilities so that all the decision-making power would not have fallen to two or three people, as well as a strong line of communication and trust between management and a board or investors could also have improved the situation. Bankman-Fried himself advised the audience at the DealBook Summit to “look for the things that I wish FTX had been able to supply,” such as proof of reserves and regulatory reporting.
“My investing philosophy and the philosophy that we use is to look to bring independent board members into the company at the Series A stage and between Series A and Series B, push the company to have a formal third-party, outside audit,” said Jack Klinck, partner at Hyperplane Venture Capital and a board member at various companies. “Independent board members and the requirement of a third-party audit are two things that ought to move from later-stage companies where they typically happen now to earlier stage [companies] to set the tone.”
Tepper agreed. “When our fund invests, we require a board seat, we require a board to be established, and we require monthly and quarterly reporting. And that’s at the earliest stages, at the seed stage.”
FOMO can push investors, business leaders, and companies to make mistakes. The fear of missing out, or FOMO, has played a huge role in how venture capital (VC) firms have invested their money, especially in 2021 and early 2022, according to Klinck and Tepper. When a few big firms invest in a company, other firms are likely to jump in as well, and sometimes make assumptions about the stability and legitimacy of the company given that other firms have already taken the plunge.
“Maybe they all thought because there were other name brands that were investing or had invested that the diligence was completely sound,” Tepper said. “They said they did extensive diligence. I would assume that would involve background and reference checks on the founders and management team, but I don’t know the details and whether they saw red flags. This just reconfirms the fact that we can never rely on someone else’s diligence. Of course, hindsight is always 20/20.”
At the DealBook Summit, Bankman-Fried said that he doesn’t think he ever tried to lie, but he did want to make FTX sound exciting; he spent far more time looking at the upside than the downside. Elizabeth Holmes at Theranos is an example of another founder who created a sense of excitement around the possibilities of her genius and turned that into support for her company from big-name businesspeople and board members, even though her product never worked as she said it did or could.
“In the case of FTX, there wasn’t a board. What those two companies [FTX and Theranos] have in common is the star power of two very dynamic, innovative individuals [that were] extremely persuasive,” Klinck said. “Despite probably bending or even breaking a number of rules that VCs have regarding governance, those all seemed to go by the wayside because of the euphoria of what this business was supposedly going to become.”
That said, a few bad apples don’t spoil the whole bunch for VC firms, Klinck continued. “There’s quite a positive track record of VCs that have invested in visionary founders. We’re talking about a couple that tipped over and were spectacular collapses, but there are a lot more that had been remarkable successes.”
He believes this is likely the justification or “escape hatch” for what happened: that the investors made a bad bet, but they made good bets on other companies that could make up for it.
VC and other investment firms may not change their tactics. VC thrives on big risk and big reward. While many companies that VC firms invest in will fail, firms still bet on a small few of their investments making it big and making up for losses in other areas. PitchBook estimates that VC firms are sitting on $290.1 billion of dry powder as of June 30, 2022. In addition to FOMO, more dry powder could very well have a role in VC firms investing rapidly and broadly to capture the next big thing.
“We shouldn’t overlook the growth of the venture industry in the last five years,” Klinck said. “There’s a little bit of a danger in the size of some of these funds now. They’re just so large and if the venture community doesn’t put them to work, their investors are going to be all over them.”
Klinck is both hopeful and skeptical that what happened at FTX will change the VC landscape.
“A lot of VC investments are about the future. They’re about the vision and the market opportunity and the ability to have a brand, celebrities, capture this enormous market share,” Klinck said. “I think the VCs did not do a deep enough job of looking at the present state of the business, not just the future state of the business.”
Klinck and Tepper agree that investors could do a better job going forward of ensuring proper due diligence and third-party auditing. But that likely won’t stop VC funds from looking to and investing in future possibilities.
“Without venture capital investment dollars, we wouldn’t have some of these incredible innovations,” Tepper said. “We [Artemis] want these founders to succeed because, at least with our fund’s investment thesis, these companies will positively impact everyone, either from a sustainability or a financial inclusion standpoint. In order to get funding, a founder has to be visionary—but they don’t have to be… fraudsters. We investors need to listen and look for red flags.”
The cycle of forgetfulness must be broken. Is FTX most comparable to Lehman Brothers Holdings, whose downfall affected an entire industry, or Enron Corp., whose demise was precipitated by fraudulent accounting practices? Media outlets are likening FTX to both. The Financial Times even dubbed FTX a “cryptocurrency exchange with weaker financial controls than Enron.”
These comparisons—and the wider industry impacts already felt at companies such as BlockFi, which received a credit line from FTX this summer and filed for bankruptcy in November—affirm that what happened at FTX is important beyond VC and the crypto market. On a large scale, however, lessons may take longer to learn, if they are learned at all.
“We have very short memories, and the finance industry, perhaps more than any other industry, has a tendency to repeat things that we learned only a few years ago,” Klinck said. “There are macroeconomic events and other market events that many individuals in the VC market have never experienced, based on their own age and demographic situation. And for those who have experienced it, the memory has become a bit dull. I think it’s a bold statement to say that because of Theranos, or because of FTX, there will be a permanent structural change in the behavior of investing.”
There may come regulation. It will likely focus on the crypto market, which will affect companies with exposure to cryptocurrencies. In fact, the Institute of Internal Auditors asked Congress in a letter in early December to bolster corporate governance requirements for cryptocurrency exchanges. But Tepper predicts that it will be a while yet before we see anything from governments or regulators, because there’s still so much information to unpack about what happened and it’s not clear what regulations to implement or how to implement them.
Even so, when speaking about Singapore-based Temasek’s investment in FTX, Singapore’s deputy prime minister, Lawrence Wong, said that investors in the crypto arena should be aware that they could lose their investments in crypto and that “no amount of regulation can remove this risk.”
“It’s not like this is never going to happen again. It can happen in any industry, but especially in an unregulated industry like crypto,” Tepper said.
In these circumstances, it comes down to individual boards to learn lessons from FTX. Boards everywhere will likely look at what happened at FTX and shore up their own companies’ risk oversight practices, including those pertaining to reputation risk, ensuring that their companies understand the two or three catastrophic events that could obliterate the companies from relevance or existence and that there are processes in place to watch out for early warning signs of such events.
“Every time something like this happens, board members look around the boardroom and they say, What can we do differently? A board that is a strong board may not need to do anything differently, but they will be able to talk about it and question it,” Tepper said.
Mandy Wright is senior editor of Directorship magazine.
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