If you want to better understand exactly how important it is that cryptocurrency exchange FTX just imploded, you could do worse than talk to entrepreneur-turned-venture capitalist David Pakman. After spending 14 years with investment firm Venrock, Pakman — who led Venrock’s investment in digital collectibles company Dapper Labs and even mined bitcoin at home years ago — is leaning on his passion for digital assets and last year joined the now seven-year-old venture capital firm CoinFund.
His timing was either very good or very bad, depending on your view of the market. Indeed, in part because CoinFund was an early investor in the collapse of cryptocurrency exchange FTX, we asked Pakman to hop on the phone with us today to talk about this very week. savage, which began with high-flying FTX on the ropes, and ended with bankruptcy filings and the resignation of FTX founder Sam Bankman-Fried as CEO. Excerpts from that conversation follow, lightly edited for length and clarity. You can hear our longer conversation here.
TC: When we last spoke, almost two years ago, the NFT wave was just beginning. Now we are talking about a day when one of the largest cryptocurrency exchanges in the world just declared bankruptcy. In fact, he declares bankruptcy for 130 other affiliates. What do you think of this development?
DP: I think it’s absolutely terrible on many levels. First, it was an entirely preventable tragedy. This business failure was caused by a bunch of wrong human decisions, not a failing business. The core business is doing well. In fact, he [was] very profitable and growing, even in a bear market. It is one of the most widely used non-US crypto exchanges and with a great deal of derivatives activity. He wrote a lot of very good software. It’s not like it’s running out of capital or falling victim to the macro environment. But its leaders, seemingly unsupervised, made a bunch of terrible decisions and did the wrong thing. So the tragedy is how preventable it was and how many casualties there are, including employees and shareholders and the hundreds if not thousands of customers who will be affected. [by this bankruptcy].
There’s also the reputational damage to the entire crypto industry, which is already suffering from questions like “Isn’t this a scam place with scammers?” This kind of Enron-like collapse of one of the most beloved and arguably most successful companies in the space is really bad, and it will take a long time to come out of it. But there are also positives.
Well, the good news is that the technology hasn’t failed; blockchains have not failed. Smart contracts have not been hacked. Everything we know about the technology behind crypto continues to work brilliantly. So it would be different if it was a meltdown because of faulty software design, or if blockchains aren’t scalable, or if big hacks hurt people. The long-term promise of the software and technology architecture regarding cryptography is intact. These are the people who keep making mistakes. We’ve had a couple of pretty big man-made errors this year.
There are many news reports describing what happened in broad strokes. How do you explain it?
I have no direct knowledge of what they actually 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 looks like FTX took FTT, which is their token held in large amounts by Alameda, and they pledged it as collateral and took out big fiat loans against it. So they took a very volatile asset and pledged it as collateral.
One would imagine that if a board of directors made up of corporate executives or investors knew about this, someone would say, “Wait. What happens if the FTT drops by 50%? This happens in crypto with high frequency, doesn’t it? So why are we pledging this highly volatile asset? And by the way, half a billion dollars of assets are held by our biggest rival [Binance]. What if they throw it on the market? »
So simply borrowing against her was ill-advised. And then it looks like they also took the proceeds from that borrowing and invested it in some highly illiquid assets, like maybe saving BlockFi or all those other private companies that FTX recently bought. But it’s not like they could sell them quickly if they needed to return the proceeds of their loan. They also apparently used customer funds and lent them or maybe even lent them to their trading arm. So all of this stuff is just stuff that I think a board of directors, if they knew about it, would be like, ‘No, no, these are non-starters, we don’t do any of that, c ‘is too high a risk.’
But there was no real board of directors, which is mind-blowing considering that VCs poured $2 billion into this company. Your company is one of these companies.
I joined CoinFund a little over a year ago, so the investment the company made in FTX was a long time ago, before my time, and it’s a very small amount. We are barely on the ceilings table. We did not hold any FTT tokens.
But I’ll answer your big question, which I think has to do with the governance of this company. I come from a traditional tech investing background, where maybe 99% of the time there is only one standard set of governance that every entrepreneur agrees to when taking on venture capital, which is: there will be a board of directors; the board will be made up of investors and employees and possibly outside experts; there is going to be a set of controls; controls typically say things like, “You must disclose all related party transactions so you don’t mix the coconuts between one company and something else we know nothing about.” The board also has to approve things, so whenever you go to pledge assets as collateral for a loan, you can’t issue new shares without [the board] the knowledge.
The fact that none of that was present here is mind-boggling. And hopefully what happens from this Enron-like moment in crypto is that all the loose norms that existed about not giving that level of oversight and governance as part of the investment disappear immediately.
Everything is so intertwined. Crypto investor Digital Currency Group reportedly gave a $140 million equity injection to a derivatives firm in its portfolio called Genesis Global Trading, as Genesis has around $175 million locked in its FTX account. How bad is it going to get? What percentage of your own investment portfolio is affected here due to the failure of FTX?
How impacted are we at CoinFund? This is negligible because we had such a small investment in this company from one of our funds and we did not hold any of our assets at FTX*, either its US or international operations. [As for broader implications], I don’t think any of us know the full, long-term impact of what’s going on here because there’s kind of a contagion, right? For example, how many other funds when companies and investors have assets at FTX and how long will it take to recover those funds? It must be assumed that all of this goes into a massive bankruptcy proceeding that takes many months or years to unfold. And so there will be this uncertainty, not just about when you get money back, but how much you get.
The overwhelming majority of startups we invest in do not trade on FTX and therefore were not clients. But FTX has been very helpful in providing a launchpad for tokens to become liquid and then either creating a market for those tokens or at least providing a place for them to trade and provide liquidity. Much of crypto today is not just about raising equity, but about creating tokens and using them as an incentive mechanism, and that requires those tokens to become liquid and trade at some point. on the exchange, and FTX was one of the biggest places these tokens traded. And now you lose that.
How does this affect your day-to-day investing activities? I saw the news that CoinFund was looking to raise a new $250 million fund, which it filed with the SEC on Nov. 1 after closing a $300 million fund three months ago. Should you put a pin now? I’m sure this debacle is making LPs nervous.
We’ve spoken to many of our LPS over the past 48 hours. I think most people deal. They ask, like you ask, ‘What happened here?’
I think late stage capital will freeze a bit here. The dust really needs clearing. And capital is unlikely to be drawn to a tragedy like this.
A more immediate impact is on startup valuations. Valuing startups is an imperfect process done by investors in illiquid markets, and one way to do it is to look at comparables. And one of the brightest star comps that almost everyone in crypto highlighted was FTX. If FTX is worth $40 billion, we’re worth X. So you take the most valued crypto company, and it goes from $40 billion to zero, so who’s the new crypto value cap? This has an immediate impact on late valuations.
* After our interview with Pakman, he learned that he misspoke when he said that CoinFund had no assets on the exchange. He has a small amount of trading assets on FTX International that he was trading.