All we are saying is give due diligence a chance in 2023

Unfortunately, FTX is only the latest in this line of failures

Looking back, 2022 was quite the year for some investors and not in a good way. Mistakes made in the boom period of the past couple of years led to many write-downs, but the most egregious example of abysmal investing practices this year was FTX, the bankrupt and disgraced crypto exchange.

In fact, while we wrote this, Sam Bankman-Fried, the company’s co-founder, was being extradited from The Bahamas to the U.S. where he faces eight criminal charges. In the past few months, his investors simply watched as the company’s value evaporated from $32 billion to zero in no time flat. Like the rock band Talking Heads, they might well have asked themselves, “Well, how did I get here?”

Well, one big reason was because FOMO often replaced due diligence. For a while, the V in VC appeared to stand for “vibes” — founders’ vibes seemingly became more important than their products.

Unfortunately, FTX is only the latest in this line of failures. We can revisit companies like WeWork and Theranos, or even look to the list of billionaires and wannabes lining up to be part of the $44 billion disaster-in-the-making that Elon Musk’s Twitter investment appears to be. Even Musk himself tried desperately to get out of the deal before finally closing it in October.

According to Axios editor Dan Primack’s Pro Rata newsletter last week, while some investors appear to think Musk has done a reasonable job of reducing costs, others are worried how they’ll explain their involvement to their investment committees. Maybe they should have thought about that before they threw their money at the deal?

This is all indicative of a wider problem in investing these days. We don’t want to paint the entire industry with the same brush, but it is fair to say that some investors stopped being careful because they felt getting in line for the latest shiny thing was a better idea.

Clearly, investing should be about getting to know the team, checking the books (to the extent possible) and ensuring you pressure test the idea. You should never be signing checks because all the cool kids are doing it — that is never a sound approach to investing millions of dollars.

We spoke to a few investors to get an inside look at how due diligence and investing practices have faltered in the recent past, and if investors who may have fallen prey to chasing the next big thing would learn anything from this year’s mega mistakes.

Have we learned anything?

There are several issues at play here, and the venture capitalists we spoke to stressed that some investing firms (and investors) have to start being more disciplined, especially when they’re doling out someone else’s money.

Stevie Cline, general partner at Vol. 1 Ventures, told TechCrunch that over the years, many funds developed an entitlement toward LP (limited partner) money, believing they were ATMs “with never-ending cash.”

“The money isn’t yours to do whatever with; there are fiduciary responsibilities attached,” Cline said. “You saw a lot of folks investing LP money to gain personal clout in hyped-up deals or to fund their friends’ ill-conceived, half-baked ideas. Being a fund manager means doing exactly that: managing funds entrusted to you. That management includes the task of diligence.”

Cline also noted that funds were afraid to tell their LPs why they didn’t participate in deals that had a lot of hype and so started cutting corners when evaluating companies.

Eghosa Omoigui, the founder of EchoVC Partners, highlights the pressure fund managers felt, saying he was criticized last year by an LP who had heard from entrepreneurs that his firm took too much time doing due diligence and so was not “founder-friendly.”

“We looked stupid and unpopular for a while,” Omoigui said. But when he recently connected with the LP, the markets had turned, and they backtracked, saying they didn’t have a problem with the fund’s approach. “That’s funny, because our notes from the meeting [last year] say exactly that [they had a problem],” he said.

In addition to cutting corners to get into deals faster, investors also started assuming that someone else was always doing due diligence properly.

Since the FTX implosion, though, Cline says some investors have started to take the process more seriously, especially as big names keep getting called out for subpar due diligence. It has “shaken some sense into people,” she said. “There is still a reality check in store for some founders and investors, but I do think it’s happening,” she added.

Jomayra Herrera, a partner at Reach Capital, believes the FTX situation validates the way her firm conducts due diligence, which includes meeting with the founding team, diving into the product and assessing metrics and fundamental financials, in addition to reference checks, speaking with experts and a legal review. “We have walked away from seemingly good deals because we felt we couldn’t get the necessary information we needed to complete our diligence processes,” Herrera said.

It’s worth noting that Temasek Holdings, one of FTX’s investors, claimed it conducted thorough due diligence on the company before investing. Hustle Fund’s Elizabeth Yin also told TechCrunch that a background check on Bankman-Fried wouldn’t necessarily have been a good indicator of the future fraud he would be charged with. However, we should note there were clear red flags with FTX that investors simply did not question further.

“I think firms will raise the bar on what diligence should look like,” Herrera said, especially regarding crypto-focused funds.

FOMO rules everything around me

The slower market has given investors time to once again conduct due diligence, a few investors said, which bodes well for a more careful review process in the coming year.

And, Omoigui noted that more LPs are worried about material write-downs next year. “There is a real risk that capital calls will be met with questions about the amount of rigor being put into the proposed underlying investments,” he said.

On the flip side, Cline said fund managers should be more transparent with LPs about their reasoning when signing or passing on deals. “It’s a good exercise and it helps develop trust in a way that gives fund managers the self-confidence to make bigger plays without FOMO,” she said, adding that investors also must start making decisions regardless of who else is on the cap table, and stop assuming that someone else has thoroughly evaluated a company.

A few VCs also noted that the new generation of investors entering the industry should be taught how to properly evaluate companies. “In the past few years, they’ve learned terrible habits,” Cline said.

Of course, that depends on which stage they are working in. Ed Sim, who co-founded Boldstart Ventures over a decade ago, says his early-stage-focused firm doesn’t have the luxury of reviewing books because the startups he looks at often don’t have a product, let alone revenue.

But he stresses that there are still ways to check the viability of an investment. “We look for highly technical founders well before they’ve written their first line of code. Most of our diligence has and will always be on the people, their history, their track record creating and shipping new products, pressure testing them during diligence on how they will function as a team and understanding where they need the most help,” Sim said.

As for FOMO investing, he says that’s been around since the dot-com bubble. “When FOMO is at its peak and the power dynamics shift to the founder, investors accelerate their diligence process so they don’t miss out. It’s important for both founders and investors to focus on relationships and not transactions, as I believe the speed and pace at which deals were done in the last two years was unhealthy,” Sim added.

For the health of the entire system, and especially the LPs who are looking to avoid major risk, it’s imperative that VC firms look more closely at deals and avoid the kind of sloppy oversight we’ve seen in recent years.

While history seems to repeat itself too often, perhaps by educating the next generation of investors to steer clear of slipshod investing techniques, firms can confront FOMO investing once and for all instead of giving in to it the next time it pops up again.