In 2021, Tiger Global invested $38 million in FTX with the help of Bain's due diligence; Temasek invested $275 million in FTX after eight months of due diligence. After FTX went bankrupt on November 11, 2022, they all wrote down the investment to zero, and Temasek conducted an internal audit of its own due diligence work. Under the iron law of "returns are proportional to risks", traditional VCs such as Sequoia, Temasek, and Tiger obviously chose risks in their investment in FTX, but they were not prepared to return to zero. From the perspective of initiative, these VCs basically focused on the due diligence link when reviewing and summarizing. For VCs, it seems that it is also the only link that can be controlled, so we brought everyone together to discuss this topic.
Guests:
Forest｜Foresight Ventures
Todd｜A&T Capital
Henry｜NGC Ventures
Joanna｜DFG&Jsquare
Host:
Larry｜Basics Capital
Larry: In the Web3 industry, due to the high degree of integration of its technical and financial attributes, the primary market, level 1.5 market and secondary market are almost open to all users, so every Web3 practitioner is an investor. However, the entire market does not have high requirements for the professionalism of pre-investment due diligence or research. As a result, the lowering of the investment threshold also lowers the financing threshold.
In addition, due diligence takes more time, manpower and money than research. The Web3 industry is advancing by leaps and bounds, and it seems that the market has not been given enough time to improve or even complete this link. Therefore, for ordinary users, the fastest way to evaluate a project is to see which head VC has participated in the investment. The premise of this is that the VC has completed the due diligence, and the target project has an extra layer of trust endorsement. Even many second- and third-tier Web3 VCs go directly to the payment link in this way, and finally the entire industry shares the results of due diligence of one or two VCs. This situation is basically the general situation of the industry in the fast-paced bull market.
However, the collapse of FTX shocked the entire industry. Sequoia, Tiger Global, Coinbase Ventures, Temasek and Paradigm, the top VCs that were admired by thousands of people, all became victims of FTX.
Reflecting on it afterwards, as institutional investors in the primary market, regarding the FTX incident itself, do you think there are any imperfections in VC due diligence? If so, what are they?
Forest: I think there must be imperfections in due diligence, but this issue is very complicated. There is no unified standard for due diligence, because the market rule is that in a bull market, the more due diligence you do, the less you earn; in a bear market, the less due diligence you do, the more you lose. So the key lies in whether you know everything you need to know when you make this decision. I personally think that neither Foresight nor our peers in Web3 have done enough, because not all the information they need to know is available.
For FTX, we need to know where its business actually takes place, how much of its business volume is real, how much is retail investors, how much is institutional investors, its fund operation, internal financial management, how risk control is done, Temasek said they spent 8 months on due diligence? It doesn’t take that long to really understand this. But the problem is that in a new industry, he doesn’t know what he needs to know, and in the end he is easily led by the project party.
After the collapse of FTX, various institutions have been conducting self-examination. I think it is actually FOMO caused by the bull market, which involves the issue of emotional control of investment institutions or investors. If it is in the secondary market, the probability of such a problem will be lower, because the secondary market is continuous, liquid, and verifiable. After the FOMO is over, the market will immediately educate you, allowing you to maintain a relatively stable and objective emotion.
However, for investment in the primary market, institutions need to conduct research, translation, analysis, benchmarking, and organize opinions to finally come to a self-convincing investment conclusion. There is such a point of view that if you are very involved in something, you cannot judge whether it is a bait, because you have invested too much subjective emotion in it, and it is easy to step on the bait. I believe that before FTX announced its insolvency, even their investors were still obsessed with this FOMO emotion towards FTX.
Todd: Because I did not participate in FTX's investment, and I don't know how far Temasek and Tiger have gone in their due diligence, it is difficult for me to say whether they have done enough in the due diligence process. Looking back at the results, I think they have some problems in their judgment of risks, or in their judgment of their own risk-bearing capacity.
Now they think that there is a problem with their due diligence process. If this is their attitude, I think it means that these investment institutions have not found the degree of investment risk control that suits them.
