4 Ways Crypto Startups Can Avoid an FTX Collapse
December 7, 2022
By now you’ve probably heard about the collapse of FTX. The $32B cryptocurrency exchange imploded after a crash in crypto prices and a reversed bailout offer from Binance (a larger, rival exchange), followed by a run on deposits and an alleged hack.
How bad was it? Well, as if the allegations of fraud and use of corporate funds to buy luxury homes in the Bahamas weren’t bad enough, it’s likely that most of the 80-some investors who put more than $2B into FTX — including several prominent venture capital firms and some celebrities — will never see their money again.
The meltdown has sent shockwaves through the industry. Cryptocurrency platform BlockFi has filed for bankruptcy, and brokerage firm Genesis has suspended withdrawals. Treasury Secretary Janet Yellin has called for more government regulations around crypto, calling the FTX collapse a “Lehman moment.” As the details emerge, many of us are wondering what the repercussions will be.
What does the FTX collapse mean for the future of crypto?
This is the question on many people’s minds. And if you’re from the East Coast, maybe you’re wondering: Was the fall of FTX a sign that “crypto winter” is deteriorating into something fatal, or was it simply a disruptive Nor-easter, a harbinger of a coming spring for the blockchain?
Any new technology comes with inherent risk; crypto is no different. The lack of transparency into FTX’s operations underscores the missteps of some bad actors, for sure. And the lack of regulations to prevent those missteps reveals some important vulnerabilities the industry needs to address. But as the banking crisis of 2008 taught us, even assets and firms considered to be safe and trusted aren’t always what they seem. This is why financial transparency and internal controls are so vital, no matter what sector you’re in.
Most importantly, if you’re a crypto startup or an investor in one, you probably want to know how the FTX collapse will impact you. Let’s look at how you might read the FTX meltdown as paving a path to healthier growth, in a dynamic market with a ton of potential, and four ways your project can avoid an FTX fate.
1. Know what’s going on with your startup’s finances.
Bloomberg’s Matt Levine has observed that “a big part of the reason that FTX believed it was so profitable is that nobody made any effort to keep track of the money.” When FTX founder Sam Bankman-Fried denied knowing that FTX was on the verge of collapse, he assigned blame to “huge management failures” and “sloppy accounting”.
“I didn’t know exactly what was going on,” he reportedly said.
Pro tip: if you’re a founder, “I didn’t know exactly what was going on” are words you should never, ever have to say. You should always make an effort to keep track of the money. There’s no reason why you can’t have a basic understanding of your finances at all times. If you don’t, it’s time to ask for help.
Knowing what’s going on with your startup’s finances isn’t just accounting 101. It means having insight into your balance sheet, your operational processes, and your digital assets. It means understanding what’s under the raw numbers and feeling assured that you’re operating with ethics and transparency.
If you’re not a financially savvy founder or CEO, this is where a fractional team can help. A great team will make sure you are operating on a best-in-class tech stack, follow best practices for internal controls (more on that, below), and feel confident enough in your numbers to talk about them with investors.
2. Have internal controls in place.
Any tech founder will tell you there’s a delicate balance between velocity and bureaucracy. Nowhere is that more true than in crypto finance. If you wanted to set up a traditional bank, for example, you’d better have a team of lawyers and consultants to help you meet all the regulatory requirements — and don’t expect to get it done on your own timeline. But you could set up a crypto exchange in a day, on a laptop from your bed. And once you’ve set it up, you could have some fun with the numbers and journal entries. You could even backdoor some fun at Margaritaville. The same rules simply don’t apply.
Decentralized finance (DeFi) on the blockchain is sometimes referred to as “trustless” or “permissionless.” One assumption you could make about DeFi is that it’s actually more secure, because no one holds all the keys. On the other hand, because there’s no official organization responsible for regulating DeFi, there’s no one to point to if something goes wrong.
Another assumption, made by many VCs and private investors from traditional backgrounds, is that the regulations governing traditional financial institutions like banks and brokerages can also apply to crypto. But there is no FDIC insurance to serve as a backstop, no SEC to hold exchanges accountable for conflicts of interest or how to handle customer funds. This assumption that regulation exists increases risk and can prevent a proper level of due diligence. FTX investors, for example, should’ve fully understood the relationship between FTX and Alameda Research.
Decentralized doesn’t mean unregulated. You need guardrails if you’re going to operate efficiently and ethically, and if you want investors to trust you. You need an internal control framework that’s well-documented. Internal controls improve efficiency, ensure compliance, and prevent fraud. They keep you, your people, and your financial processes honest and transparent. This matters a lot over the long run because, along with unpolished financials, dishonesty is one of the seven deadly fundraising sins.
Ironically, FTX has selected John Jay Ray III, who presided over Enron’s bankruptcy scandal, as its new CEO. In a recent court filing for FTX, Ray said he’d never seen “such a complete failure of corporate controls and such a complete absence of trustworthy financial information.” If this is crypto’s “Enron moment,” then it’s also a good lesson in the importance of internal controls.
3. Bake financial transparency into your DNA.
Crypto may not (yet) mandate regulations around financial transparency, but there are lots of reasons you should bake it into your DNA anyway. The work you do now to invest in internal controls will absolutely pay off over the long run. You won’t have to waste time balancing your books, digging for numbers, or putting together metrics for a pitch deck. You’ll be ahead of the game if international bodies do decide to impose regulations on crypto. Holding yourself to a higher standard (than crypto’s current no standard) will help you stand out among competitors when it’s time to fundraise. And, you’ll never be that CEO who says, “I didn’t know exactly what was going on.”
At Propeller we produce what we call the Statement of Digital Assets, a “fourth financial statement” that shows proof of digital assets. With this Statement of Digital Assets we can run analytics off the numbers and do trend analysis on a per-wallet, per-token basis.
If you’re deploying capital into a protocol, we can crack open the books and make sure they have the assets in their wallets that they say they do. We do an operational review where we look at how your processes are running, evaluate whether you have the proper separation of duties, and put controls in place for who touches the money vs. who sets things up to move the money. As an example, we can set up transactions but we never touch the funds.
This level of transparency is not the market standard right now—there IS no standard right now. But it should be the baseline.
4. Be ready for what’s next in crypto.
Market volatility and credibility crises make it more important than ever to keep good books if you’re a crypto startup. You can move fast and break a few things, but you still need transparency, ethics, and internal controls. Your fiduciary duty to stakeholders still applies, even if you don’t have a government document codifying it. Before you think about spending on advertising and marketing, you should have your financial house in order. And if you’re not an adult, please find one and put them in the engine room.
The FTX collapse has no doubt shined a spotlight on some bad players in the industry. But in doing so, it’s also created an opportunity for better players to come in—players who are building financial integrity, credibility, scalability, and operational discipline from the ground up. We think the biggest players over the next 10 years are just starting to emerge, and they’ll have a chance to apply the lessons learned from this fiasco.
There’s an estimated $5B of investor capital waiting to be injected into the crypto market, and even the most risk-tolerant investors won’t make a mistake like FTX again. If you want to fundraise and be a scalable player in the next generation of crypto, it’s time to hold yourself accountable to a higher financial standard.
Want to discuss further? Let’s chat.