How VCs' 'Suspension of Disbelief' Enabled FTX - And Its Collapse

As the FTX post-mortem continues, issues being raised include the role of sophisticated VCs in funding a company which had - especially in hindsight - such glaring governance issues. 

The funding environment - with a lot of money chasing few opportunities - fueled a 'suspension of disbelief' so VCs trying to put funds to work did want to risk being excluded for asking difficult questions. The larger concern is whether this is a lesson learned or - after Theranos, FTX, etc - this will continue to be considered just a cost of doing business. JL 

Fran Velasquez reports in Coindesk:

In the case of FTX, the red flags VCs missed may have in part been a “byproduct of the funding environment,” which made it easier for crypto startups to receive early-stage funding with "extremely low interest rates," as "tons of capital" flooded into the VC market. "When you have so many more bidders than opportunities, that moves the price up and [it] shortens diligence time [and] the amount of negotiation and leverage that VCs have in those conversations.” Discerning investors were turned off by the lack of oversight at FTX's board, (but) "VCs who were asking for that weren’t getting into the round." FTX’s collapse may address broader issues of “oversight, compliance [and] auditing”

The fallout of bankrupt crypto exchange FTX's collapse is a wake-up call for venture capitalists, Tom Schmidt, a partner at crypto-centered investment firm Dragonfly Capital, said Monday.

Schmidt told CoinDesk TV’s “First Mover” program that in the case of FTX, the red flags that VCs missed may have in part been due to the “byproduct of the funding environment,” which made it easier for crypto startups to receive early-stage funding with "extremely low interests," as "tons of capital" flooded into the VC market.

“Naturally, when you have so many more bidders than opportunities, that moves the price up and [it] shortens diligence time [and] the amount of negotiation and leverage that VCs have in those conversations,” Schmidt said.

But the market is different now. According to a report from investment-management firm Galaxy Digital, VC funding for crypto startups plunged 80% to $5.5 billion in the third quarter from a year ago, although the report also said that early-stage investing remained “competitive and robust,” while late-stage investing appeared to have shown signs of “notable weakness.”

Schmidt, who says that Dragonfly Capital is looking to back teams that are in the early stages of development, implied that the amount of money available from funds that didn’t ask tough questions more than offset the amount from more discerning investors who were turned off by the lack of oversight at FTX's board.

“The VCs who were asking for those weren’t getting into the round, and that’s sort of where the rounds ended up getting cleared,” Schmidt said, adding that at the time, “things may have looked fine.”

Now, the tide for VCs may be “shifting,” giving investors more “leverage in negotiations,” Schmidt said.

FTX’s collapse may be a marker for addressing the broader issues of “oversight, compliance [and] auditing” and that may weed out some founders, he said.

“The type of skills that you need as a seed-stage founder are very different than what you need at a Series C and beyond,” Schmidt said.

Half of the San Francisco-based firm’s portfolio is composed of investments in decentralized-finance (DeFi) and non-fungible tokens (NFTs) projects, which Schmidt says is an effort to give the community control over a protocol earlier on, reducing the role that a founder needs to play in a project’s long-term growth.