As for why I didn't find it, whether you say it's the FOMO of the bull market or your own insufficient understanding of the industry, what I want to express is that venture capital means there must be risks. At the moment of making a decision and pulling the trigger, are you ready to pay for the decision you made?
For example, I know that FTX will have some problems like this, and there may be a 5%-10% probability that such problems will cause me losses. When making decisions, I can still accept it. As a venture capitalist, this is within my acceptable range. Then I think such due diligence is appropriate. It is a dynamic match and a dynamic balance.
Henry: I think traditional VCs like Temasek and Tiger are much more comprehensive in due diligence than crypto VCs. I read the reports at the time and they spent a lot of time and money on it, and they also did things similar to equity investment due diligence. So I think they also saw a lot of risks. But I think the due diligence process is more about facilitating rather than destroying the deal.
For example, when investing in a project, you should conduct due diligence on the organizational structure, team background, business model and some key parts to identify the risks. After you discover these problems, they can assist in your decision-making. Only such decisions are scientific.
In fact, it is not difficult for these traditional VCs to find problems, so the FTX incident is not necessarily due to incomplete due diligence for them, but rather that they have maintained the inertia of equity investment and feel that it will not result in a total loss, thus ignoring some key risks.
Having seen the risks through due diligence, they still chose to take the risk, but the scope of the risk exceeded their own understanding. This is most likely the problem that Temasek is facing.
Larry: Combining the views of Henry and Todd, when we decide to invest in a project, due diligence answers the question of why I should not invest, and investment decision answers the question of why I should invest. The combination of these two reasons determines whether to invest in this project.
Jenny: My understanding is that when traditional Web2 capital enters Web3, they can only choose from a few targets. Apart from Binance, it seems that only FTX is the most suitable. Just like Henry said, due diligence only assists him and will not interfere with his desire to invest.
Forest: I think DD is to objectively and neutrally show its advantages and disadvantages, and then present all these things, put them on the investment decision-making meeting, and then make an objective decision. But many times, the institutions become what Jenny said, I want to invest in the first place, but I just go through the process, the partners or bosses above have already agreed, the big guys have already had dinner, and decided that we should do this together, and then go through the process.
Larry: This is where the risk of due diligence lies. In this case, its role is not to correct, but more like an accomplice to the evil.
Todd: In fact, the formal process should be to conduct due diligence before the investment decision, and use the results of due diligence to make the investment decision, rather than using the results of the investment decision to conduct due diligence. If we look at due diligence from a rational and professional perspective, due diligence is actually a prerequisite for investment decision, not just an auxiliary tool.
Forest: In addition, FTX's business is suspicious. First, it does not have enough retail business volume. Its main business comes from institutions. Institutional business is not profitable. Even retail investors can achieve fee-free transactions by pledging FTT, so FTX's profitability is very poor. Secondly, it has built up a high amount of debt, constantly raising funds for mergers and acquisitions, and then raising funds and mergers and acquisitions with the main body of the merger and acquisition, and expanding its balance sheet infinitely by acquiring companies with many assets. This is actually an operation that goes against market common sense, and is very similar to the Delong Group and Evergrande Group in China.
Joanna: We still have to return to common sense. Mainstream exchanges of the same level have thousands of employees. If FTX's business volume is really large enough, it is obvious that only a few hundred people are not enough. There may be a lot of tricks here.
Forest: The judgment criteria of traditional Web2 equity institutions are not perfect either, so when we make investments, we will not blindly follow these large institutions. Large institutions are also made up of people, and they will encourage each other.
Larry: We just transitioned to another topic. Do you think there is a difference between due diligence for Web3 project investment and due diligence for traditional equity investment? If so, in what aspects do you think it is mainly reflected?
Henry: I think there is a difference between investment due diligence for Web3 projects and traditional equity projects. Most Web3 projects have been established for a short time, and many things are not yet visible. Generally speaking, when we invest in Web3 projects, the due diligence process is not complicated and the time is very short. It mainly observes the track logic, business logic, code audit and team background of the project itself, and conducts some targeted due diligence on the areas that we are interested in or have questions about, and it ends quickly.
