Reflections on Crypto Venture Capital After the FTX Collapse: How to Optimize Investment Management Mechanisms and Avoid Paying for FOMO?

Author: flowie, ChainCatcher

"During the last round of the crypto bull market, venture capital firms rushed to complete deals without proper due diligence." This statement was made by Amy Wu, the head of venture capital and business at FTX Ventures, during a panel discussion at Breakpoint, just one day before the massive run on FTX. Ironically, one of the guests at this roundtable was Kyle Samani, co-founder of Multicoin Capital, a significant investor in FTX.

We are all too familiar with the story that followed. Within days of Amy Wu's remarks, the venture capital firms that had successfully invested in FTX became some of the biggest victims of this crisis, with Multicoin's assets shrinking by 55%. Other top venture capital firms such as Sequoia Capital, Paradigm, and Temasek saw hundreds of millions of dollars in investments go to waste.

Although the truth about the FTX incident has not been fully corroborated, various media reports suggest a chaotic relationship between FTX and Alameda, and there are numerous allegations regarding FTX and SBF's personal finances and management. As important drivers of the crypto space, the performance of investment firms in this incident is hard to question; did they really conduct proper due diligence, and was post-investment management and risk control out of control?

As Maverick stated in an open letter to investors, after the explosion, it is more important than discussing specific investment losses to deeply reflect on and optimize investment and management systems.

Currently, investment firms led by Temasek have officially initiated internal reviews to study and improve their investment processes. ChainCatcher recently interviewed several Web3 investors to discuss their pain points in crypto investments and their thoughts on the current crypto investment and financing environment.

"Too much FOMO"

A very intuitive reason behind the collective "crash" of these star investment firms is that the FOMO (Fear of Missing Out) sentiment among investment firms during the bull market was too severe, leading them to not spend enough time on due diligence.

FTX rapidly raised five rounds of financing in three years, totaling $2 billion, with participation from hundreds of investment firms. The speed of fundraising also meant that investors were not given much time to think.

Simiao Li, founder & CIO of Maverick, stated, "When a project is at its peak, it won't give investors time to ask 100 questions; if you don't invest, there are plenty of firms that will." This situation also exists for traditional VC and PE, but it is more pronounced in the crypto industry.

Looking back, just before the FTX collapse, Amy Wu revealed a fact during the roundtable discussion: "Under the bull market, the FOMO sentiment among investment firms reached a peak, allowing them to provide term sheets and investment commitments within 24 hours, with almost no due diligence."

"Venture capital in the primary market still has the opportunity to access team and project financial information. If VCs of Paradigm and Sequoia Capital's caliber cannot conduct due diligence to eliminate risks, then secondary investments are even less feasible." Earlier this year, Maverick considered secondary investments in FTX but ultimately refrained due to concerns about FTX's overvaluation and the opaque value capture of FTT.

However, Simiao Li admitted, "Looking back to February and March of this year, any investment firm that had the opportunity to acquire relatively reasonably valued FTX equity would likely not have refused."

Under the FOMO sentiment, the atmosphere of following the trend to invest is also very unhealthy. FTX's Series B and B1 financing rounds had 60 and 69 firms participating, respectively. Many crypto projects have dozens of investment firms "co-investing," making the investment list look like a "novel." Nicole Zhang, founding partner of LIF, analyzed that many large funds entered the market at that time, making it easy for investors to be misled and become less objective.

Wang Feng, founder of Element & Consensus Labs and one of the earliest investors in FTX, although fortunate to have exited with a 40x return, also admitted to having regretted being too conservative, as FTX's expansion speed exceeded everyone's expectations. A saying in the industry was, "Don't short SBF," and in hindsight, he is contemplating whether the issues with FTX had long existed, but SBF's packaging ability exceeded conventional understanding.

In Wang Feng's view, one of the lessons for investors from the collapse of FTX and other star projects is that the common saying in the crypto investment industry, "I didn't get in fast enough" or "I got in too late," is often an illusion. When everyone is experiencing FOMO, it also means that the risks are very high; after all, a project that rises the fastest will also fall the fastest in the future, especially at a stage where many crypto projects cannot achieve complete decentralization. Once a project encounters negative news, there won't even be time to run, and at that point, one should not fantasize about having an opportunity to buy the dip.

