The encounter is a dream come true for the scriptwriters who are already hard at work on the film version of events. In 2021, Sequoia Capital, a large venture capital (VC) firm, made its first investment in FTX, a now bankrupt cryptocurrency exchange. To publicize the agreement, Sequoia posted part of the transcript of the virtual pitch meeting on its website. Sam Bankman-Fried, the founder of FTX, explained that he wanted the company to be a “superapp” where “you can do whatever you want with your money from within FTX.” Sequoia investors swooned. “Love this founder,” one said in a chat feature; “Yes!!!!” said another. An FTX executive who sat next to Mr. Bankman-Fried during the pitch noticed another detail: “Turns out that motherfucker was playing ‘League of Legends’ the whole meeting.”
It also turns out that ftx was doing more with the customers’ money than it promised. His disappearance forced Sequoia to write down its $210 million investment. It will also hurt another beleaguered backer. On November 11, SoftBank, a Japanese conglomerate turned technology investor, announced that its Vision funds, which focus on venture capital investments, had lost about $10 billion in the three months to September. The company is expected to write off about $100 million of its investment in ftx.
This adds to a series of bad news for tech investors. Since the tech downturn began last December, many Silicon Valley darlings have gone bankrupt, including Fast, an online payment company, and LendUp, a payday loan provider. There has also been a flurry of other explosions in cryptoland, such as the failure of Three Arrows Capital, a hedge fund, and Voyager Digital, a lender.
Venture capital investing is all about taking risks. An investor can expect only two companies to succeed out of a portfolio of ten, hoping that the outsized returns from the stars compensate for the misfires. Usually the risk is greater when companies are young and cheap. But FTX’s valuation in January was $32 billion. Many believe that the industry’s inability to notice that something was wrong is symptomatic of larger issues. “Venture capital is in la-la land,” says one industry veteran. There are three areas of risk: governance, due diligence and a focus on growth at all costs.
The problems are the hangover from years of explosive growth. Today, the market is flat due to high inflation, rising interest rates and the war in Ukraine. But in 2021, venture capital investment hit a record $630 billion, double the previous record set the previous year. Part of the reason for the growth was new entrants. SoftBank raised its first venture capital fund, worth $100 billion, in 2017. After that, crossover investors (which back both public and private companies), such as Tiger Global and Coatue, also started looking for more deals with startups.
The new entrants have created fierce competition and injected much more capital into the market. This meant that some investors “started to streamline a set of governance structures that would have been unthinkable before,” says Eric Vishria of Benchmark, a venture capital firm. In the past, venture capitalists were expected to sit on the boards of companies in which they made significant investments. This is no longer the case. FTX had no investors on its board. Tiger, for example, has invested in around 300 companies in 2021 with few board seats in return.
Due diligence is another issue. Before the boom years, investors had weeks to scrutinize a company’s founders and grill customers. As competition intensified, lead times got shorter. Some hot startups only gave investors 24 hours to make an offer. For many, the risk of missing the next Google was too great. As a result, much of the due diligence went out the window. Instead, some investors have used the involvement of big companies, such as Sequoia or Andreessen Horowitz, as a shortcut test. If a renowned venture capital firm invested in a startup, according to the theory, it had to be a safe bet. This logic is currently being revised. (Sequoia says it performs “rigorous” due diligence on all companies in its portfolio.)
The industry’s obsessive focus on growth presents the final problem. Many investors are pushing startups to grow at all costs, especially after major funding rounds. But not every company can truly sustain this supercharged growth model, argues Mark Goldberg of Index Ventures, another venture capital firm. Startups that get swept up risk falling flat. This includes companies such as WeWork, a flexible office rental company that halted its initial public offering in 2019, and Opendoor, a real estate company that has been stung by falling house prices this year. “It’s like giving kerosene to cars,” Goldberg adds. “If you do that, bad things will happen.”
The market slowdown has, for now, relieved some of the pressure on the industry. In most cases, investors say they now have more time for due diligence. Governance could also improve, thanks to FTX’s setbacks and the fact that the crisis has given investors more bargaining power. But, as the recession drags on, more Silicon Valley startups will struggle to raise the capital they need. The hangover of 2021 has only just begun.
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From The Economist, published under licence. Original content can be found at https://www.economist.com/business/2022/11/17/ftxs-failure-and-softbanks-struggles-point-to-a-tech-investing-hangover