I understand that traditional equity due diligence requires coordination with multiple parties, such as law firms, consulting firms, accounting firms, finance, bank statements, teams, customers and partners, etc. The timeline is generally much longer than the due diligence of Web3 projects. The overall process, time, cost and focus are different.
Todd: Most of the projects that people invest in Web3 are in the first or second round, so we are investing in very early projects. Traditional investment circles generally invest in relatively late-stage projects. The process and results of due diligence on an early project and a late-stage project with actual business data will definitely be different.
I talked with friends who are more Angel-oriented than traditional VCs before, and found that the difference is not that big. It is just because of the difference in business that the actual content of due diligence may be different, but the core things that everyone is concerned about are nothing more than whether the general logic agrees. If the general logic agrees, then is the team reliable and do they have the ability to do it? If so, or if we believe that they have the ability to do it, then basically the due diligence is over.
We often encounter people who come to chat with you with a PPT, and you can only see very limited information to set prices. FTX's incident is one of the rare ones in the industry. If you are an early-stage VC, you will not be exposed to such incidents. So I think there may not be much difference between the due diligence of early cases and Web2.
Forest: I think there are still some differences:
First, the objective conditions are different. There doesn’t seem to be that much material in the industry for you to learn about. In the Web2 industry, you have to communicate face to face, but in the Web3 industry, there are no such conditions, so the pricing is definitely quite different. In addition, in Web2 you can also do financial statement analysis, compliance analysis, etc., but Web3 doesn’t have this, so the objective conditions are different.
Second, the logic is different. Traditional industries need to look at business information such as revenue rate and annual output, but in this industry, the revenue rate is not needed. The Web3 industry has an advantage, that is, its value does not need to be measured by profit, nor does it have to be supported by revenue. This is a different logic from the traditional one, but I think this logic is still valid.
Larry: Everyone mentioned the team factor. From the team perspective, I have two questions: 1. What do you think of teams or founders working on two or more projects at the same time? 2. What do you think of anonymous team projects?
Todd: From the perspective of the A&T Fund, we say no to both of these situations. We do not invest in anonymous projects, nor can we accept you working on two or more projects at the same time.
In the bull market, I myself have visited some anonymous team projects of Angel. I think anonymity is to make it easier for them to run away in the end. If anything is revealed, they don’t need to take too much responsibility. Something will definitely happen to them. This type of investment will definitely make you take on additional risks.
As for those who are working on two or three projects, I think the core of early-stage investment is investing in people. When you invest in this person, you must hope that this person is 100% focused on the direction he promised you at the beginning. If this person is working on two or three projects, it means that his energy must be dispersed. I really can't find any reason to accept this situation.
Larry: Let me ask you a follow-up question. Because this industry changes very quickly and the life cycle of projects also rotates very quickly, does that mean that after he has already done a project, when he does another one, he can redraw the narrative because he has project experience, so when he does the second project, he has one more reason to succeed?
Todd: This situation is OK. If the case that this person has completed before is very successful and he can withdraw from it, I think this situation is OK. We at A&T Fund should not accept that even if your old case is relatively successful, you still haven't completely withdrawn from it.
Larry: Even though you were successful, you could only choose one, right?
Todd: Yes, because we hope that your energy is focused. I think only by focusing can you produce the best results. Otherwise, I think it is difficult to achieve a particularly good effect.
Larry: That's a very clear point. OK, let's hear Henry's opinion.
Henry: We basically don’t invest in anonymous teams. I think even if you are anonymous, you cannot be anonymous to investors, otherwise we don’t know who we are investing in, because Web3 was invested in people in its early days. If you don’t tell me your background, your situation, or the situation of your team, and then just bring a PPT and say that our project can succeed, why should we believe you? So if it is an anonymous team, if you want to be anonymous to the outside world and disclose your identity to investors, we will consider it, but if you want to be completely anonymous and don’t tell investors about your background, we will definitely say no to this.
