Earlier today, renowned VC Bill Gurley put together a list of the many “red flags” that VCs should have paid closer attention to when funding FTX, suggesting in a tweet that this summary of warning signs might help keep VCs “out of the investor hurt locker” going forward. Gurley includes such no-nos as “unique financial data presentations,” “aversion to audits,” “large secondary transactions” and “lack of a legitimate board.”
Yet publishing them now is a little like shouting “fire!” after everyone is already outside the theater, watching its smoldering remains dissolve into the parking lot. Most of the behaviors that Gurley identified today came to a grinding halt when the market abruptly shifted in spring, and by then, the damage was already done. More, if history has shown us anything, it will happen again and not because VCs miss red flags but because they sometimes throw these investing rules out the window.
Gurley observes, for example, that a big risk to investors is when they “let the good times roll” (red flag No. 1). It’s pretty hard to argue with this one. Consider how little VCs really knew about Sam Bankman-Fried, all while he burnished his image as the crypto industry’s wunderkind. (Weirdly, Bankman-Fried’s smiling visage is still plastered around parts of San Francisco.)
Gurley also cites the “lack of a legitimate board” as a red flag (No. 2). This was another nod to FTX, which the world was shocked to discover had no board of directors. But barely-there boards have become pervasive. In a story just tonight about Pipe, TechCrunch’s Mary Ann Azevedo writes that the three-year-old marketplace has only one outside board member who is not a co-founder of the company, and that individual has been a VC for three years. (Pipe raised more than $300 million from more than a dozen firms.)
Another warning sign is dual-class shares (red flag No. 3), which in many cases give entrepreneurs the power to ignore the wishes of investors. But VCs who once argued against these long ago gave in to founder demands for them, no matter how ridiculous the ask. Don’t believe us? Lyft’s founders and Snap’s founders have shares designed to keep them in control until they kick the bucket. Adam Neumann had so much control over WeWork that had he not been elbowed out, his children and grandchildren might have been in charge of the company ultimately.
Not last, Gurley pegs secondary sale transactions (red flag No. 8) as an obvious sign that something is amiss. Hopin, the virtual events platform, is a prime example. The three-year-old company has been dealing with shrinking market share and layoffs, yet according to a Financial Times piece from earlier this year, its founder was able to take $195 million worth of shares off the table while also retaining nearly 40% of the company and voting control. Bankman-Fried similarly took $300 million off the table last fall in a $420 million round. At the time, FTX was barely two years old. VCs don’t want founders to kill themselves for future riches, but there’s obviously a tipping point when it comes to allowing these early sales, and VCs blew past it a long time ago.
One problem with Gurley’s list of things to avoid is that Gurley himself was complicit in some of these offenses. Remember WeWork, which promised that Adam Neumann’s progeny would rule the company for eternity? Gurley’s firm — Benchmark — had a seat on the company’s board. It had a seat on Snap’s board, too.
The bigger issue ties to how venture firms are structured and paid. VCs can afford to push it to the limit because they know someone else — their own investors — will be around to pick up the pieces.
Unfortunately, the picture isn’t nearly so rosy for everyone else. Instead, the consequences of every “red flag” that was waved away is becoming more apparent with each layoff, down round and executive change-up.
VCs had a good run, and they will again. But right now, if you don’t foresee that tens — if not hundreds — of billions of dollars from pension funds, school endowments, hospital systems and the others that provide capital to VCs is about to go up in smoke, you haven’t been paying attention.
It’s not just FTX that’s going down.