The Bahamas-based cryptocurrency exchange FTX was established in 2019 and, at its peak in 2021, it had over a million users and was the third-largest crypto exchange by trading volume.
FTX raised nearly $ 2 billion from over 80 investors in just two years. However, on the 11th of November 2022, the crypto exchange faced a cash shortfall of $8 billion and filed for bankruptcy due to a liquidity crisis and accusations of fraud. The Justice Department and the Securities and Exchange Commission are examining whether FTX improperly used customer funds to prop up a separate trading firm, Alameda Research, which Mr. Bankman-Fried also founded.
But how did this happen?
According to investors, the entrepreneur left little room for negotiation. “FTX was his company and he planned to run it with little oversight. Interested investors should “support him and observe,”
In an interview with The New York Times in April, one of FTX's top executives, Ramnik Arora, described a video call between Mr. Bankman-Fried and partners at a prominent venture company last year “Mr. Bankman-Fried played a video game while delivering a presentation during the meeting. He was playing League of Legends throughout the entire partner meeting”
Before another meeting, investors requested that Mr. Bankman-Fried put together a slide deck. The presentation was put together by the entrepreneur in a matter of hours.
According to Mr. Arora, fonts were everywhere and there was no formatting at all. “You can just feel discomfort — both sides — because the investors are like, ‘How the hell are we being shown a deck that no one spent any time on?’”
However, it seems like Investors weren't offended. Over the years, they had been loosening the deal-making procedures that gave them control over a company and protected their investments. It was a way to get into the best deals as money from all over the world flooded into high-growth start-ups. The tendency was intensified by overlapping investment trends in cryptocurrencies, equities, and start-up valuations last year.
NEA, IVP, Iconiq Capital, Third Point Ventures, TigerGlobal, Altimeter Capital Management, Lux Capital, Mayfield, Insight Partners, Sequoia Capital, SoftBank, Lightspeed VenturePartners, Ribbit Capital, Temasek Holdings, BlackRock, and Thoma Bravo are just a few of the well-known investment firms that have funded FTX.
Investors who dared advise Mr. Bankman-Fried that a more experienced executive run the business were likely to be excluded from further rounds of funding as he was very resistant to outside input.
Despite raising $2 billion, he remained the majority owner of the company. No investors joined FTX’s board of directors and the company did not inform investors about the nature of its business with Alameda Research.
Earlier this year Mr. Bankman-Fried accused venture capital investors of doing deals based on a fear of missing out, rather than financial models during an interview with Bloomberg. And maybe he was right.
By investing in FTX, investors were able to own a piece of the hottest startup in an industry that was predicted to grow as much as mobile apps or the internet itself. Many investors have publicly said that they supported the deal. Sequoia went so far as to post a flattering profile of Mr. Bankman-Fried online. However, investors are now under scrutiny too.
Due diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all relevant facts and financial information and to verify everything that was brought up during an M&A deal or investment process (CFI, 2022)
This is one of the most important compliance components and its neglect may lead to serious consequences. Failing to conduct proper regulatory due diligence can be likened to failing to conduct a proper home inspection before purchasing a home.
Another factor that everybody neglected is the system by which companies are controlled and directed, also known as corporate governance. One would have expected that such reputable and experienced investors would have some sort of influence over the board of directors after providing the company with substantial amounts of funding. Risks and failure, however, are not unexpected or shocking given that this was a multibillion-dollar firm, solely managed by one person.
Although it may come as a shock to some, it's not unusual to see big-name VC firms skip due diligence procedures. Theranos, the blood testing startup founded by entrepreneur Elizabeth Holmes, has been another recent example of the dangers of inadequate due diligence for VC investors and for the IPO later on.
Due to false claims regarding its blood-testing technology, Theranos shut down in 2018. After purposefully misleading investors in Theranos Inc., Holmes was later found guilty of four counts of fraud and was recently sentenced to serve more than 11 years in prison. According to one of Holmes’ investors, they requested audited financial statements from Theranos but never received any. That didn’t stop them from investing $6 million in the company anyway.
We can only hope that these cases will serve as a reminder to investors of the risks and encourage them to make investment decisions the old-fashioned way, by thoroughly researching a company before making any promises.
Due diligence (2022) Corporate Finance Institute. Available at: https://corporatefinanceinstitute.com/resources/valuation/due-diligence-overview/ (Accessed: November 17, 2022).
Griffith, E. and Yaffe-bellany, D. (2022) Investors who put $2 billion into FTX face scrutiny, too, The New York Times. The New York Times. Available at: https://www.nytimes.com/2022/11/11/technology/ftx-investors-venture-capital.html?searchResultPosition=6 (Accessed: November 17, 2022).