Why do venture capitalists make the investments that they do?
It's a strange business model
Venture capital is a strange asset class. Its practitioners structure their investment portfolios on the assumption that 1 or 2 of their investments will generate most of the positive return for the fund. They further estimate (roughly speaking) that 1 or 2 of their investments will be written down to $0, and that the balance of their investments will barely return the capital invested.
Theirs, in other words, is a power law business. Given this, chasing a hot deal is sometimes tempting. Sometimes, too tempting, as the FTX crash has shown us.
It’s very easy to criticze VC investments ex post, whether we’re talking about FTX or Bird or any other number of failed venture investments. It’s much more interesting, and illuminating, I think, to figure out why a VC investment was made given knowledge at the time of investment. Sometimes, as with FTX, investments seem to be made solely on a FOMO basis.
Sometimes, it’s just bad extrapolation, or pattern matching, or any other number things. Sometimes a company’s unit economics look promising, but subsequent developments, such as competition, regulation, or interest rates, kill those unit economics.
And ex post many of these investments look crazy! Here’s John J Ray, newly appointed CEO of FTX Trading Ltd, et al, writing in a filing filed with the United States Bankruptcy Court for the District of Delaware, about that group of companies’ management practices:
Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.
As has been widely reported, FTX apparently had no board:
So let’s use the framework of figuring out what VCs knew about FTX at the time of their investment. They clearly did no, or little, due diligence about the company. Why, then, did they invest?
Well, FTX was growing rapidly. Its revenues, customer numbers, and trading volume were all growing. And venture capitalists invest in…growth. So, consider that you are a venture capitalist, tasked with finding new investment opportunities. Also remember that your investment fund is structured with the expectation that 1 or 2 investments will deliver most of the fund’s return, and that 1 or 2 investments will be complete losses. And you’re keenly aware of your competitors: other venture capital funds. And they’re all champing at the bit to invest in FTX. It’s the hottest ticket in town.
What do you do? Do you insist on doing due diligence? Well here’s Chamath discussing his reaction to Sam Bankman-Fried pitching him:
So venture capitalists were left with a decision: invest or request due diligence and so lose out on the opportunity to invest.
And—that’s really it. A bunch of venture capitalists bet on FOMO, and, well, we all know how that worked out for them. They made a bad bet. Incentives generate outcomes. Bad outcomes arise from bad incentives.