On FTX, Sequoia and Why Power Law Works
On Friday, crypto trading platform FTX declared bankruptcy. It was a stunning fall for a company once valued at more than $32B and whose CEO was being lauded as the next Warren Buffet.
One of the threads being discussed across the internet was how FTX’s investors, a list that included prominent VCs like Sequoia, NEA, IVP, LSVP and Tiger Global, could have failed so miserably at diligence. Amongst the many salacious narratives was this one, from a profile of FTX founder Sam Bankman-Fried:
I’m not here to scrutinize or editorialize the diligence process of Sequoia or any other investor in FTX. I have zero direct knowledge of what did or did not transpire in any fund’s diligence process. The vast majority of VCs perform substantive diligence for each and every investment and, while it might be fun to believe, in general they do not “skip diligence”.
In this post, I want to shine a light on how power law VCs think about portfolio construction and why properly constructed funds are able to withstand losses of this magnitude. Moreover, I’m going to share my thoughts on why this ability is so crucial to the rapid advancement of tech that we’ve enjoyed over the past two decades.
Marking Down to $0
Last Wednesday — two days before FTX declared bankruptcy — Sequoia publicly shared a letter that they had sent to their investors about FTX. In the letter, they stated that they had effectively written off FTX entirely by “marking our investment down to $0.”
The letter instantly made its rounds across social media, with plenty of sensational headlines. In reality, the action of marking an investment down to $0 is quite normal for venture capital firms. Every quarter, VCs around the world review their portfolio in advance of preparing a “quarterly update” for their investors. For each company in the portfolio, the fund managers must decide one of three actions to take with respect to the company’s current value:
“Mark up” the company (increase the valuation)
“Mark down” the company (decrease the valuation)
Maintain the company’s current valuation
The process of choosing which companies to “mark up” or “mark down” is dictated by a formal policy that every VC has, called its “valuation policy.” In general, valuation policies are very particular about when, why and by how much a company’s valuation can be changed. These policies are scrutinized by investors and incorporated into annual reviews by external auditors.
Mark Ups / Write-Ups
The most common reason for a company to be “marked up” by an investor is that a subsequent investment occurred at a higher valuation (e.g. Panache invested in a company with a valuation is $5M and, two years later, another VC led an investment round that valued the company at $10M. At that point, we would “write-up” our investment in the company based on the new, higher valuation). This process is referred to as “mark-to-market.”
Mark Downs / Write-Downs
Mark downs typically occur for one of two reasons:
A subsequent financing at a lower valuation (i.e. a “down round”)
A discretionary write-down by the fund managers
Unlike mark ups, which are almost never discretionary, it is very common for VCs to mark down investments for discretionary reasons. Doing so regularly and consistently builds confidence with the fund’s investors and ensures that the overall fund valuation is never too “optimistic.”
That said, even the process of “discretionary” write-downs is dictated by a formal policy, which defines when, why and by how much an investment should be marked down. Here is Panache’s policy on discretionary write-downs:
Typically, individual mark downs are shared with investors on a quarterly basis (as part of the fund’s “quarterly report). So while Sequoia’s decision to share it’s write-down of FTX immediately and publicly was notable, the fact that it marked the company down was not.
It’s Only $150M
In Sequoia’s letter to investors, they noted that the “$150M cost basis accounts for less than 3% of the committed capital of the fund.” To many casual observers, this statement came across as an excuse:
In fact, Sequoia’s declaration highlights that their investment in FTX was inline with a typical portfolio model for a power law VC.
Panache’s portfolio model (which is codified in the agreement between Panache and our investors) specifies an almost identical limit of ~%3 committed capital into any given company. So while the commentary above may get a lot of engagement on Twitter, the reality is that the two points made by Katie are the literal definition of power law VC investments.
Why Power Law Works
Why does all of this this matter?
Investing a relatively small percentage of a VC fund into a large number of companies ensures that when companies we invest in fail (and to be clear, that’s the majority of the time for an early-stage VC), no single failure dooms the fund.
Last week, I wrote about the 9 different types of startup investors. In describing power law VCs (a category that both Sequoia and Panache belong to), I noted that this type of VC “…expect[s] one or two companies to drive the returns of their fund, while the rest will provide a rounding error.” Put another way, an effective power law VC will generate a meaningful return for its investors even if all but one or two companies go to zero.
Leo Polovets of Susa Ventures once captured this point aptly:
To most people, losing $150M on a single investment seems absolutely absurd. But within the context of power law investing, what’s most important is not the number of dollars invested, but the percentage of the fund that the investment represents. As such, Sequoia’s loss of < 3% on FTX is par for the course.
That fact underscores why power law investing is so crucial to how the modern startup ecosystem operates. If VC funds were not constructed in a manner that could withstand the majority of their investments failing, it would be virtually impossible for founders to raise funding for anything other than businesses that represent incremental improvements to the status quo.
This is why the behavior of “Silicon Valley” VCs often draws such a stark contrast to regional VCs and investors in other parts of the world. In knowing that the fund is designed to withstand an incredible number of failures, the fund managers of power law VCs are empowered to take bigger risks.
The origins of power law investing go back nearly 250 years — this book provides an excellent history of that
Final Thoughts
In writing this post, I’m not absolving any of FTX’s investors of anything. As I stated earlier, I have zero direct knowledge of what did or did not transpire in any fund’s diligence process. Each VC, undoubtedly, will face questions from their investors on the process that led to their investment in FTX. There will be lessons learned.
I’m also most certainly not absolving FTX itself of anything. Individuals and businesses around the world have been impacted by their downfall, and there are likely still more shoes to drop.
But this situation provides an excellent case study in the thought process of power law VCs. The reaction of Sequoia — which, to the general public, can come across as shocking or a dereliction of responsibility — is exactly how power law VCs should invest.
When they see something with potential – even if that potential is unlikely – we want investors to back it. True innovation at scale requires financial resources, which demands investors who embrace risk.
And if they take a big swing and miss, we don’t want them to stop swinging.
To innovate, we must fail a lot. And that includes investors.