How the world’s best VCs torched $1.9B

We were once aggressively pitched to invest in a sports beverage firm.  The frontman was a twitchy but smooth-talking CEO from Newport Beach, peddling an extraordinary story about explosive growth.  The company – H2O Overdrive – was going to become the next Gatorade, and we had invest, and right now, or we’d miss it.  Turns out, it was pure fiction.  More on that in a moment.

Investment diligence is on our minds as nutty details emerge about the FTX collapse:

Sam Bankman-Fried playing League of Legends during a video call pitching investors.  Sequoia wrote a fawning piece about the moment.  It didn’t age well.  (They’ve since deleted it but it’s still available on the wayback machine.) Highlights:

Suddenly, the chat window on Sequoia’s side of the Zoom lights up with partners freaking out.

  • “I LOVE THIS FOUNDER,” typed one partner.
  • “I am a 10 out of 10,” pinged another. 
  • “YES!!!” exclaimed a third.


Paying Tom Brady $55 million to do 60 hours of work.

Offering Donald Trump $5 billion not to run.

But perhaps most astonishing: SBF raised $1.9 billion in seven months – despite FTX being draped in red flags.

Diligence, Schmiligence

And that’s not just Monday morning quarterbacking.  The flags were blindingly obvious at the time, not just in retrospect:

  • The auditor for FTX when it raised at a $32B valuation: Prager Metis.  Never heard of them?  No one else had either.
  • The directors on the FTX Board?  Sam; an Antigua-based gaming lawyer; and an FTX employee SBF was unable to name (he described their job as being “just to DocuSign whatever.”)  And…no one else.  Even Temasek, the largest single investor, who stroked a $215mm check, didn’t have an observer seat, much less a Board seat.

FTX was later described by the bankruptcy trustee as showing “a complete failure of corporate controls and a complete absence of trustworthy financial information.”  It seems that should have been patently obvious to anyone doing the most cursory diligence.  Instead of spending time on diligence, investors wrote fawning hagiographies of SBF.

FOMO-Induced Blindness

So why did they invest?  The four horsemen of bad due diligence: Greed.  FOMO.  Social proof.  Emotion.

FTX had it all.  A glittering array of other check writers provided social “proof” that FTX was legit.  NEA, IVP, Third Point Ventures, Tiger Global, Insight Partners, Sequoia Capital, SoftBank, Lightspeed Venture Partners, Temasek Holdings and BlackRock to name a few.  If they’re in and you have doubts, there’s not something wrong with them.  There’s something wrong with you.

That social proof fueled the FOMO.  FTX’s valuation exploded to $32 billion in just 3 years.  It’s going to the moon.  How can you afford to miss out when everyone else was in?

As Sparkline Capital described it, “You get a bizarre f*cking process that does not look like the paragon of efficient markets that you might expect.  VCs see what all their friends are chattering about, and their friends keep talking about this company…and they start FOMOing and then they find a way to get into that…”

FTX investors seemingly missed the most the basic form of diligence: Systems.

There’s another basic form of diligence missing in another recent investment blow up:  Common sense.

It was ignored in evaluating WeWork.  The idea that WeWork should be valued like a social media company, instead of what it was – a real estate firm – always defied common sense.  WeWork’s S-1 reported “Community-based EBITDA” which subtracted expenses including real estate.  As Scott Galloway noted at the time, a more honest description of the metric would be “EBEE, Earnings Before Everything Else.”  (Galloway suggested some other alternative measures which would be equally illuminating, including “EBG, or Earnings Before Gluten.”)

Softbank didn’t use this common sense diligence filter on its review of WeWork.  They invested $18.5 billion.   WeWork’s market cap before its bankruptcy filing last week: $45 million.  Masayoshi Son described the WeWork investment decision as a “stain on my life.”  Yikes again.

FOMO Almost Took Us Down, Too

We’re not trying to dunk on these investors.  We’ve felt the same pull of FOMO.

dorky but confident CEO pitched our growth equity fund on his explosively-growing sports beverage business, H2O Overdrive.  The company came out of nowhere and hit $28 million of revenue in year 2, he said.  It was flying off the shelves.  They had huge purchase orders from Costco, CVS and Rite Aid.  They were a lock to hit $42 million the following year with EBITDA of $8.2 million.

Greed glands were pumping on our side of the table.  Big time.  And H2O Overdrive had dozens of high net worth individuals ready to take the whole investment round.  We needed to act now or we’d miss it.  But they got quiet when we asked for detailed financials.  They got quiet when we asked to speak to their largest retail accounts.  They got quiet when we asked to speak to their Board.

So, we walked away despite having chased them hard.  Good decision.  He later went to prison for fraud.  He said projected sales for were $28 million; they were actually less than $579,000.

He said Costco, CVS and Rite Aid had major contracts to sell the drinks.  Not true.  All told, he scammed more than 50 people out of $7 million.  He went from the corner office to the big house, the kind with bars on the windows.

Is it Rational to Pile In Anyway?

Now, it might actually be rational to pile into an investment despite red flags, if you’re sitting on a monstrous war chest.  You might miss the occasional superstar if you get too fussy with your diligence.  Ontario Teachers lost $95 million when they wrote their FTX investment down to zero.  But that was only 0.05% of their total net assets.  (They drily noted that “not all early-stage investments perform to expectations.”)

But as a Wharton prof noted, “You can look like a genius making successful big bets, but sooner or later you’ll crash spectacularly if you aren’t doing real diligence.”

If you’re not in a position to torch a few million here or there, you have to be comfortable with sitting out a red hot story that lacks systems, or defies common sense.

And if you pile in anyway, the SEC may make it easier for your investors to sue you for engaging in groupthink.

So, investment counsel from the Department of the Obvious: Diligence?

It’s due, when you’re writing checks.

To learn more about how VO2 Partners can optimize your investments, schedule a get-acquainted conversation here.


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