FTX collapse pushes VCs to rethink oversight of crypto startups

“Many crypto entrepreneurs look at governance with disdain," said Salil Deshpande, general partner at Uncorrelated Ventures, an early-stage investment firm that sometimes invests in the crypto sector.

FTX, for example, didn’t have a standard board of directors, The Wall Street Journal has reported.

Venture investors might have enabled thin oversight as they piled into the crypto market, allowing traditional corporate-governance standards to sometimes take a back seat in deal negotiations amid competition. The collapse of FTX could force more venture investors to rethink their approach with crypto investments.

FTX raised close to $2 billion in funding from investors including Sequoia Capital, Paradigm and others, and was valued at about $32 billion at the start of the year. FTX, along with its affiliated trading firm Alameda Research, filed for bankruptcy protection on Friday. The Journal reported that FTX tapped customer accounts to fund risky investments made by Alameda. Sequoia Capital has told its limited partners that it is marking its $213.5 million investment in FTX to zero.

FTX didn’t reply to requests for comment.

FTX illustrates why there is a need for greater governance in crypto markets, said David Pakman, managing partner at crypto-focused investment firm CoinFund. “Investors should demand and expect a more traditional governance mechanism," Mr. Pakman said. CoinFund had a small equity investment in FTX that represented less than 1% of its assets under management, and has a small amount of assets on the FTX exchange, he said.

But enforcing such governance is difficult given that the blockchain sector is driven by the ideology that decision-making should be distributed widely, with some founders looking down on investor rights and oversight as it indicates a concentrated control over a business, Mr. Pakman said.

“One of its ethoses is decentralization, and what’s more centralized than a board?" Mr. Pakman said about crypto culture. “That ethos will be heavily challenged," he said, adding that sometimes a lack of board oversight results in too much control in the hands of the founder alone.

Sam Bankman-Fried, co-founder of FTX, apologized for the collapse of the crypto exchange last week on Twitter, saying that he had an inaccurate impression of the company’s leverage and liquidity.If FTX continues operating in the future, he added, “All of the stakeholders would have a hard look at FTX governance. …All of the stakeholders—investors, regulators, users—would have a large part to play in how it would be run." Mr. Bankman-Fried resigned from his role as chief executive on Friday.

Too often crypto entrepreneurs believe that crypto-token holders will provide the necessary governance, said Mr. Deshpande, of Uncorrelated Ventures. “But it’s grossly inadequate," he said, about supervision through token control. He said that he has had to persuade founders to include more governance provisions and reduced investment amounts in the past if that wasn’t happening.

Another factor in the relatively thin oversight of crypto firms is that many receive funding through “party rounds," where many investors take relatively small stakes in a startup. There were 8.7 investors on average in crypto startup deals in the U.S., compared with 4.7 in non-crypto venture investments last year, according to data from PitchBook Data Inc. Such deals can result in lower oversight, since no single investor has meaningful control over a company.

Another problem for corporate governance in crypto is that some investors are reluctant to take on board seats for legal reasons. A partner at a large crypto venture fund said that the firm avoids board seats because of the higher risk of liability in the crypto sector where regulatory gray areas abound.

It isn’t clear if more thorough due diligence by investors would have prevented the problems at FTX, said Greg Brogger, founder of Collective Liquidity Inc., a platform that gauges the share value of high-worth private companies. Some of the problematic behaviors might have happened after investors put the money in and conducted their diligence, he said.

“Unfortunately, crypto is such a relatively new market there are very few CEOs or founders with enough history behind them to be easily trusted managing billions of dollars worth of assets," Mr. Brogger said.

One potential upshot of the FTX bankruptcy: more federal oversight. Tomasz Tunguz, partner at Redpoint Ventures, said he expects to see more government regulations for entities taking customer deposits, similar to rules governing banks. “This is an important but painful evolution of the space," Mr. Tunguz said.

Still, even before the collapse of FTX, corporate governance was already becoming a bigger issue in the crypto market, driven by the rising participation of institutional limited partners, such as pensions and endowments. Limited partners have been requiring that venture funds invest only in projects that have a corporate entity and identify key people, for example, rather than letting founders take money anonymously, which sometimes occurs in crypto.

However, some deals were getting done quickly amid competition among venture investors to get positions in high-profile startups, leading to lighter than usual diligence, especially last year and the beginning of this year.

The crypto venture market has cooled considerably since its peak earlier this year amid a general downturn in high-growth investing related to rising interest rates and jitters after the bankruptcies of crypto startup Celsius Network LLC and crypto hedge fund Three Arrows Capital Ltd.

Crypto venture and hedge funds globally raised just $3.8 billion in the third quarter of 2022, down from $20.67 billion in the second quarter, according to data provider Messari.

Venture-capital deployment into crypto startups also dropped. Deal volume stood at just $4.9 billion globally for venture investments into crypto in the third quarter of this year, down from $7.5 billion in the prior quarter and the peak of $11.5 billion in the first quarter of this year, according to PitchBook.

The cooling in the market generally, coupled with the collapse of FTX, will likely put an even greater onus on governance for future crypto deals.

“Governance may seem like an administrative topic. It’s meant to prevent exactly what happened here," Mr. Pakman said. “We intend to reinforce standard tech norms of good governance," Mr. Pakman said, adding that CoinFund expects board seats for large investments and standard investor rights protections.