Saturday, December 3, 2022

The Meaning of FTX

When it comes to FTX, I’ll let the crypto people talk about the implications for that space generally, and I’m sure we all have our opinions on Samuel Bankman-Fried’s conduct – both before the collapse, and his endless apology tour afterwards – but what will live on for me is not any of that, but the 14,000 word hagiography that Sequoia had published on its website until very recently; they took it down after the bankruptcy declaration, though of course you can’t erase anything from the internet.

Sequoia has gotten a lot of flak for it not only for the fawning coverage, but because it revealed that Bankman-Fried actually was playing a video game during his pitch meeting.  More than that, after FTX raised $1 billion in its B round, it apparently held a “meme round” of financing, and raised $420.69 million from 69 investors.

Such revelations have inspired a lot of criticisms of the due diligence process today, not only by Sequoia but also by other FTX investors like Ontario Teachers’ Pension Plan.

But what really stood out to me not just was the evidence of due diligence failure, but the fact that Sequoia intentionally, by their own volition, put this article on its own website.  It wanted you to know that this was who they were funding, and this was the process they used.  They believed this would give them credibility, perhaps with founders, perhaps with their own investors – and they may very well have been right.

I’ve previously blogged (twice!), and written an essay about, about how the changes to the securities laws create these situations (though, of course, macroeconomic changes are responsible as well, as this Financial Times article explains).

In particular, my point is that the securities laws cultivate investors with particular preferences, and that leads to particular corporate outcomes.  As relevant here, in 1996, Congress gave the green light for private funds to raise unlimited amounts of capital, without becoming subject to registration under either the Securities Act or the Investment Company Act, so long as their own investors consist solely of persons with $5 million in assets.   At the same time, Congress and the SEC also made it easier for operating companies to raise capital while remaining private, so long as they mostly limit their investor base to these newly supercharged private funds.  The illiquid nature of the funding vehicles (necessitated by their private, non-tradeable status) encourages a short-termist orientation in search of a quick payout.  Due to the high-risk nature of these investments, private funds invest in multiple firms in the expectation that most will fail but a few will become outsized hits.  The result has been that one category of investor – wealthy, institutional, private, illiquid, risk-seeking, and with limited ability to express negative sentiment – has come to dominate the private markets.   And that’s how you end up with Sequoia bragging about funding being based on obscene numbers rather than DCF models. 

The securities laws are ultimately supposed to facilitate the efficient allocation of capital, but unfortunately, too much weight is being put on “let sophisticated investors make their own choices” and not enough on how these rules shape these sophisticated investors themselves and their preferences, which may not up end up aligning with society's preferences.

Ann Lipton | Permalink


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