3 Practical Lessons Startups Must Learn From FTX's Collapse

It's no longer news that FTX has collapsed. What is news is just how spectacular the scale of that collapse has been and continues to be as the company (FTX Trading Limited and a network of over 180 affiliated companies) has declared bankruptcy and its customers are now unsure whether they’ll be able to receive their deposits back.

Just a few weeks ago the company was the second largest cryptocurrency exchange globally, Processing between $10 and $15 Billion daily through much of this year. In just a few days, however, the entire company collapsed, taking its market capitalization from about $32 billion dollars at its last fundraising round to zero, give or take a few zeroes. Here's a graph that shows the value of the exchanges own token FTT.

Why is this important? It's important first because FTX was one of the largest cryptocurrency companies globally and thus had great influence in the broader market in terms of visibility and media.

The company’s collapse has increased FUD (Fear Uncertainty and Doubt) in the crypto market (since its collapse, Bitcoin has dropped to levels not seen since 2020), with almost $150 Billion in value wiped out for investors over the past week, from over a $1Trillion last week to $845.73 Billion today. It’s also important because of the company's shareholdings in a variety of other crypto related companies. Here's a graph that shows the companies that FTX was invested in.

Many startups had their funds domiciled there, and at least one startup has declared that it’s having to let go of staff due to its losses in the collapse and one hedge fund has delared that most of its funds are stuck there. Given the scale of FTX, it's very likely there will be many more similar cases announced soon.

You can check the latest issue of Oghenerukevwe Odjugo 's The Beginner Investor newsletter for more analysis on why all of that happened, but what is certain is that this is a fate startup founders and investors must work to avoid at all costs. So, what are the lessons to be learned and implemented?

1. Corporate Governance. This relates to the rules that determine how a company is controlled. It flows from the board of directors to the management of the company. Often, it is imposed by law, but most elements are left to the discretion of the company. In FTX’s case, there have been doubts as to whether the company had a board of directors, and if they die, who was on it. In retrospect, that’s astounding for a company that held billions in customer deposits. 

One example of a major corporate governance failure was in the fact that the company loaned money to Alameda research under very opaque terms. Alameda Research was a crypto trading company headed by a person who had been described as SBF’s girlfriend. Such a transaction would have been subject to disclosures and increased scrutiny in an organisation with strong corporate governance measures, likely requiring a vote in which SBF would not have taken part in. Unfortunately, it seems that all that was required was SBF’s sign-off and retail investors now have to bear the brunt of the near-inevitable consequences of mixing business and pleasure. 

Startups MUST institute corporate governance controls. All startups. It might not be the right time to have a full board in place, but a company without clear delineations of authority among the co-founders and checks and balances (set out in legally-binding agreements or policy documents) to ensure that authority isn't abused, is very likely going to be making huge, avoidable mistakes. Just look at Twitter.

2. Jurisdictions and Regulations. FTX finance set up a wide range of corporate entities in a variety of jurisdictions aiming to reduce the exposure and the financial regulations which they had to comply with. 

The headquarters of the organisation was in the Bahamas and it had other in other offshore jurisdictions that had very few regulations. For instance, there was FTX US, which was incorporated in the United States of America as a legal requirement to be able to market directly to American citizens. Unfortunately, most countries did not impose any additional obligations relating to custody of the funds, insurance etc. That meant in practice that customers who invested from countries with strict financial regulations (see the Bahamas below) would have a higher chance of getting their funds back. However, the vast majority of customers would not have understood these distinctions and will have no recourse now.

Many startups and indeed many large, established businesses choose to take this approach because it minimises their regulatory obligations. However, it's an approach that must be taken carefully, cognizant of the fact that those regulations exist for a reason, and that although avoiding them might make business easier, it might not necessarily make business better or safer, especially in the long run. If FTX had kept its operations primarily in a jurisdiction that had strict controls on corporate governance, custody, insurance etc., it would most likely have been able to avoid this implosion because many of the things that led to the implosion, such as undeclared conflict of interest would have been spotted and rectified either internally by measures that are required by law, or externally by regulators.

In my field - privacy compliance, the general mindset among practitioners is to maintain the highest standards (currently the European GDPR) even when in places that have less-strict ones. That makes compliance more efficient since it’s uniform (even if it sometimes can cost more) but it drastically reduces the chances of breaches or regulatory penalties happening. It’s an approach worth considering by startups - remain domiciled where there's less regulatory overhead but default to global compliance best practices unless it's absolutely necessary to deviate.

3. Expert and Objective Advisers. FTX was audited, advised or in partnership with many of the largest professional services firms globally, including their auditors Armanino and Prager Metis, and extending to Big 4 firms like Deloitte and PWC, global banks and investment funds, and law firms in the top 10 lists in the UK, US and other countries, according to its survey responses to Forbes Magazine as recently as August. It’s an impressive list, but it becomes alarming when one considers recent developments, especially the allegations that there was a backdoor installed that allowed SBF to manipulate the company’s accounts without any oversight. 

Were all these advisors oblivious to the serious legal and financial failings at the company? Were audits conducted and were audits properly conducted? Were there red flags identified in those audits and were remediation actions recommended and implemented?

Those are not questions one can speculate on, and they're questions that’ll very likely be settled in court in due time, but it’s clear that something certainly wasn’t being done right.

Too often, advisors deliver lots of policies to allow clients tick boxes and move on, but little is done to track and audit compliance on a regular basis. In FTX's case, FTX.com's terms of service make it clear that the company promised users it would not do what it is recently alleged to have done.

• "You control the Digital Assets held in your Account," says Section 8.2 of the terms. "Title to your Digital Assets shall at all times remain with you and shall not transfer to FTX Trading."
• The terms continue: "None of the Digital Assets in your Account are the property of, or shall or may be loaned to, FTX Trading; FTX Trading does not represent or treat Digital Assets in User’s Accounts as belonging to FTX Trading."

For startups, the lessons here are simple - hire the best possible advisors, but define ‘best’ by actual experience and expertise, not branding. It might impress investors to have big names on your slide decks, but it won’t do you any good unless those advisors actually guide (or push if necessary) you to the best decisions. Ensure that they build a compliance framework and actually follow it.

Perhaps if all that had been done someone would have said ‘wait, I don’t think you should be loaning your other company that's run by your romantic partner billions of $ of customer funds without adequate collateral, while your main company has liquid assets of about 1/10 of its liabilities.’

And perhaps SBF would have listened.

Perhaps.

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What are your thoughts on FTX? Would you still deposit to crypto exchanges and what would you be taking into consideration, if so? Please like this post if you enjoyed it, share your thoughts and be sure to forward the newsletter to anyone who would find it useful.