Startups: Avoid the ‘Emperor’s New Clothes’​ hallucination of FTX

In a matter of weeks, FTX, an emblem of venture-backed crypto, has become a casualty of consensual hallucination between a bombastic startup founder, and investors who seemingly shopped at the tailor who makes emperor’s new clothes. FTX filed for bankruptcy on November 11, having been valued at $32bn in January. The Financial Times reported an $8bn black hole in its balance-sheet, looking as sophisticated as a household’s spreadsheet.

The collapse of wunderkind founder Sam Bankman-Fried’s FTX looks set to go down as one of the greatest financial debacles of all time. FTX was the third largest crypto financial exchange acting as an intermediary, one of the major factors fuelling cryptocurrencies’ price growth, and accordingly, bitcoin and ethereum prices have plummeted. The pertinent question is whether crypto lobbyists will be able to contain the damage.

Centralised exchanges such as FTX democratised the crypto domain, allowing ordinary people without technical skill to invest and conduct transactions. The 30-year-old Bankman-Fried wore a halo of sorts on his mop-haired head not just for trying to bring a semblance of respectability to the chaos of crypto, but for appearing to do it to promote the greater good of humanity.  Bankman-Fried’s net worth reached $26bn at its peak. He played the iconoclastic whizz kid and raised almost $2bn from investors. All appear to have been blindsided by the hubris.

Many saw a new John Pierpont Morgan, the banker who saved the American financial system in 1907. Bankman-Fried had spent millions of dollars supporting campaigns on crypto regulation. Many thought he was the man who could save the industry from itself, a reputation he hardly discouraged. In frothy capital markets such a romantic delusion is possible, where the charisma and audacity of the founder is more alluring than spreadsheets, and investors jostle with each other to write cheques of $100m.

However, the fundamental flaw here is that capital isn’t a strategy – which has been the FTX operating model. In 2021 Sequoia Capital made its first investment in FTX, which reached $210m but is now written down to zero. The fallout will have wider consequences. The crypto winter has previously claimed only the types of victims that would be expected, including a poorly designed stablecoin.

To the moon, and beyond. Much of crypto is a casino, high-octane, shiny and tempting. Bankman-Fried positioned himself as the champion for the less dubious end of the industry. But it is now clear he ran one of the most dubious casinos of all. Crypto advocates must hope it is the underlying technology’s turn to shine. There remains potential for decentralised finance but there are also many more excited by the technical possibilities of crypto than the financial benefits who are looking to create new industries built on blockchain, such as decentralised science.

The guardians of capitalism too often fall for too-good-to-be true narratives. FTX crashed, leaving 1m creditors out of pocket. SoftBank has been acting like it’s the 1850s Californian gold rush all over again. They lost $23bn on We Work where megalomaniacal founder Adam Neumann seduced their ambition, and now $100bn on FTX. Once bitten, twice shy surely?

So, what are the lessons and impact for tech startups in Manchester we can take from this debacle?

Valuations Are Unicorns overvalued? In a recent survey, Yes said 91% of VCs who don’t have any Unicorns in their portfolio; and Yes said 92% of the VCs who do.

The spiralling valuations of tech startups in 2021 were based on unsustainable rates of assumed rocketing growth and have now been corrected. Uber, once considered the biggest and fastest unicorn of all, lost $1.2bn in Q2. Uber’s growth has been spectacular, but there is something unreal about a company losing $8k a second.

We need to blend the reckless ambition of founders with the sober adult supervision of investors to both create and sustain the startup eco-system. Show your startup has a genuine edge and innovation, an ambitious customer scaling roadmap, and a credible strategy to achieve cash generation – and don’t get greedy on your valuation. Focus on your fundamentals not the hype of someone else’s story. Valuations are the process and mechanism for connecting founders and investors, so let’s be sensible.

Attract investors with innovation Asked whether they make a gut decision to invest in a fledgling company rather than relying on analysis, 44% of VCs said yes. Some 9% admitted they didn’t use financial metrics to back this up.

Crypto is now facing the unhappy confluence of worsening macroeconomic conditions and regulators hungry for control, and will, for the first time, be subject to value-driven investment. Tokenomics was never real. There is supply, and there is demand. When in balance, market’s function. If they are not, markets do not. We know now centralization in crypto markets does not work. There are too many opportunities for profiteering charlatans. The result? Shattered illusions of those who believed in the pot of gold at the end of the crypto rainbow.

There are two challenges. The first refers to cryptocurrency as a financial asset class; the second to blockchain as technological scaffolding. The stumbling block to assessing crypto as a financial asset class is that there is simply no functioning model for valuing protocols, it’s still a nascent industry. In the earliest stages, no yardsticks existed to assess these networks.

Back on planet Earth, a startup is a bet on a business model executing its innovative offering, attaining the scale/critical mass beyond which the unit economics starts making sense. Be clear about your innovation goals and show potential investors this will enable growth and long-term competitive advantage, in the context of the current market dynamics.

Be clear about your growth strategy SoftBank’s cash infusion helped FTX cover the cashflow risks of its whirlwind growth and weak, if not falsified balance sheet. The lack of transparency and regulation on crypto deals made it difficult to determine the underlying dynamics, as demand and price points have fluctuated significantly, so what was their growth strategy?

