Crypto VC David Pakman on FTX: A “Completely Avoidable Tragedy”

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If you want to better understand the big deal that cryptocurrency exchange FTX just imploded, you could do worse than talk to David Pakman, an entrepreneur turned venture capitalist. After working for the investment firm Venrock for 14 years, Pakman – who led Venrock’s investment in the digital collectible Dapper Labs and even mined bitcoin years ago in his own home – leaned into his passion for digital assets and last year joined the now seven-year-old crypto venture CoinFund.

His timing was either very good or very bad, depending on your view of the market. Indeed, partly because CoinFund was an early investor in the collapsing cryptocurrency exchange FTX, we asked Pakman to come on the phone with us today to talk about this very wild week, one that started with high-flying FTX on the ropes, and which ended with bankruptcy filings and the resignation of FTX founder, Sam Bankman-Fried, as CEO. Fragments of that conversation follow, lightly edited for length.

TC: The last time we spoke, almost two years ago, the NFT wave was just getting started. Now we are talking about a day when one of the largest cryptocurrency exchanges in the world just declared bankruptcy. Actually, it is declaring bankruptcy for 130 additional member companies. What do you think of this development?

DP: I think it’s absolutely terrible on a number of levels. First, it was a completely avoidable tragedy. This company failure was caused by a bunch of flawed human decision-making, not a failing company. The core business is doing very well. In fact, it is very profitable and growing even in a bear market. It’s not like running out of capital or being a victim of the macro environment. But the leadership, apparently almost unsupervised, made some terrible decisions and got things really wrong. So the tragedy is how avoidable it was, and how many victims there are, including employees and shareholders and the hundreds or even thousands of customers that will be affected. [by this bankruptcy].

There is also the reputational damage for the entire crypto industry, which is already suffering from questions like, “Isn’t this a scam with scammers?” This kind of Enron-esque collapse of one of the most highly regarded and arguably most successful companies in the space is just really bad, and it will take a long time to dig out. But there are also positives.

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Positives?

Well, what’s positive is that the technology didn’t fail; the blockchains did not fail. The smart contracts are not hacked. Everything we know about the technology behind crypto continues to work brilliantly. So it would be different if this was a meltdown due to flawed software design, or not scaling the blockchains, or major hacks injuring people. The software and technology architecture’s long-term promise over crypto is intact. It’s the people who keep making mistakes. We’ve had two or three pretty big man-made mistakes this year.

There are plenty of news stories that broadly describe what happened. How do you explain it?

I don’t know firsthand what they really did or didn’t do. But apparently FTX and [the trading desk also owned and run by Sam Bankman-Fried] Alameda Research had a relationship that may not have been known to all shareholders, employees or customers. And it sounds like FTX took FTT, which is their token that was held in large quantities by Alameda, and they put it as collateral and took fiat big loans against it. So they took a highly volatile asset and pledged it as collateral.

You might imagine that if a board of directors or investors knew about this, someone would say, “Hold on. What happens if the FTT falls by 50%? It happens in high frequency crypto, right? So, like, why are we pledging this super highly volatile asset? And by the way, half a billion dollars in assets are in the hands of our biggest rival [Binance]. What happens if they dump it on the market?’

So borrowing alone was unwise. And then it sounds like they also took the proceeds of that loan and invested that in very illiquid assets, like maybe to save BlockFi or all these other private companies that FTX bought recently. But it’s not like they could sell it quickly if they had to repay the proceeds of their loan. They also apparently took customer money and lent it or maybe even lent it to their branch of trade. So all these things are just things that I think a sign, if they knew about it, would be like, no, no.

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But there was no board, which is mind-boggling given that VCs have put $2 billion into this company. Your company is one of those companies.

I joined CoinFund a little over a year ago, so the investment the company made in FTX was way back before my time, and it’s a very small amount. We’re barely on the cap table. We had no FTT tokens.

But I’ll get to your big question, which I think is about the governance of this company. I come from a traditional tech investment background, where maybe 99% of the time there’s just a standard set of governance that every entrepreneur agrees to when they take venture capital, namely: there’s going to be a board; the board will consist of investors and employees and perhaps outside experts; there will be a series of checks; the controls usually say things like, “You need to disclose related party transactions,” so you don’t shuffle coconuts between one company and something else we don’t know about. The board also has to approve things so that when you start pledging assets as collateral for borrowing, you can’t issue new shares without [the board] knowing about it.

The fact that none of that was here is mind-boggling. And I hope that what comes of this Enron-esque moment in crypto is that any loose standards that were there about not giving that level of oversight and governance as part of investing immediately disappear.

Everything is so highly correlated. Crypto investor Digital Currency Group is reportedly giving a $140 million equity injection to a derivatives company in its portfolio called Genesis Global Trading, as Genesis has approximately $175 million dollars in its FTX account. How bad is this going to get? What percentage of your own investment portfolio is affected here by the failure of FTX?

How Much Are We Affected At CoinFund? It’s negligible because we had such a small investment in this company from one of our funds and we had none of our assets with FTX, neither its US nor international operations. [As for broader implications]”I don’t think any of us know the full long-term impact of what’s happening here because there’s some kind of contagion, right? Like, how many other funds when companies and investors have assets with FTX and how long does it take to get those funds back? One must assume that the whole matter will end up in a massive bankruptcy proceeding that will take many months or years to settle. And so there will be uncertainty, not only about when you will get money back, but also about how much you will get.

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The vast majority of the startups we invest in do not trade on FTX and thus were not clients. But FTX was very useful to provide a launch pad for tokens to become liquid, and then create a market for those tokens or at least provide them with a place to trade and provide liquidity. A big part of crypto today is not just raising equity, but creating tokens and using tokens as an incentive mechanism, and that at some point requires these tokens to become liquid and traded on exchanges, and FTX was one of the largest places where tokens traded. And you’ve lost that now.

How does that affect your daily activities of making investments? I’ve seen the news that CoinFund is looking for a new $250 million fund, which it filed SEC papers on Nov. 1 after closing a $300 million fund three months ago. Do you have to put a pin in that now? I’m sure this debacle makes LPs nervous.

We’ve been talking to many of our LPS over the past 48 hours. I think most people are processing. They ask, as you ask, “What happened here?”

I think capital will freeze a little bit here in the late stages. The dust really needs to go. And capital is unlikely to be attracted to a tragedy like this.

A more direct impact is on startup valuations. Valuing startups is an imperfect process performed by investors in illiquid markets, and one way it’s done is by looking at comparable companies. And one of the brightest star compositions that just about everyone in crypto pointed to was FTX. If FTX is worth $40 billion, we are worth X. So you take the most valued venture-backed crypto company, and it goes from $40 billion to zero, who’s the new ceiling of crypto value? It immediately affects late stage valuations.