"If the project team does not have time to conduct proper due diligence amid FOMO, and if the project team is adept at manipulating market sentiment and intentionally concealing or defrauding investors, it is very easy for investors to be deceived, and this risk is extremely difficult to avoid." Chris Jin, a partner at SAIF Partners, told ChainCatcher, for crypto funds, bear markets are more conducive to reflection. At this time, establishing a clear investment strategy will do the utmost to resist FOMO during bull markets. Regarding due diligence, Sequoia Capital's recent open letter to LPs mentioned that they would have one of the Big Four accounting firms audit the financial statements of early-stage startups.

Moreover, conducting deeper background checks on founding teams is a very obvious trend. "LPs in Europe and the U.S. have already included this in their constraints on GPs." For Chris Jin, he prefers entrepreneurs who have succeeded in traditional Web2 industries. It's not just about experience; more importantly, this somewhat proves that the team has seen "money," so they won't easily lose their way and have backgrounds that can be verified.

Difficult Post-Investment Management in Crypto

"It's time to reflect on the constraints and influence of post-investment management on founding teams." This is a call from Web3 investor @26x14eth on Twitter to investment firms.

Traditional venture capital places a strong emphasis on post-investment management, which seems to be rarely mentioned in crypto investments. One reality is that managing and controlling risks in Web3 projects is indeed much more challenging than in traditional Web2 projects. On one hand, Web3 is growing too fast. In Wang Feng's view, many investment firms haven't had the time to understand it, let alone manage and control risks for these projects.

"Especially for traditional investment firms that entered later, the emerging tracks and technologies in the crypto space are very complex, and they have not yet established systematic research methods." A certain crypto fund investor, Leo, told ChainCatcher that traditional investment firms often choose projects that already have good cash flow and a certain level of certainty, which tend to be more centralized. Centralized projects are also more prone to collapse events.

On the other hand, the lower barriers to entry for financing models also make it easy for project teams to inflate, while investors have very little space for post-investment constraints or supervision. Chris Jin mentioned, "Not long after investing, projects can issue tokens, founders take a lot of money, and the project's valuation reaches billions or even hundreds of billions, which makes them very arrogant. Institutional investors do not have as much say as they might imagine. Traditional Web2 projects need to do something and have good data to get funding, while Web3 projects can achieve financial freedom without having time to settle down and work, easily triggering human weaknesses."

Leo shares a similar sentiment; only when projects are very early do they need investor assistance. Once the project team has funding after issuing tokens, it becomes very difficult for investors to meet with them or schedule a meeting.

In this situation, Web3 investor @26x14eth predicts that more and more investors will not only demand token rights but also equity. One reason is that, "equity can bring management constraints and legal protections for the project team's management at the board and shareholder levels, establishing confidence in traditional finance for investments in the crypto market."

At the same time, to feel more secure, investment firms may still try to negotiate shorter lock-up periods to allow themselves an earlier exit opportunity.

Iterating Under Pressure from LPs

After multiple collapse events, investment firms face not only "mockery" but also LP withdrawals, disputes, and stricter demands.

Chris Jin stated that from the end of last year to the beginning of this year, many Old Money investors entered the crypto market, but with the arrival of the bear market, this momentum was quickly curtailed. With this year's significant pullback, Old Money has significantly reduced its allocation to crypto assets.

After confidence in crypto assets was shaken again, GP (General Partner) fundraising difficulties became inevitable. A researcher from The Block stated on Twitter that many investment firms claimed to have secured investment commitments this year, but in reality, many had not received LP confirmations.

How difficult fundraising has been this year is hard to quantify, but Nicole Zhang shared a fact: "For example, our fund needs to exit within six years, while many projects, especially infrastructure projects, have a post-investment lock-up period of 3 to 4 years. This necessitates completing all investments in about two years to ensure an exit within the specified time. At this pace, for a $30 million fund, if each early seed round investment averages about $500,000, it would need to invest in 60 projects within two years, which is extremely tight even without breaks. So those funds claiming to raise $100 million or $200 million can really guarantee a faster investment pace? In reality, they may just be bluffing."