We don’t want to see teams and founders working on two or more projects, but as I just said, if one of your projects is very successful, you can almost withdraw and start working on the next project. Indeed, there are quite a lot of founders who do this, and there are also some who have been successful in serial entrepreneurship, so this matter still depends on individual cases.
Forest: I share the same view as these two. Of course, anonymous teams can also succeed, but the probability is too low. We are more certain about serial entrepreneurs, but we may need to distinguish whether his experience is good or bad. Did he only try out his previous business ventures briefly? If he is a serial entrepreneur who only tries out his previous business ventures briefly, I think it is very bad. But if he knows what he is doing every time and goes all out, and accumulates a lot of experience in the process, then even if he fails the first time, the probability of success the second time will be much greater than that of someone who has never started a business.
In fact, Web3 projects will eventually involve some management, finance, rights and responsibilities. People who have never started a business lack experience and knowledge in these areas. For founders who manage multiple projects, if they don’t try their best to invest in this business, it is unlikely that they can do their best in this job as a part-timer. Investors are not their parents, and no one is willing to pay for their entrepreneurial trials and errors.
Larry: We have always said that in the Web3 industry, ‘Code is Law’. Is Web3 investment really about investing in people? If there is a project with a team but no product, and there is another project with a finished product but unwilling to disclose its team, what would you choose?
Forest: Everyone says that investing is investing in people, but I don’t think so.
In Web3, you must look at the trend. The wind is bigger than the people. You may even lose money in the wind. So many people in Web3 can make so much money. Is it because they are better than those in Web2? Of course not. It’s just because we are in the industry that is on the trend.
Therefore, choosing a track is more important than the team, and the team is the second most important. Then there is another question. Investing is investing in people. How can your investment manager identify this person? How does he judge whether this person is capable or not? It is relatively simple for you to see a track, but it is difficult to judge a person, because it is very difficult to judge whether his previous ability can support him to do a new business. Even if he has a better resume before, it may just be because he studied hard, went to a big company, and then worked step by step and had good luck. This does not mean that his ability will be stronger than others, nor does it mean that he can do new things in a new industry. So I strongly disagree with the saying "investing is investing in people."
Todd: I think this needs to be case by case, because if this product is in a state like UNI appeared in 2019, I might pull the trigger, because at that juncture, UNI is different from all the projects on the market. UNI can really move the DEX thing to the chain, and most of the order books before it cannot solve this problem. If faced with such a case, if he can put the product in front of me, I think I might pull the trigger. But other than that, facing most mediocre products on the market, I will say No, and only those very few, I might say Yes.
Henry: Whether a project can succeed is strongly related to the founder and the team, but these two are interactive things. It is necessary to judge whether their resources and capabilities match what they want to do. The question of whether to invest in people or not, it comes down to the fundamental fact that you need to come up with your ideas and your narrative to see if this narrative matches you. The most important thing is whether the team is suitable for doing this thing.
So it’s not just about the ability of the person. There are so many talented people in big companies, but big companies may not necessarily succeed in Web3. They need to be matched together for comprehensive evaluation.
Larry: The next question is a subjective one. What do you think of the due diligence process in the crypto VC industry? If you were to rate the industry level, how would you rate it? Why?
Joanna: The current market due diligence, especially from a security perspective, is far from thorough and detailed enough for large projects. Of course, this is not just a VC problem. Supervision is not in place and audits are not up to standard. We don't know how early project owners use their own funds. Where are the funds raised by these project owners placed? Where is it used? Is it safe? Is there any custody? These are all black boxes.
Therefore, if I were to give a score from the perspective of safety, it would probably be relatively low, around 4-5 points.
Forest: Regarding the completion of the due diligence, I would only give it 3-4 points.
In a bull market, everyone is very excited. You can’t be FOMO or not. At that time, there are too many people and too little porridge. Due diligence must be imperfect. Everyone is thinking about getting on the train. In fact, most VCs in the cryptocurrency circle do not have high AUM, and it is difficult to build a comprehensive team. For example, for code audits, technical solutions, business models and Tokenomics, you can’t hire so many people. One person plays several roles, but it is impossible for one person to play all the roles. When you encounter a project you don’t understand, ask a friend to help take a look. The person who looks at it may not be very professional. If he comes to you and tells you that there is no problem, then you make a decision. This is a very common situation. I can only give it 3-4 points.
