WTF FTX?!? Part 2
The red flags we should have seen
Yes, we're a day early! I wanted to make sure I didn't miss your inbox on the holiday here in the States. For those celebrating, I wish a Happy Thanksgiving to all!
Last week I gave FTX’s backstory and looked at their Balance Sheet. You can read that here if you missed it.
This week, I want to tie it back to YOUR business.
What red flags did we see that you need to avoid?
This goes for anyone in leadership.
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WTF FTX?!? Part 2
Last week when I wrote up the FTX backstory, I knew that the story wasn’t over.
Despite this, I’ve still continued to be surprised by the new revelations that have come out.
Just a few of the headscratchers:
- FTX lent SBF over $1 billion for personal uses
- FTX purchased houses for employees in the Bahamas, but the houses went in the employee names. There is no record of the purchases on their books.
- HR could not (still cannot) put together a full list of employees and what they were paid because they presumably didn’t keep one.
- Sam encouraged all employees to use Signal for communication because Signal automatically deletes all communications after a period of time (MAJOR red flag).
- They had no record of the outside investments they made.
I’m sure we’ll see more and more things “break” over the coming weeks, but with every news cycle this looks worse and worse.
SBF has continued to post on Twitter about the situation, which goes against all legal advice in the history of man. So, that makes it no surprise that his legal counsel has ditched him as a client.
So, as much as I’m sure you want to, we’re not going to dig into the soap opera that this story is anymore. Instead we’re going to focus on:
- What went wrong
- Could we have known?
- How can we see these red flags in the future?
Close connections, with little experience, among the leadership
Many founders who were friends have been extremely successful. Apple, Airbnb, Ben & Jerry’s, Google, Microsoft, and Warby Parker were all founded by pairs that were friends for years before they started their companies.
While some of the friendships suffered, many of these pairs remained close.
So, you may be saying… okay, you’re disproving your point, Kurtis.
My point is, this in and of itself isn’t a bad thing. But, it isn’t always a good thing, either.
Familiarity among the team removes some when hiring an unknown. But too much familiarity, plus limited experience, is an environment ripe for mistakes.
Based on what we’ve learned to this point, it appears less than 10 of FTX’s 200+ employees knew the fraud was taking place. So, in this scenario, the closeness of the leadership becomes a key component of this fraud.
SBF, along with much of the leadership at FTX, all lived in the same house in the Bahamas. Those who lived there included:
- Co-founder and Chief Technology Officer Gary Wang
- Director of Engineering Nishad Singh
- Caroline Ellison, CEO of Alameda, who was also romantically connected to SBF
Coindesk quoted someone saying “Gary, Nishad, and Sam control the code, the exchange's matching engine and funds. If they moved them around or input their own numbers, I'm not sure who would notice."
This was a situation ripe for fraud and collusion.
- Long-term relationships among most (if not all) of leadership
- Highly centralized control with limited outside intervention
- Limited experience in high-profile and stressful positions
In these cases, the best thing you can do is:
- Bring in outside voices
- Increase external oversight (which we’ll see they didn’t do)
- Seek out experienced counsel for the whole leadership team
Lack of due diligence by the investors
There are 2 trends I’ve seen in venture capital that are extremely concerning:
- A shotgun investing style among firms with lots of capital. Because of the amount of money these firms have, it becomes virtual impossible to do true due diligence and actually deploy all the capital. By its nature, venture capital is won by hitting “home runs.” So, we’re told the story that by increasing their investment frequency they’re able to hit more “home runs” and due diligence goes out the door.
- Venture firms using investment from a high-profile firm as primary proof of the investment quality and choosing to invest in the round themselves.
Think about this: when you combine the two trends you have the perfect atmosphere for startups with very little credence getting large sums of cash.
Say Firm A is new to the block but has chosen to implement strategy one (ie. invest in anything with a pulse) because it has backers with a lot of money.
Firm B is more conservative, but is a single founder just off his company going lunar. That means they don’t have the infrastructure to do deep due diligence.
Firm A gets a big hit, thus “solidifying” their investment chops with the industry. So, because of Firm B’s confidence in Firm A’s “track record,” Firm B joins a round of a risky startup they would have previously avoided.
It creates a slow and steady walk towards less and less due diligence.
This year I learned that there is no"smart money"
A16z, Sequioa, Chamath, Tiger, Tribe Capital, Coatue, Softbank, Paradigm, Ark, 3AC, Alameda, FTX, etc..
all made terrible financial decisions, at huge size.
and yet - most will get richer.
— Shaan Puri (@ShaanVP)
Nov 9, 2022
Add the media frenzy around fast-growing startups, escalating valuations, and young founders… and you have a recipe for disaster.
