If Sequoia, Paradigm and Thoma Bravo settle a new lawsuit, it could upend VC; here’s why

It was only a matter of time before frustrated customers of the fallen crypto exchange FTX went after its deep-pocketed venture backers. Indeed, the most surprising thing about a class-action lawsuit flagged earlier by Bloomberg — one that accuses Sequoia Capital, Paradigm, and Thoma Bravo of promoting FTX to the detriment of its users — is that it was filed yesterday and not sooner.

Still, VCs at every firm had better hope that nothing comes of it or the entire venture industry is in big trouble. A trial — even a settlement — could have widespread ramifications.

Here’s the potential problem: the new complaint specifically accuses the three firms of bestowing FTX with the “air of legitimacy” through their various actions, including a glowing piece about FTX founder Sam Bankman-Fried that Sequoia Capital commissioned (and later took down from its website), a Startup Grind event last year where Sequoia partner Michelle Bailhe interviewed Bankman-Fried for a session titled “The Unstoppable Rise of FTX,” and boosterish tweets by Paradigm cofounder Matt Huang and Thoma Bravo founder Orlando Bravo. (In response to a tweet by MicroStrategy Michael Saylor, warning people to “Only trade #bitcoin on a legitimate exchange you trust,” Bravo tweeted to his Twitter followers: “Only trade #bitcoin with @FTX_Official.”)

The legal complaint also refers to several media outlets where these investors were quoted singing Bankman-Fried’s praises, including a MarketWatch piece where Bravo was quoted as saying that Bankman-Fried “combines being visionary with being a phenomenal operator . . . That is rare.”

None of what is cited in the complaint is new information. All of it makes the investors look foolish in retrospect. None of it suggests the investors did anything out of the ordinary in terms of their public comments. They actively promoted an investment, and is there a single investor who doesn’t do the same? Take a look at Twitter or TechCrunch or Bloomberg TV at nearly any time of day and you’ll see or read investors blathering on about how wonderful their portfolio companies are.

Is such promotion crime? If it is, the entire industry is guilty of it. VCs see part of their “value add” as helping to extend the brand of the startups they fund. They’ve been “talking their book” since the industry got off the ground many decades ago. With the advent of social media, it only became much more annoying.

Does it prove that these specific investors were trying to dupe anyone — that they were trying to attract attention to an exchange that they secretly believed was a house of cards? I’m not a lawyer, but I really doubt it. More important, I don’t see that case being made in the filing (see below).

There is no question that the institutional investors in FTX royally screwed up. The three firms named in this new suit alone lost a stunning $550 million on FTX, which has since been accused of orchestrating “old-fashioned embezzlement” by the lawyer-CEO now steering the company through bankruptcy.

But VCs don’t tend to screw up on purpose; public humiliation isn’t good for business. You could argue that for all the credit it gets for its investing savvy, Sequoia Capital in particular should have known better. FTX is now believed to have been freely commingling funds with another outfit that was founded by Bankman-Fried, Alameda Research, right under the firm’s nose.

At the same time, Alfred Lin, the Sequoia partner who led the firm’s investment in FTX, has said explicitly that the firm believes it was “misled” by Bankman-Fried, and that he feels personally deceived by Bankman-Fried, not because of the investment itself but because he thought he knew Bankman-Fried. “It’s the year and a half working relationship afterwards, that I still didn’t see it. And that is difficult,” Lin said at an event I hosted last month.

Asked about Sequoia’s due diligence, he defended it, suggesting there is little a venture firm can do when it isn’t being presented with the whole picture by a founder. “We looked at balance sheets, we looked at organizational charts of the subsidiaries, we looked at how [big a percentage] Alameda was of FTX’s volume. We looked at a variety of things. The company Alameda we knew was a hedge fund. We knew that they were trading on FTX. But it was not on any of FTX’s organizational charts. [And] when we asked, ‘Are these two companies independent?’ We were told that they were.”

The new lawsuit is being spearheaded by the law firm Robbins Geller Rudman & Dowd of San Diego.

In 2014, the same law firm helped wring a $590 million settlement out of three private equity firms —  Kohlberg Kravis Roberts, The Blackstone Group, and TPG Capital —  after they were accused of colluding with one another to drive down the prices of corporate takeover targets.

We reached out to the firm last night for comment on its FTX-related suit and have yet to hear back. In the meantime, it has filed another class action lawsuit against Avaya Holdings, a business communications company that filed bankruptcy yesterday, five years after emerging from its previous bankruptcy.

Pictured above: Alfred Lin of Sequoia Capital at a 2016 TechCrunch Disrupt event

Class-action lawsuit filed on behalf of FTX investors by TechCrunch on Scribd