Henry: I might be relatively optimistic. I would give it a score of 5-6, which means I am just approaching the passing line.
After all, in the Web3 industry, we mostly invest in early-stage projects, and the depth of due diligence matches the risks that the investment can bear, which is considered reasonable. Because of the risk appetite under the bull market, it is basically on the edge of qualified but risky. Now that the market has cooled down and the pace has slowed down, everyone has paid more attention to the depth of due diligence, so the industry has the ability to correct errors. Although it lags behind the risks of individual cases, it is still in dynamic adjustment and tends to balance the current level of industry development.
Todd: I would say it’s probably 4-5 points in a bull market, and 7-8 points in a bear market. Just now everyone talked about that in a bull market you have to scramble for allocations, and in a bear market you have time to talk about two or three rounds. The objective conditions are different, so the depth is naturally different.
Larry: Let’s make a simple summary:
Next, I would like to ask how do you do due diligence during the investment process? Will the FTX incident make you pay more attention to due diligence? What proportion do you think due diligence accounts for in your entire investment process?
Henry: I mentioned some of our operating procedures earlier. We first look at the narrative logic and the basic situation, then look at the overall situation discussed in the meeting. Then we will do some targeted due diligence on the overall narrative of the project itself and the points we think are key, especially the key content in the team and narrative, as well as possible risk points and other information.
The FTX incident will definitely make us pay more attention to the due diligence link, and I believe this is also the trend of the entire industry.
I feel that due diligence accounts for about 50% of our entire investment process.
Forest: In our own investment decision-making chain, due diligence definitely accounts for the vast majority. My requirement is 80%. I think the investment decision meeting is not the core part. The core part must be due diligence, which must be sufficient and objective.
We are very clear internally that if there are problems, you should write them down. It does not mean that we will not vote if it is not good. Of course, we will still vote objectively. But if there are problems and due diligence does not find them, then we will hold people accountable. This is a question of work ability.
If I were to give a score to our own due diligence process, I would give it 6 points. Being above the industry level is our requirement, and I hope we can achieve 9 points.
The due diligence process ultimately comes down to whether you understand the business. Even if you spend a lot of time, if you don’t understand FTX’s business, you still don’t know why FTX failed. If you understand the exchange business, you will know at a glance where its core problems lie and where its core value lies.
Therefore, it is very important to understand the business, which is also a relatively high standard for due diligence. We have also recruited some people from investment banks, but the financial analysis, technical analysis, framework analysis, etc. of investment banks are the most basic due diligence procedures, and they alone are not enough.
Todd: I think the due diligence process is similar for everyone. In a sense, I would also include the background of the person in the due diligence. We think it is very important and we will do it no matter what case we are looking at. We can understand the person's moral level based on the people who know him, his partners, and the places he has worked in the past. The part about people is not specific to a single case. You must dig out the person's moral level in every case.
As for whether the FTX incident will make us pay more attention to the due diligence process, I think the answer is definitely yes. I think whether it is a bull market or a bear market, as a responsible fund, we must do everything we can if objective conditions allow. As for how much proportion the entire due diligence process takes up on our side, I think it should be divided into stages. Especially for early-stage projects, due diligence may be 50%; but for those that have released POC, the proportion will be higher at this stage, and may reach 80%.
I think it depends more on the stage the project is in, because you really can’t see anything about early projects.
Joanna: Our due diligence is generally divided into three types:
The first is early stage projects, focusing on the track and founding team of the project. For projects at this stage, our investment amount will not be large, and there is not much data to track. The track and trend of the project are more important than the project itself.
Another thing is the team. We will dig more into the character of the founding team, understand their style, what they have done in the past, their personality traits, and whether they are willing to run a long-term race with investors and share their revenue and future together.
The second is mid- and late-stage equity projects. These projects generally have real revenue streams, such as banks, lending institutions, and exchanges. We will look at the real data, data reports, and financial statements, and the due diligence in this area is relatively in-depth.