When LPs cannot withdraw their funds, conflicts with GPs will further escalate. According to Web3 investor Zoe, this year, disputes and withdrawals between LPs and GPs in the crypto industry have been quite common. Although LPs and GPs have signed very detailed terms, when the results are unsatisfactory, it is very normal to exploit the terms. Recently, Multicoin's LP publicly complained on Twitter, expressing dissatisfaction with its handling and attitude towards FTX, as well as criticizing Multicoin's rough management and high management fees.

LPs are also demanding that crypto investment funds meet the same standards as traditional investment funds, while also adding specific clauses targeting cryptocurrencies. For example, CoinFund's managing partner David Pakman stated in an interview with The Wall Street Journal that crypto investment funds will be required to invest only in projects involving fully real-named corporate entities or key personnel in the additional clauses. Additionally, Atul Rustgi, a fund manager at Accolade Partners, revealed that due to the ease with which crypto projects can be hacked, they need to ensure that the investment fund has the capability to audit the software code of its investment projects and assess their security.

Under pressure from LPs, crypto investment funds are also making better changes. CoinFund stated that about half of their manpower is dedicated to security, compliance, and other operational functions. Strong post-investment operational capabilities are key to their ability to raise $300 million from LPs this year.

Have "Respect" for Traditional Finance and Web2

Losing confidence in the future of crypto may be the biggest scar caused by the collapse events.

Zhu Su, a prominent KOL, stated on Twitter, "The FTX collapse has set the crypto industry back 7 to 8 years." Spartan Capital's former partner Jason Choi is also pessimistic, believing that institutional investors will lose confidence in the coming years, making project financing very difficult, leading to closures or rug pulls.

In fact, aside from the crypto industry itself being in a low cycle, the series of collapses like Luna and FTX has indeed caused crypto funds to slow down their investment pace. ChainCatcher collected primary market financing data for five sectors—Infrastructure, DeFi, CeFi, Web3, and NFTs—over the past year, six months, and the past month (data sourced from Rootdata).

Overall, if we take the number of financing projects and amounts from the past year as a baseline, the financing amount in the past six months only accounts for about one-third to one-fifth of the annual total, while the recent month's activity has sharply declined, accounting for about one-thirtieth to one-fiftieth of the annual total.

Source: Rootdata

Although the negative impact has become a given, there is no need to be overly pessimistic. Most interviewed investors believe that the current macroeconomic and financial markets are bleak, and it's not just the crypto market that is unique. "It's not surprising that U.S. growth stocks have fallen by 80 to 90 percent, even more than Bitcoin. In a year of interest rate hikes, all assets are declining, including U.S. Treasuries. This is a time of despair," Simiao Li analyzed, noting that many KOLs make pessimistic predictions because they previously held unrealistic fantasies about the development of the crypto market. Although a wave of upstream money entered during the bull market, the industry's development and value creation did not match the speed of hot money, and now it is merely a mean reversion that correctly adjusts expectations.

Furthermore, when viewed over a longer historical cycle, the negative impact of this collapse event is not as exaggerated as the public currently imagines. Chris Jin stated that SAIF Partners, as an established institution, has experienced multiple cycles, including the 2000 internet bubble crisis and the 2008 financial crisis, both of which were as severe as this crypto crisis. "But the memory of financial markets is also short; as soon as the bull market arrives, similar histories are always repeated."

This crypto crisis is forcing participants in the crypto space to reflect and iterate. Currently, meaningful improvement ideas are emerging around self-supervision of exchanges, external regulation, and investment management of crypto funds. Additionally, there needs to be "respect" for traditional finance and Web2, which is a viewpoint that investors mentioned throughout the interviews. In establishing risk control mechanisms and financial standardization, the Web3 industry still has a lot of work to catch up on.

With the collapse of "bad money" projects like Terra and FTX, many mainstream venture capital firms have paid a heavy price for their mistakes this year, and this also represents a fundamental opportunity to change the logic and style of crypto venture capital. How to optimize investment management mechanisms, avoid paying the price for FOMO, and truly support "good money" projects will be one of the most important topics for crypto venture capitalists moving forward.