If you want to better understand what a big deal it is that cryptocurrency exchange FTX just imploded, you could do worse than speaking to David Pakman, an entrepreneur-turned-venture-capitalist. After 14 years at investment firm Venrock, Pakman — who led Venrock’s investment in digital collectibles company Dapper Labs and even mined Bitcoin in his own home years ago — reignited his passion for digital assets and joined the now seven-year-old crypto last year -Venture firm CoinFund.
His timing was either very good or very bad depending on how you view the market. In fact, partly because CoinFund was an early investor in the collapsing cryptocurrency exchange FTX, we asked Pakman to call us today to talk about what has been a very wild week, one that started with FTX soaring on the ropes and what’s up ended with bankruptcy filing and the resignation of FTX founder Sam Bankman-Fried as CEO. The following are excerpts from that interview, edited slightly for length and clarity.
TC: The last time we spoke almost two years ago, the NFT wave was on. Now we’re talking about a day when one of the largest cryptocurrency exchanges in the world just filed for bankruptcy. In fact, it files for bankruptcy for 130 other subsidiaries. What do you think of this development?
DP: I think it’s absolutely awful on a lot of levels. First, it was a completely avoidable tragedy. This company failure was caused by a series of flawed human decisions, not a failed company. The core business is going extremely well. In fact, it’s highly profitable and growing, even in a bear market. It’s not like it ran out of capital or fell victim to the macro environment. But his leadership has apparently made a series of terrible decisions with almost no oversight and got things really wrong. So the tragedy is how avoidable it was and how many casualties there are including employees and shareholders and hundreds or even thousands of customers who will be affected [by this bankruptcy].
Add to this the reputational damage for the entire crypto industry, which is already suffering from questions like “Isn’t this a scam place with scam people?” This sort of Enron-like meltdown of one of the highest-rated, and arguably most successful, companies in the industry is just really bad, and it’s going to take a long time to dig up. But there are also positives.
On the positive side, the technology hasn’t failed; The blockchains have not failed. The smart contracts were not hacked. Everything we know about the technology behind crypto continues to work great. So it would be different if this was a meltdown due to flawed software design, or the blockchains not scaling, or big hacks that hurt people. The long-term promise of the software and technology architecture over crypto is intact. It’s the people who keep making mistakes. We’ve had two or three pretty big man-made bugs this year.
There’s a lot of news out there that broadly describes 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, that’s their token that was held in bulk by Alameda and they pledged it as collateral and took big fiat loans against it. So they took a very volatile asset and pledged it as collateral.
One could imagine someone saying, “Wait a minute. What happens if the FTT drops by 50%? It happens with high frequency in crypto, right? So why are we pledging this super high volatile asset? Incidentally, our biggest competitor has half a billion dollars in assets [Binance]. What happens when they put it on the market?’
So it wasn’t wise to just borrow something against it. And then it sounds like they took the proceeds from that borrowing as well and invested them in highly illiquid assets, like bailing out BlockFi or all those other private companies that FTX bought recently. But it’s not like they could sell these quickly if they had to return the proceeds of their borrowing. They also apparently took advantage of client funds and lent them or maybe even lent them to their trading arm. So all of these things are just things that I think a board, if they knew about, would say no, no.
But there was no board, which is stunning considering VCs have poured $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 firm made in FTX is a long time ago, before my time, and it’s a tiny, tiny amount. We’re barely on the cap table. We did not hold FTT tokens.
But I’m going to address your big question, which I think is about running this company. I come from a traditional tech investment background where maybe 99% of the time there is just one standard governance that every entrepreneur agrees to when raising venture capital, which is: there will be a board of directors; the board will be composed of investors and employees and perhaps external experts; there will be a series of controls; The controls usually say things like, “You need to disclose all related party transactions so you don’t mix coconuts between one company and something else that we don’t know about.” The board also has to approve things so that if you’re pledging assets as collateral for loans, you can’t issue new stock without it [the board] know about it.
The fact that none of that was here is amazing. And I hope what comes out of this Enron-like moment in crypto is that any loose norms that have existed about not giving that level of oversight and governance as part of investing go away immediately.
Everything is so strongly correlated. Crypto investor Digital Currency Group is reportedly giving a $140 million equity infusion to a derivatives deal in its portfolio called Genesis Global Trading because Genesis has about $175 million locked up in its FTX account. How bad is this going to get? What percentage of your own investment portfolio is affected here because of FTX’s failure?
How badly 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 haven’t held any of our assets with FTX, either the US or international business. [As for broader implications], I don’t think any of us know the full, long-term implications of what’s happening here because there’s such a thing as contagion, is there? How many other funds if companies and investors have assets on FTX and how long will it take to get those funds back? One has to assume that the whole thing will turn into a massive bankruptcy procedure that will take many months or years to complete. And so there’s going to be this uncertainty, not just about when you’ll get money back, but how much you’ll get.
The overwhelming majority of the startups we invest in do not trade on FTX and therefore have not been clients. But FTX has been very useful in providing a launch pad for tokens to become liquid and then either creating a market for those tokens or at least giving them 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 requires those tokens to eventually become liquid and trade on exchanges and FTX has been one of the biggest places where this was the case tokens were traded. And now you lose this.
How does this affect your day-to-day investment business? I saw the news that CoinFund is trying to raise a new $250 million fund, that it filed SEC filings on November 1, after closing a $300 million fund three months ago. Do you have to stick a pin in there now? I’m sure this debacle makes LPs nervous.
We have spoken to many of our LPS over the past 48 hours. I think most people process it. They ask, like you ask, “What happened here?”
I think late stage capital will freeze here for a while. The dust really needs to go. And capital is unlikely to be attracted to a tragedy like this.
Startup valuations have a more immediate impact. Evaluating startups is an imperfect process undertaken by investors in illiquid markets, and one way to do it is by looking at benchmarks. And one of the brightest star comps pointed out by almost everyone in crypto was FTX. If FTX is worth $40 billion, we are worth X. So take the highest rated crypto company with venture capital, and it goes from $40 billion to zero, then who is the new crypto value cap? It directly impacts late-stage valuations.