The third is the mid-to-late stage token projects. At this stage, they have accumulated a certain amount of users, TVL or active addresses. There are real data support such as community, users, locked positions, wallet addresses, etc. However, after the FTX incident, we will do due diligence on the authenticity of this information. The result is that for some seemingly splendid projects, 80% of the real user addresses may be witch addresses. It is not ruled out that the project party has made a lot of data to create this false prosperity. In addition, when our team recently did on-chain analysis, it was found that even those well-known large Defi projects have more than 50% witch addresses. Of course, if all projects have 50%, I think it is acceptable, but if you are 80%, it means that you are almost all fake data, and such projects must be passed.
The FTX incident will certainly make us pay more attention to the due diligence process, but unlike before, I will pay more attention to how the team manages the cash flow. I think this is very important. For example, some of the project parties that have completed financing in the market have switched to UST to manage their finances at Anchor, some have lent their money to Sanjian, and some have put it in FTX. This kind of loss is very risky for the subsequent operation of the project. How will the project party use the money after getting it? You can seek some stable interest-bearing behaviors, but it must be transparent to us, and the risk exposure must be controllable.
Due diligence actually accounts for a high proportion of our entire investment process, especially for equity projects, which I think should be at least 80%-90%; for early projects, I think due diligence accounts for a much lower proportion, about 40%-50%. Our style has never been particularly FOMO-like, and we haven't stepped on any landmines during the entire bear market. On the one hand, we are lucky, and on the other hand, we have our own investment ideas.
Larry: Let’s make a summary first:
Finally, let's have an open-ended question. From the perspective of the Web3 industry, in this crypto market where the primary market has higher risks, do you think there are still potential systemic risks? Are there any gaps that can be filled through due diligence?
Todd: I think there will still be systemic risks, such as regulatory risks. The crypto market does not yet have an effective regulatory framework. Before and after the implementation of regulation, the systemic risk of industry reshuffle will be very high. As for whether it is possible to compensate for it with due diligence, first of all, you can avoid regulatory-sensitive projects, and secondly, when conducting due diligence on related projects, check whether the team is well prepared, whether there are compliant licenses, etc.
Larry: Which sectors do you think may face regulatory risks?
Todd: I think there are two. The most obvious one is Defi. The closer a sector is to money, the more strictly regulated it will be. So the Defi track is definitely a possibility.
Another possibility may be in the wallet or RPC aspect. I believe you may have seen some news, like Meta Mask jumped out and said that if your RPC uses Infura, then your transactions will be reviewed later.
The underlying infrastructure is threatened by regulation, and the asset layer above is naturally at risk.
Joanna: Several major events this year have eliminated the major deleveraging risks, but as the macro environment changes, there may still be lower prices. Of course, we cannot rule out the possibility of black swan events that will lead to continued leverage liquidation. In addition, the risk of small-scale deleveraging will still follow.
Todd: Actually, in my mind, USDT is still a big pit. I don’t know how the industry will digest it in the end, but the current state may not be safe enough, which may also constitute a factor of systemic risk.
Henry: I think compliance is a battle of wits and courage between the Web3 industry and regulatory agencies. Many projects were previously banned in China, and then they went abroad and are still doing well.
In fact, the Web3 project itself is supported by code, and it does not require any compliance at all, but the problem is that the people behind the project have to confront regulators, which is a problem that Web3 cannot avoid.
Stablecoins are something at the infrastructure level in Web3, but they are a black box and we cannot see them. This is a big systemic risk, but due diligence cannot solve it. Of course, the risk itself is not terrible. The most important thing is that you have to control the risk exposure of your assets.
Conclusion:
The fast-growing crypto industry is full of crises. Every industry correction brought about by risks will be precipitated into the practitioners' constantly improving Web3 mentality, which is painful but wonderful, thrilling but exciting. Facing the problems in the growth process of the industry and facing the opportunities and challenges brought by risk events, perhaps it is through such discussions and dialogues with wise men that the industry has been able to evolve again and again. Thank you very much for sharing!
