My dear Friends,

Anybody following the news has heard about FTX‘s spectacular collapse at the beginning of November, and many will remember the downfall of Theranos. The founder, Elisabeth Holmes, was recently convicted and sentenced. I can`t help it, but I think both FTX and Theranos have much more in common than meets the eye

This leads to a nagging question: What is wrong with investors? There were plenty of red flags. Maybe the financial market has other principles than I do, but I still wonder how seasoned investors and other “experts” could have fallen for their BS.

I really think it is time that every investor needs to change her mindset and learn some important lessons.

The Scammers

Elisabeth Holmes or Sam Bankman-Fried are not the first or the last founders accused of being scammers. Nor are Theranos and FTX the only companies that ever collapsed. However, the frequency of investors losing quite substantial amounts of money seems to be on the rise.

Remember the 2020-21 Special Purpose Acquisition Company (SPAC)frenzy? By December 2022, most were down sharply. With investors losing considerable amounts of money. Similarly, many of the once “promising” crypto firms are teetering, despite their multi-billion funding and “cool” ideas back in the early days of crypto

As a mere “retail” investor, I do ask myself, however, if all those clever and seasoned investors have lost their ability to see red flags. What drives them to be so reckless?

The others

The Theranos saga

The protagonists are Elizabeth Holmes, a Stanford dropout. And Ramesh(Sunny) Balwani, a self-made Millionaire. Balwani’s coup had been to sell his shares in a software company at a profit shortly before the very same went belly up.

In 2002 Balwani and Holmes met on a college trip to Beijing. She was 18, and he 37. Aged 19, Holmes launched Theranos(2003)- a company that would make medical diagnosis easier, faster and cheaper. With the help of her well-connected family, she had secured $6.9 million in funding by 2004.

Together they went on the “troublesome quest” to build a multi-billion business, apart from being lovers. Holms‘s “mission” was to build the lab of the future. The kind of lab where you needn’t spend hundreds of dollars on different tests and would get results almost instantaneously. “Edison”, as the device was called, would revolutionize blood- tests.

This dream machine, however, was never actually built. But they faked it and convinced the world that they had it. Balwani and Holmes had lied to the press, their investors and even patients who trusted them with their blood samples.

The crypto wunderkind

Sam Bankman-Fried, or SBF as his friends call him, was hailed a crypto ” Wunderkind”. In 2021, he was said to be one of the richest people in the crypto market. At only 30 years of age, his private wealth was estimated at $20,5 billion. Within five years, he had moved from being an arbitrage trader to a billionaire. The trading platform FTX was declared the third-largest cryptocurrency exchange with a $32 billion market cap.

With some private savings and money from friends and family, SBF, a math viz, launched Alameda Research in 2017. His business model: arbitraging price differences of cryptocurrencies in different markets. SBF was a smart actor and he soon earned almost one million daily. Despite his success, he grew increasingly frustrated with existing crypto trading platforms, so in 2019 he launched the crypto exchange FTX.

Between Alameda, FTX or Sam Bankman-Fried, for that matter, boundaries could, at best, be called fluid. It seems that funds were moved from one entity to another as and when “needed”. These funds were used to either supply much-needed liquidity, fund trading activities, buy a penthouse, or simply cover losses. In regulated markets, these activities are against the law. But all entities are registered in the Bahamas, including their CEO.

“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”

John RayIII, bankrupcy Attorney

The Downfall

The only difference between Theranos and FTX is the speed of their respective downfalls. Yet, both cases are stories of hybris and believing in their own baloney. But dramatic downfalls they were, and that did cost investors millions. FTX collapsed within a week, but it took almost two years to expose the shortcomings and inaccuracies at Theranos.

For Theranos, the turning point was 2015-2016. Three whistleblowers, an article in the Wall Street Journal, a persistent journalist and a visit by The Centers for Medicare and Medicaid Services brought the truth to light. By 2018, investors finally realised the medical science company was nothing more than a house of cards. Subsequently, Balwani and Holmes were indicted for wire fraud and conspiracy to commit wire fraud.

By privately investing in Theranos, business and government leaders had lost more than $600 million. In November 2022, Elisabeth Holmes was sentenced to 11 years and three months in prison. Balwani was convicted of 12 counts of fraud in July 2022- his sentence is still outstanding.

FTX’s and Sam Bankman-Fried‘s downfall, on the other hand, was a matter of 10 days. Back in 2021, FTTs had a market cap of $3.4 billion- by November 21st 2022, the market cap was at $500.000. FTX´s collapse dragged Bankman-Fried down as well; his 70% ownership of FTX’s US business is now estimated worthless. Subsequently, Bankman-Fried stepped down as CEO on November 11th, 2022. FTX filed for bankruptcy, and John Ray III, a bankruptcy attorney, stepped in as CEO.

Crypto Contagion

In early November 2022, rising interest rates caused contagion in the crypto market, and prices dropped rapidly. Sam Bankman-Fried, the smart and fast mover, uses falling prices to invest heavily- $ 1 billion– in crypto platforms and currencies. However, on the 2nd of November, CoinDesk, a crypto newspaper, publishes an article questioning FTX‘s liquidity. As a consequence, Binance and others sold their FTT holdings. By the way, FTT is FTX‘s native token and Binance, owned by Changpeng Zhao(CZ), was FTX‘s biggest rival.

