A new term has entered the business lexicon. What is now known as ‘the FTX Debacle’ has dominated headlines. Beneath the headlines is derisive commentary about the methods used by VCs to invest. These VCs are accused of poor practice and worse.
Jessica Lessin at The Information speaks for us all: “I once again have to ask the question of how the heck world-class investors gave FTX more than a billion dollars without realizing the CEO—out of malice, ineptitude or sheer laziness—was directly borrowing money from the company, commingling corporate accounts and using customer deposits to bail out his own personal crypto-trading giant.”
Matt Levine, now ensconced as the Oracle of Fintech, suggested an explanation: “… the typical VC company has a very simple balance sheet and terrible governance, so it is sort of understandable that they sailed right by these [balance sheet] problems”.
A contrarian position was well represented by Dror Poleg, an Economic Historian who has made his name as the person who takes on the task of explaining the inexplicable. He says that VCs are rational. Their job is not to ensure they don’t lose money; it is to avoid failing to be sitting round the table when they are sharing out the biggest gains.
As he says in his newsletters last week: (first in the one titled “Reasonable FOMO”) “Their job is not to avoid failure; it is to avoid missing out on the biggest success” (and then in the one titled “Financial Hits and Misses”) “… investors will continue to make bets of this kind and will learn very few “lessons” from the collapse of FTX”.
This is a new take on loss aversion. Psychologists know that people hate to lose money more than they like to gain it. We are wired to value things that are ours, and we appear to give an economic value to them that is greater than the price a third party would pay for them. VCs don’t see it that way. Their loss aversion is “prospective loss aversion”. A gain you could have made but didn’t, counts as a loss. Why? Partly because your VC neighbour made the gain, but mainly because some recent gains have been so spectacular that they upend traditional business logic. Not so much a home run, more like winning the World Series with one hit.
Not all VCs are the same though. Commentary surrounding FTX has looked at VCs that invest in the equity of fast-growth businesses. Equity is all about The Upside; the outsize gains go to the equity holders.
But some VCs also invest debt. The methods and character of venture debt funds are different. Venture debt is expensive debt but it’s still debt. If you lend to a risky start up that becomes a unicorn it just has to repay your loan (albeit at a higher coupon than banks charge and maybe a warrant or some synthetic equity). Venture debt funders have downside risk because their loans that perform never return 100x to the fund.
We see how this works when venture debt funders lend to lending fintechs. There are lots of lending-based fintechs now – revenue share lenders, BNPL lenders, any embedded finance firm, for example.
When a debt fund lends to one of these fintechs it has this one thought in its corporate head: it’s easy to lend money, you find out if you’re good at it when your borrowers pay you back (or don’t).
These funds have a different view of growth. A lending fintech can double its lending book if it makes one loan and, the day before the maturity date, it says to its borrower – “you’re doing great, don’t pay me back, I’m going to increase the size of your facility by 100% and I’ll advance the funds tomorrow and push out the maturity by another six months.” An equity investor will say: “good job, great growth in the lending book.” A debt fund will say: “what I really wanted to know is if you found a borrower who will pay you back.”
Debt funds enforce discipline in lending fintechs by requiring reporting, access to their systems, and access to all their information.
There are no hard assets in venture lending. All the collateral is intangible and taking security over intangible assets is a special skill for debt funds and lawyers. First, you must identify assets and attach security interests to them. If assets are missing or imaginary, the process of taking security reveals that. Second, you must make sure these assets don’t subsequently disappear. Information, access, and control are written into the deal documents and the borrower’s systems are thoroughly checked. This is the same with crypto lending – when it is done well.
VCs are getting it in the neck and there is now talk of them being joined in actions by dissatisfied investors – as if VCs perform some previously unheralded role of being a kind of unofficial, inadvertent rating agent for their investee companies.
Meanwhile, if you want to get a read on the financial strength and systems of a fintech, don’t look at their cap table to see who has invested, look at the register of security interests (the charges register at Companies House in the UK and the UCC in the US) to see if you can spot the name of any venture debt lenders.
There are more equity VCs than debt VCs. And the more competition there is among VC equity investors, the less diligence they will do. If you have something to hide, create competition among investors. FTX is a story about the power of marketing. We thought it was Too Big To Fake.
Charles Kerrigan is a Crypto and digital assets partner with law firm CMS