Avoid a rolling round of bets like FTX enacted. Focus on determining the economic drivers of success, not throwing out outrageous revenue projections, and build a growth story around this in terms of scaling and winning market share. FTX failed to demonstrate any foundations for growth, everyone fell for the hype.

Set and hit your (proper) metrics  Finding normal accounting a bit boring? FTX failed to apply proper governance and financial control protocols – because in crypto land, there is no de facto regulation and compliance requirement. FTX looks to have been manipulating and massaging its numbers, even using customer deposits to supplement cash flow, adding further fuel to undermining trust in crypto.

The hype superseded numbers. It was accounting jujitsu at its finest. At some point, startup gestalt of overpromise and underdeliver can paint founders into a corner where they begin massaging numbers. Simply, set your metrics to give you a line of sight to run the business, and also create credibility, trust and confidence with investors.

Know the risks in your business model FTX’s collapse marks more than just the failure of a crypto exchange. It signals the time has come for the industry to grow up and embrace value. The value schism is here. FTX was the world’s second-largest crypto exchange. Now, it is the death rattle of absurd amounts of money being poured into refurbished centralized business models whitewashed in pseudo decentralization.

In all markets, the market leader gets an unfair advantage as casual and unsophisticated customers choose the leader because it feels safer. But your startup strategy is not to wish and dream of becoming a big fish, rather to pick a small pond initially. By engaging with a small but viable audience, you gain the reputation and trust you need to move to ever-bigger audiences.

Have a vision, but don’t hallucinate Until recently the image of an entrepreneur was of a thrifty workaholic toiling away long hours. But Bankman-Fried was more iconoclast than entrepreneur. In such cases, attention invariably focuses on the founders’ hubris. Their rise and fall is the stuff of barnstorming bestseller novels. Ultimately, they fall off their pedestal because the foundations lacked grounded reality.

The startup world is filled with the idolatry of winners, constantly promoted on Instagram, creating a high many then chase with a false narrative that we live in a meritocracy, which has dulled our sense of reality. We’re addicted to growth at all costs. Overnight. I’ve always preferred opportunities where time is an ally, not an enemy.

We’ve lost sight of what’s important. We’ve lost ourselves. You’re a founder in your own image, for yourself, for your vision, your purpose. Stick to creating your own journey, and don’t hyper ventilate on false heroes and usurpers who mirror Iago in their own being.

Avoid Blitzscaling The folly of FTX began with adoption of ‘blitzscaling’, a growth strategy devised by Hoffman and Yeh, from the blitzkrieg or ‘lightning war’ strategy of Nazi General Heinz Guderian. It’s based on the premise that if a company grows big and fast enough, profits will follow.

Blitzscaling means you need investors with deep pockets as you raise continuously ahead of profitability to win market share. You’ll need more money than you think, to recover from the mistakes you’ll make along the way. For me, blitzscaling isn’t a recipe for success but rather survivorship bias masquerading as a strategy. Eventually it spreads the company too thin, just as Guderian’s blitzkrieg which had worked so well against France and Poland, failed during the invasion of Russia.

Blitzscaling is a do-or-die approach. Cash-burning startups may find themselves stranded. Winners-take-all is an investment philosophy perfectly suited for our age of greed, inequality and economic fragility. But is a business really a business if it can’t pay its own way?

Beware false prophets Hagiographies in the financial press didn’t help. Bankman-Fried graced the covers of both Forbes and Fortune.  You could call it the Icarus complex. He flew too close to the sun. But where was Daedalus? Why do the self-interested stewards of capitalism – VCs, investors, the business press – so often fall victim to too-good-to-be-true narratives?

I’m stunned at how Bankman-Fried’s cult of personality kept the questions about FTX’s viability at bay, masking an outsized view of his own leadership capabilities. Investors tolerate and accept a fragile, embryonic startup leadership culture, but again the FTX fiasco may change this.

Speculating and investing are two different things Many leading investors regard crypto as not, in any shape or form, investment but sheer speculation. But FTX’s investors all made the same mistake: when there is big money to be made, investors lose their heads. Then their shirts. Huge financial institutions such as BlackRock, the world’s biggest fund manager, fell for the hype.

The key takeaway here is build your team as much as your brand and product. Remove as much risk from the sole focus on the founder an investor’s perspective as you can. Make your startup a compelling opportunity for investors to ‘get in early’ and whilst there will always be an element of speculation in any new venture’s future, address the potential points of failure as soon as possible.

The salutary lesson from the trauma of FTX is that common sense will prevail, and the rocket fuel stoking the crypto mania may be rationed. This will cause a shift away from the quest for growth at all costs towards more responsible stewardship of startup capital to ventures that can show better runway management alongside growth. The goal for startups should be to make their ventures sustainable, not just explosive.

When an entrepreneur, for all his charisma, cannot demonstrate how to systematically move from cash burn losses to profitability, we’re back to the parable of the Emperor’s New Clothes. This gets to the heart of values and virtues that must be central to everything: the truth. But for Bankman-Fried, truth didn’t matter. What mattered was the narrative and he managed the narrative to perfection even before his house of cards came crashing down.

Maybe it’s the greatest example of Hanlon’s Razor ever – never attribute to malice that which can be adequately explained by stupidity – because there is no way to do justice to the retelling of Han’s Christian Andersen’s classic tale with the FTX narrative, but a review of the characters and their shared drama might serve to position us better for improving startup investment ethics.

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