Nothing should replace the need for due diligence in making investments. Without your own fundamental understanding of the investment you’re making, you’re doing nothing more than gambling.
If you invest based on the signals and moves of others, you’ll have to rely on them for signal to get out. That means you’ll be the last out and likely end up with worse returns.
Only by establishing your own criteria and then measuring against those criteria can you see the red flags earlier in the cycle.
No board of directors or “adults” in the room
For whatever reason, FTX did not have a board of directors. Well, technically they did, but it only comprised of SBF, an FTX employee, and a lawyer. No investors chose to join the board, which is extremely rare in these situations.
Starting out, it can be understandable to limit the board to those who are a part of the operation. But as you grow, it becomes necessary to bring in different stakeholders to get a variety of perspectives. Adding to the board becomes especially necessary when you start taking outside money.
A board provides accountability, governance, strategic direction, oversight of the CEO, and has a fiduciary duty to the business. A good board can reign in the worst (and most harmful) ideas of a visionary CEO.
By limiting the size of their board, FTX and SBF were able to operate unencumbered by the questions from the outside.
As the CEO, a good board acts as “cover” for you to make the hard decisions, as they can support your decision, making it clear there is a “united front.”
A balanced board is big enough to provide different perspectives but also united in the business's goals.
While a hard balance to maintain, it’s way better than the alternative we see in this situation.
No discernible checks and balances
This might be the most shocking one for me.
First, FTX had its audit done by a metaverse CPA firm whose primary business is in the music and entertainment industries. I am still not sure I completely understand this whole Metaverse CPA firm concept if I’m completely honest.
YOU HAVE GOT TO BE F*CKING KIDDING ME
Audits for #FTX were performed by the “first-ever CPA firm in the Metaverse.”
— Meet Kevin (@realMeetKevin)
Nov 11, 2022
But, what this does tell us is that they were intentionally going outside the normal channels to get their audit reviews done. This should have been an immediate red flag. While we can’t know for sure, it’s likely that the firm had never done an audit of that size in the crypto space (if they’d even done a crypto audit at all).
Second, after news started breaking of the “hole” in their books, it came to light that SBF implemented a “backdoor” into the FTX bookkeeping system that allowed him to alter financial records and withdraw funds without alerting the finance team and external auditors.
This wipes away any chance that the whole thing was a “mistake.”
Appropriate checks and balances not only protect the business but the individual employees.
Having a good system of controls protects senior-level staff and gives confidence to internal staff that leadership is going about business with integrity.
In designing controls, you should look to protect staff and yourself from situations where you’re the only person who knows the details. It minimizes the opportunity for something fraudulent to be done.
I encourage all CEOs of small businesses to look at transaction-level data. It doesn’t take much time and a few well-placed questions can go a long way in reminding employees that you’re not asleep at the wheel.
I harp in this newsletter the importance of everyone understanding the numbers. Part of the reason for that is without understanding you’re completely relying on the trustworthiness of the person interacting with the accounting records.
I wish we could operate that way, but I’ve heard too many horror stories of a lifelong friend or family member stealing tons of money.
Complicated corporate structure
If you look at any list of “red flags” for fraud, money laundering, or terrorist organizations, a complex corporate structure is always on the list.
Unnecessarily complex corporate structures burden the business and can be used to obscure business activities. They keep information siloed, making it easier for the designer of the structure to operate unfettered by the bureaucracy of a normal company structure.
As you can see below, FTX’s structure was beyond complex.
There is (intentionally) no clear leader outside SBF, which assures everyone has to funnel to him and that no one else know “who’s leading.”
When looking at an organization, you want 2 things:
- Clarity in who reports to who
- A simple structure
Within a business, there should always be an effort to make the structure as simple as humanly possible. Our nature is to add complexity over time, which gradually slows down innovation and adaptability.
In almost every case, simplicity is harder and takes more work. But it’s that work that really makes an organization perform at peak performance.
Wrapping it up
Running a business is hard. It’s human nature to let little details slip over time. Add that there is always a fire burning and it makes sense that people “fall asleep at the wheel” and miss these obvious signs.
It’s why we have to actively fight against complacency. While this situation has hurt a lot of people, it’s a great reminder to always be vigilant… because the big moment always happens just when we least expect it.
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- Here is a great breakdown of the bankruptcy filing written up on Twitter.
- I just finished reading The Space Barons, which is about the renewed interest in space. It goes back to the beginning of Elon Musk, Jeff Bezos, and Richard Branson’s entries into the space business and all their steps along the way. It was published in 2018, so it doesn’t have some of the latest developments, but it’s an entertaining read for anyone interested in space or those billionaires.
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