If you want to better understand how big of a deal it is that the FTX cryptocurrency exchange just crashed, you could do worse than talking to David Pacman, an entrepreneur turned venture capitalist. After 14 years with investment firm Venrock, Pacman — who led Venrock’s investment in the digital collectibles company Dapper Labs and even mined Bitcoin in his own home years ago — leaned on his passion for digital assets and last year joined now-seven-year-old crypto venture 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 Pacman to get on the phone today to talk about this very wild week that started with high-profile FTX on the ropes and ended with bankruptcy and resignation of FTX founder Sam Bankman-Fried as CEO. The following are excerpts from that conversation, edited lightly for length.
TC: The last time we spoke, almost two years ago, the NFT wave was just in progress. Now we’re talking about a day where one of the biggest cryptocurrency exchanges in the world just declared bankruptcy. In fact, it is a declaration of bankruptcy 130 additional subsidiaries. What do you think of this development?
DP: I think it’s absolutely terrible on a bunch of levels. First, it was an entirely avoidable tragedy. This company failure was caused by a bunch of bad human decisions, not a failing business. The core business is developing excellently. In fact, it is very profitable and growing, even in a bear market. It’s not like he’s out of capital or a victim of the macro environment. But his leadership, apparently with little to no oversight, made a bunch of terrible decisions and got things really wrong. So the tragedy is how much could have been avoided and how many victims there are, including employees and shareholders and hundreds or even thousands of customers who will be affected [by this bankruptcy].
There’s also reputational damage to the entire crypto industry, which already suffers from questions like, “Isn’t this a fraudulent place with scammers?” This kind of Enron-style collapse of one of the most highly regarded and arguably most successful companies in the space is really bad and it will take a long time to dig out of it. But there are also positives.
Well, the positive is that the technology didn’t fail; blockchains did not fail. Smart contracts have not been hacked. Everything we know about the technology behind crypto continues to work brilliantly. So it would be different if it was a crash due to faulty software design, or blockchains not scaling, or major hacks that hurt people. The long-term promise of crypto software and technology architecture is intact. It is the people who keep making mistakes. We’ve had two or three pretty big man-made errors this year.
There are many news stories that outline what happened in general terms. How do you explain it?
I have no firsthand knowledge of what they really did or didn’t do. But obviously 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, which is their token that is held in large amounts by Alameda, and they pledged it as collateral and took out large fiat loans against it. So they took a highly volatile asset and pledged it as collateral.
One can imagine if a board of corporate executives or investors knew about this, someone would say, “Wait. What happens if DFT drops by 50%? It happens in crypto with high frequency, doesn’t it? So why are we betting on this super highly volatile asset? And by the way, half a billion dollars worth of assets are held by our biggest rival [Binance]. What if they dump it on the market?’
So simply the act of borrowing against him was inadvisable. And then it looks like they also took the proceeds of that loan and invested it in highly illiquid assets, like maybe bailing out BlockFi or all those other private companies that FTX recently bought. But it’s not like they can quickly sell them if they need to pay back the proceeds of their loan. They also apparently used customer funds and loaned them, or perhaps even loaned them to their trading branch. So all of those things are just things that I think the board, if they knew about it, would be like, no, no.
But there was no board, which is mind-boggling given that venture capital poured $2 billion into this company. Your company is among these companies.
I joined CoinFund a little over a year ago, so the investment the firm made in FTX was long before my time, and it’s a small, small amount. We’re barely at the hat table. We did not hold FTT tokens.
But I will answer your big question, which I think is about the management of this company. I come from a traditional tech background where maybe 99% of the time there’s just a standard set of governance that every entrepreneur agrees to when they take on venture capital, which is: there’s going to be a board; the board will consist of investors and employees and perhaps outside experts; there will be a set of controls; the controls usually say things like, “You must disclose all related party transactions” so you’re not shuffling coconuts between one company and something else we don’t know about. The board also has to approve things, so 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-blowing. And I hope that what comes out of this Enron-like moment in cryptocurrency is that whatever loose norms there are about not providing that level of oversight and governance as part of investing disappear immediately.
Everything is so strongly connected. Crypto investor Digital Currency Group is reportedly giving a 140 million dollars injecting capital into a derivatives business in its portfolio called Genesis Global Trading, as 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 due to the failure of FTX?
How affected are we at CoinFund? It’s negligibly small because we had such a small investment in this company from one of our funds and we didn’t hold any of our assets in FTX, either the US business or the international business. [As for broader implications], I don’t think any of us know the full, long-term impact of what’s going on here, because there’s some kind of contagion, right? For example, how many other funds when companies and investors have assets in FTX and how long will it take to recover these funds? One must assume that everything goes into a massive bankruptcy proceeding that takes many months or years to unravel. And so there’s going to be this uncertainty not only about when you’re going to get the money back, but how much you’re going to get.
The majority of startups we invest in do not trade on FTX and therefore have not been clients. But FTX was very helpful in providing a launch pad for tokens to become liquid and then either creating a market for those tokens or at least providing a place to trade and provide liquidity. A lot of crypto today isn’t just raising equity, it’s creating tokens and using tokens as an incentive mechanism, and that requires that at some point those tokens become liquid and traded on exchanges, and FTX was one of the most the big places where these tokens are traded. And now you’re losing that.
How does this affect your day-to-day investment work? I saw the news that CoinFund is looking to raise a new $250 million fund, that it filed with the SEC on November 1st after closing a $300 million fund three months ago. Are you going to have to put a pin in that now? I’m sure this failure is making the records feel nervous.
We have spoken to many of our LPS over the past 48 hours. I think most people process. They ask, as you ask, “What happened here?”
I think late stage capital will freeze for a bit here. The dust really needs to be cleared. And capital is hardly attracted by such a tragedy.
A more immediate impact is on startup valuations. Valuing startups is an imperfect process performed by investors in illiquid markets, and one way to do it is to look at comparables. And one of the brightest star companies that almost everyone in cryptocurrency pointed to was FTX. If FTX is worth $40 billion, we are worth X. So take the highest valued VC-backed crypto company and it goes from $40 billion to zero, then what is the new crypto value ceiling? This immediately affects late-stage valuations.