If you want to better understand exactly how big a deal it is that the cryptocurrency exchange FTX just imploded, you could do worse than talk with David Pakman, an entrepreneur turned venture capitalist. After logging 14 years with the investment firm Venrock, Pakman — who led Venrock’s investment in the digital collectibles company Dapper Labs and even mined bitcoin at his own home years back — leaned into his passion for digital assets and last year joined the now seven-year-old crypto venture 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 collapsing cryptocurrency exchange FTX, we asked Pakman to jump on the phone with us today to talk about this very wild week, one that began with high-flying FTX on the ropes, and which ended with bankruptcy filings and the resignation of FTX founder, Sam Bankman-Fried, as CEO. Excerpts of that conversation follow, edited lightly for length and clarity. You can hear our longer conversation here.
TC: The last time we talked, almost two years ago, the NFT wave was just getting underway. Now, we’re talking on a day where one of the biggest cryptocurrency exchanges in the world just declared bankruptcy. Actually, it’s declaring bankruptcy for 130 additional affiliated companies. What do you make of this development?
DP: I think it’s absolutely terrible on a bunch of levels. First, it was an entirely avoidable tragedy. This failure of the company was brought on by a bunch of flawed human decision-making, not by a failing business. The core business is doing great. In fact, it [was] highly profitable and growing, even in a bear market. It’s one of the most-used non-U.S.-based crypto exchanges and with a big derivatives business. It wrote a lot of really good software. It’s not like it was running out of capital or a victim of the macro environment. But its leadership, with almost no oversight apparently, made a bunch of terrible decisions and did 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 who will be affected [by this bankruptcy].
There’s also the reputational harm to the entire crypto industry, which already suffers from questions like, ‘Isn’t this a scammy place with scammy people?’ This sort of Enron-esque meltdown of one of the most highly valued and arguably most successful companies in the space is just really bad, and it will take a long time to dig out of it. But there are also positives.
Well, what’s positive is the technology did not fail; the blockchains did not fail. The smart contracts were not hacked. Everything we know about the tech behind crypto continues to work brilliantly. So it would be different if this was a meltdown because of flawed software design, or the blockchains aren’t scaling, or big hacks that injured people. The long-term promise of the software and the technology architecture about crypto is intact. It’s the people who keep making mistakes. We’ve had two or three pretty big human-generated mistakes this year.
There are plenty of news stories out there outlining what happened in broad strokes. How do you explain it?
I don’t have firsthand knowledge about 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 maybe was not known to all shareholders, employees or customers. And it sounds like FTX took FTT, which is their token that was held in great amounts by Alameda, and they pledged it as collateral and took big loans in fiat against that. So they took a highly volatile asset, and they pledged it as collateral.
One could imagine if a board of corporate executives or investors knew about that, someone would say, ‘Hang on. What happens if FTT goes down by 50%? It happens in crypto with high frequency, right? So, like, why are we pledging this super highly volatile asset? And by the way, half a billion dollars’ worth of the asset is held by our biggest rival [Binance]. What happens if they dump it in the market?’
So just the act of borrowing against it was ill-advised. And then it sounds like they also took the proceeds of that borrowing, and they invested that in highly illiquid assets, like maybe to rescue BlockFi or all these other private companies that FTX recently bought. But it’s not like they could quickly sell out of those if they needed to return the proceeds of their borrowing. They were also apparently using customer funds and loaning that out or maybe even loaning it to their trading arm. So all this stuff is just stuff that I think a board, if they knew about it, would be like, ‘No, no, these are total nonstarters, we’re not doing any of that stuff, it’s too high risk.’
But there was no real board, which is mind blowing, considering that VCs poured $2 billion into this company. Your firm is among those firms.
I joined CoinFund a little bit more than a year ago, so the investment that the firm made in FTX was a long time ago, before my time, and it’s a tiny, tiny amount. We’re barely on the cap table. We didn’t hold any FTT tokens.
But I will address your big question, which I think is about the governance of this company. I come from a traditional tech investing 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, which is: there’s going to be a board; the board is going to be made up of investors and employees and maybe outside experts; there’s going to be a set of controls; the controls usually say things like, ‘You have to disclose any related party transactions so you don’t shuffle coconuts between one company and something else that we don’t know about.’ The board also has to approve things, so that whenever you’re going to pledge assets as collateral for borrowing, you can’t issue new shares without [the board] knowing about it.
The fact that none of that was present here is mind-boggling. And I hope what comes of this Enron-like moment in crypto is that whatever loose norms there were about not giving that level of oversight and governance as part of investing goes away immediately.
Everything is so highly correlated. Crypto investor Digital Currency Group is reportedly giving a $140 million equity infusion to a derivatives business in its portfolio called Genesis Global Trading because Genesis has about $175 million dollars locked in its FTX account. How bad is this going to become? What percentage of your own investment portfolio is being impacted here because of FTX’s failure?
How much are we at CoinFund impacted? It’s negligible because we had such a tiny investment in this company from one of our funds and we held none of our assets at FTX*, either its U.S. or international business. [As for broader implications], I don’t think any of us knows the full, long-term impact of what’s happening here because there’s like some contagion, right? Like, how many other funds when companies and investors have assets at FTX and how long will it take to get those funds back? One must assume that the entire thing goes into a massive bankruptcy proceeding that takes many months or years to unwind. And so there’ll be this uncertainty, not just about when you’re getting money back but how much you’re getting.
The overwhelming majority of the startups that we invest in aren’t trading on FTX and so they weren’t customers. But FTX was very useful for providing a launching pad for tokens to become liquid, and then either making a market for those tokens or at least providing a place for them to trade and providing liquidity. A big part of crypto today is not just raising equity capital but creating tokens and using tokens as an incentive mechanism, and that requires at some point for these tokens to become liquid and trade on exchanges, and FTX was one of the largest places where those tokens traded. And now you lose that.
How does that affect your day-to-day business of making investments? I did see the news that CoinFund is looking to raise a new $250 million fund, that it filed SEC paperwork on November 1 after closing a $300 million fund three months ago. Will you have to put a pin in that now? I’m sure this debacle has LPs feeling nervous.
We’ve talked to a lot of our LPs in the last 48 hours. I think most people are processing. They’re asking, like you’re asking, ‘What happened here?’
I think late-stage capital will freeze up for a little bit here. The dust really needs to clear. And it’s unlikely that capital is attracted to a tragedy like this.
A more immediate impact is on startup valuations. Valuing startups is an imperfect process done by investors in non-liquid markets, and one way it’s done is to look at comparables. And one of the brightest star comps that just about everyone in crypto pointed to was FTX. If FTX is worth $40 billion, we’re worth X. So you take the most highly valued venture-backed crypto company, and it goes from $40 billion to zero, then who is the new ceiling of crypto value? It immediately impacts late-stage valuations.
* After our interview with Pakman, he learned he’d misspoke when he said CoinFund had no assets on the exchange. It has a small amount of exchange assets on FTX International that it was in the process of transacting.
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