The rapid decline in the value of FTX‘s native token caused a run by customers to exchange their tokens for real currency. The token’s price dropped by 80% erasing $2 billion in value. FTX is now faced with a serious liquidity crisis and stopped further withdrawals. On the 11th of November, FTX declared bankruptcy.

“I am sorry, I fucked up”

Sam Bankman-Fried, ex-CEO of FTX and Alameda Research

About Hype

Holmes’ product may have been more fluff than substance, but the funding that backed it wasn’t. Clearly, part of the reason for the hype was not just the product but Holmes herself. This attractive, smart, persuasive 19-year-old, and the only woman in tech, was “cool”. Styled as a female, Steve Job, speaking with a faked deep voice, she put a hypnotic trance on almost anyone she spoke to.

Theranos/Holmes raised over $1.3 billion in its history. The initial funding of $6.9 million was courtesy of her well-connected family. They had introduced her to investors like Don Lucas, Tim Draper and Larry Ellison. With such prestigious investors in her pocket, she could assemble a board and counsellor comprising Former US General Jim ‘Mad Dog’ Mattis, Former state secretaries of state George Shultz and Henry Kissinger.

“They weren’t interested in today or tomorrow or next month. They were interested in what kind of change we could make.”

Elisabeth Holmes, Founder and CEO of Theranos

The Utilitarian

A twenty-something ex-broker becomes a billionaire – his purpose is to “earn to give”. Sounds super cool and absolutely fits the Silicon Valley trend of “effective altruism”. But, the reality is SBF only ever donated 0,1% of his wealth.

However, the real driver of success was always SBF himself. Firstly, he perfects his Gen-Z nerd image. Apart from a few occasions, he is dressed in trainers, shorts and a hoody. Moreover, he only ever visits “sustainable” restaurants, is a vegan, sleeps on beanbags in his office, and is rumoured to play video games while pitching. He embodies the start-up hustle culture by optimizing his life for the maximum amount of work.  

“…we conduct robust due diligence on all private investments”.

Ontario Teachers’ Pension Plan, FTX Investor

This very charismatic CEO was hailed as the JP Morgan of crypto, while he brags about having a balance sheet that could one day buy Goldman Sachs. With a good dose of hybris, he went on extensive press tours, engaged celebrities to market FTX and became a fixture in Washington. The latter is not only a ” donor presumptive” but a trusted advisor for regulating the crypto market. Which is quite ironic in hindsight. The FTX logo was suddenly everywhere, from Formula 1 to basketball stadiums and even the London underground.

Nobody can yet foresee what else will come to light or what will happen to Sam Bankman-Fried. One thing, however, seems obvious: the many “improper transfers” of FTX customers’ funds to Alameda had been going on for a while and left FTX vulnerable to withdrawals. However, why Alameda lost so much money is less clear. In the end, it was a steep fall from hero to villain.

Important lessons

Fake it till you make it; isn’t this how one gets rich, fast? Come up with a vision, build hype, throw the media into a frenzy and collect as much funding as possible along the way.

At its best, Silicon Valley is optimistic. At its worst, it is so naïve it believes its own hogwash. Meanwhile, investors collectively caught the “negligence” virus or suffer from collective FOMO.

Well, there is no law against faking something unless you injure and defraud someone. However, let’s not forget it takes two to tango! One is the scammer, but the other partner is a willing investor who does not bother to check. This is not an excuse for scammers but a wake-up call for investors- especially for those who invest in other people‘s savings.

In conclusion, it seems that due diligence went out of fashion. Yes, there is nothing more boring than the process of checking that potential investments can live up to their promises. However, letting this important tool fall completely by the wayside seems to have become common practice. Celebrities, social media and peer bias have become the latest resources for investment decisions

Investors who want to restore standards should start with the financials. By now, Theranos and FTX should be enough reason to insist on proper audits that delve into how companies spend their money and fully disclose related-party transactions.

Some touchy founders will object, and some visionaries will struggle to meet the higher bar. But the best new companies will survive -they are probably less flashy but more sustainable. They might even soar higher if they no longer face competition from zombies kept alive only by prodigal investors and social media endorsement.

Postscriptum

Firstly, on Nov. 16, 2022, a class-action lawsuit was filed in a Florida federal court, alleging that Sam Bankman-Fried created a fraudulent cryptocurrency scheme designed to take advantage of unsophisticated investors from across the country. Secondly, celebrities are also named in the lawsuit, including Steph Curry, Shaquille O’Neal, Shohei Ohtani, Naomi Osaka, Larry David, and Kevin O’Leary, who allegedly helped Bankman-Fried facilitate the plan.

Take Away

Over the last decade, the amount of easy money has grown exponentially, and so has investors’ fear of missing out(FOMO) on the next Amazon or Google deal. That left investors vulnerable to scammers. Desperate for opportunities, preferably with a high degree of “exclusivity” and “fame”, rendered investors picking companies based on the charm of founders, celebrity endorsement, mainstream blabla or who else was part of the funding round. Rather than on whether the entrepreneur’s business plan made sense or not.

With interest rates rising the problem might solve itself. With money getting more expensive, investors will hopefully learn the important lesson that the many frictions and frustrations with traditional financial markets are there for a reason – protection!

Investing in a vision is certainly good, but checking out the business idea and demanding a business plan before investing is called due diligence and is the most important tool investors should use. Investing in a charming person, a vision or just a dream without a concept for its implementation is gambling.