First, two caveats:
- I have invested in two outright frauds in my life (to my knowledge) and lost in total a few million dollars on them. At the seed investment stage, losing around 1% to things that turn out to be frauds probably says you’re being innovative.
- I pick on Marc Andreessen for his “no additional work required” line, which he sent to Elon Musk to confirm his nine-figure investment in Musk’s Twitter deal, because it is just too good. However:
- I think it is incrementally more reasonable when the acquisition target is already a public entity, and
- It is shocking, as others have pointed out, that Andreessen Horowitz wasn’t on the FTX cap table considering the way it invests.
That said, here is why Silicon Valley has a problem investing in late-stage deals that turn out to be fraudulent.
1) A diligence-light cultural heritage
Venture capitalists are culturally programmed to invest based on a founder, a theme, and maybe a few numbers, but not based on a deep diligence process. This comes from the small-scale, early-stage bets venture capitalists make on startups where there is usually no real company yet, and therefore, candidly, little or nothing to perform formal due diligence on. Only recently did firms that grew up writing $1 million checks to baby startups start dropping nine figures into mature, late-stage companies that deserve a different depth of analysis.
What is to be done? Either late-stage venture capitalists need to evolve or someone else—say, traditional private equity—needs to do the nine-figure work.
2) Too much trust in brands
VC has, historically, been a niche industry led by trusted brands, therefore folks have become accustomed to joining up-rounds behind a lead investor who has, presumably, already done the diligence required to get comfortable with the investment. This strategy works when members of the same small group of funds have to trust each other over and over again. In a world where reputation matters, screwing up is not an option.
Early-stage firms only have so much capital and rely on collaboration, so the system works particularly well. At later stages, though, when firms have basically infinite capital, it’s co-opetition at best. These firms don't necessarily talk and share diligence so much as trust each other’s brands at arm’s length. This creates a potential house of cards where no one is doing diligence, thinking they can just trust everyone else.
What is to be done? Firms need to stop blindly trusting each other’s brands and make sure someone has one the work.
3) Not enough experts
Most VC firms keep their investments within some defined range of tech categories, and yet VC is, by its nature, a game for generalists. Theranos was a disaster because none of the firms investing in it could have understood the science even if they’d tried. FTX wasn’t as complicated as all that, but it was complicated enough that a generalist off the street likely couldn’t have parsed exactly what was going on.
What is to be done? Firms investing in specialized industries—particularly those on the bleeding edge of innovation—need actual specialists to help them sort out what’s what.
4) Mounting time pressure
For the past few years, VC firms have been writing huge checks very, very fast. This has happened for a few reasons:
- A bunch of firms realized that lower multiples on enormous sums of money can be a great business model compared with bigger multiples on smaller dollars.
- Coupled with low interest rates, these mega-win opportunities convinced limited partners to keep pumping money into bloated VC vehicles.
- Once everyone had a huge fund, the competition to jam money into late-stage winners got intense.
This time pressure transferred all the power away from venture capitalists and into the hands of sought-after companies, which meant there was no time for diligence even if you wanted to do it.
What is to be done? Higher interest rates will sort all this out naturally in the coming years.
At the end of the day, if some VC firms lose money because they didn't do diligence and invested in frauds, it isn't that big a deal—for them. They’ve gotten so big that in many cases, they can take the write-offs and still provide stellar returns to their limited partners. Those limited partners might not like all the investing-in-frauds, but the overall returns speak for themselves.
Where these iconic blowups are a big deal is in the vast arena outside the comparatively tiny VC and LP world.
Twenty years ago, nobody outside this group cared about VC firms at all. Today, consumers trust young companies in ever deeper ways. FTX is a 3-year-old business, and yet more than a million people trusted their crypto transactions to it (at least according to FTX). As young companies do more and more important things for people (electric cars!), the VC stamp of approval matters—both to the consumers who use it as a guide for where to put their trust and to the companies that rely on that stamp to communicate to consumers, “I’m legit.”
When that trust deteriorates, the real cost isn't in the money lost for LPs. It’s in the brand erosion with consumers, employees and regulators, all of which matters in our highly connected world.