Lighting Money on Fire

Email agenda:

Estimated read time: 8 minutes 45 seconds

1. Bad Business Models = Bad Businesses (Lighting $92m on Fire)

2. Defi Disaster - What the Hell Happened with FTX

Good morning and happy Monday - let's get smarter

Bad Business Models = Bad Businesses (duh)

When I was in college I had an accounting professor who was a former CFO, who’s daughter went to Penn State

When she was picking a major, he wouldn’t force her to major in accounting, but told her “You HAVE to minor in it then because if you’re in sales & marketing you need to understand the flow of the $”

I think about this when I see a company like Allbirds

Why Allbirds? Well, Allbirds IPO'd during the crazy market boom post-covid at a CRAZY valuation

Why do I say their valuation was crazy? Keep reading and I will walk you through why

But Allbirds report earnings recently and with a massive EBITDA (proxy for cash flow) loss and their gross margins (which I dive into below) are going DOWN

BAD BUSINESS MODELS DON'T SUDDENLY BECOME NOT BAD

Allbirds Review

Allbirds, the trendy shoe company, IPO’d in 2021 and on 12/31/21 had a valuation of $2.5b, a valuation of 25x their revenue

To put that into perspective, I invested in a Cole Haan competitor called Wolf & Shepherd in the private markets last year (granted they do a lot less revenue) at a valuation of 1.5x revenue….

Under Armour was trading at 6x revenue at that time

Snowflake, one of the largest software IPOs in history, recurring revenue business model, had a valuation at 12/31/21 of 300x revenues, and NOW trades at 22x revenue

So Snowflake's (software = great business model) current valuation 22x revenue (recurring revenue model), gross margins of 62%

Allbirds IPO’d at 25x revenue (non-recurring revenue model), with gross margins of 53% and now they are going LOWER

So why would investors invest with this crazy valuation?

Well, there’s a few reasons:

1. Gross margins should improve with economies of scale

   1. As you do more volume, you can purchase at better prices, gain more market share and charge more, and gross margins can improve

2. As the gross margins improve, the company should get closer and closer to breaking even (not losing money), and then down the line have positive EBITDA (cash flows)

3. Cheap money = Dumb Money

Cheap Money Makes Smart People Do Dumb Shit

Cheap money, or when the federal reserve has interest rates pinned close to 0% (a lot different environment than today), investors tend to take on a lot more risk

The federal reserve pins Interest rates are near zero in order to:

increase borrowing -> spending -> and therefore the economy booms

But when interest rates are low, you are really getting sucked into a trap

A Personal Example Most People Get From College

Artificially low interest rates are like showing up the bar at 7 pm. It sounds great in theory, more time out, more upside, but when 2 am hits and you’ve consumed 15 bud lights and 3 jaeger bombs, the next day is hell on earth

Well this current macroenvironment, where interest rates are no longer pinned near zero, is that hangover

When interest rates are near zero and capital/debt is cheap, people are willing to borrow more, and pay more, to invest in companies, buy companies, etc

This drives up valuation's because you have more dollars chasing the same # of goods (companies)

If you and I can both take on debt at 2% interest, why would we not pay more for a company if we think it can make us 10% back? We would borrow at 2% and pay the bank that rate, but could make 10%? An 8% spread.

The issue is, when interest rates are no longer at 0% and GDP stops accelerating, company's profits go down while at the same time their valuations are going down

That free money that investors were throwing at investment rounds at crazy valuations isn't flowing anymore because debt isn't cheap anymore

So if your valuation is going down and you need to raise more $, investors may not want to invest, they may want a lower valuation than you'd like

The house of cards comes crashing down, and investments like Allbirds that looked a bit crazy at the time of zero interest rates due to the very high valuation, now look absurd at non-zero interest rates and the valuation comes back to reality

If you invested $100m in Allbirds at $2.5b valuation in December of 2021, that same $100m would now be worth......

$8.68m

Zero interest rates distort reality, and reality isn't nice when it comes back around

As the great investor Howard Mark's always says: excesses get corrected

Zero interest rate valuation excesses to the upside get corrected back to reality

DeFi Disaster - Sam Bankman-FrAUD

This past week, one of the largest crypto exchanges, FTX, went under and declared bankruptcy

The founder, who Jim Cramer said “is the next JP Morgan” and who Kevin O’Leary/Mr. Wonderful from Shark Tank said “"If there's ever a place I could be (invested), that I'm not going to get in trouble, it's gonna be at FTX"

Here are the people and companies involved + a summary of the events that shook the crypto world this past week

Sam Bankman-Fried ("SBF") - Founder and CEO of FTX, a crypto exchange like Coinbase and Founder of Alamada Research, a quantitative research firm

Changpeng Zhao ("CZ") - Founder and CEO of FTX's biggest competitor, Binance, another crypto exchange

1) The Tweet That Started it All

FTX, SBF's crypto exchange saw a massive amount of customer withdrawals when their main competitor, Binance, who was the first equity investor in FTX, CEO tweeted this

"Due to recent revelations that came to light" uh oh that doesn't sound good

Summary: Coindesk published a report that most of Alamada Research, SBF's trading firm's holdings were FTT, a token founded by his crypto exchange platform, FTX

CZ's tweet that Binance was selling all of its FTT token caused the price of the FTT token to TANK, making SBF's crypto exchange platform, FTX, insolvent

2a) Withdrawals COMING IN HOT

In a great depression run on the bank type manner, FTX users started to panic and withdrawal $ from their FTX accounts at insane rates

Assuming FTX has enough reserves, this shouldn't be an issue

As you will learn in more detail below, FTX did not have the liquidity for these withdrawals as customer's money was transferred to Alamada Research, which had a massive stake in FTT token, which was now down 90%

2b) Sam Assures All is Fine

In an effort to stop the panic withdrawals, SBF, FTX's founder, tweets that everything is fine and that their competitor, Binance/CZ, is sharing false info to try and hurt them

Announcer: Things were indeed NOT FINE and as we discussed, FTX was insolvent to the tune of billions of dollars

Summary: FTX had billions more in liabilities (money owed) than assets (cash, crypto, etc) because the FTT token price was worth such little value now and that was a core asset

3) BINANCE BAILOUT?

FTX Competitor Binance Offers to Buy FTX to Save Them From Liquidity Trap

BUT - after just a few days of due diligence, Binance learns that "things are even worse than they thought" and they back out of their non-binding LOI to acquire FTX

Now FTX is screwed

4) FTX and Alamada Research File for Chapter 11 Bankruptcy

Sam puts a long thread on Twitter apologizing. He says that he plans to figure out what happened and he will work hard to get clarity on users liquidity ASAP

Summary: SBF took customers deposits that were supposed to in exchange for crypto currencies and instead took their money and made high risk investments (what we like to call betting) through his research/trading firm Alamada, and lost

Here's a look at some of what has been uncovered so far regarding what SBF did with customer's money:

1. Sam admitted that they were taking customer's money from FTX and giving it to Alamada which was making high risk trades, but there's also some discussion that they were actually invested customers money in high risk venture investments

   1. In Alamada's 2018 pitch deck they offered "high returns with no risk" AHH the Bernie Madoff investment strategy!!

Customer money went to make high risk venture investments in startups

It also looks the reason nobody noticed Sam moving FTX customer's funds into his research/trading firm Alamada is because he set-up a backdoor technology that wouldn't alert anyone

Of the $10b that was moved, $1b is also missing! Maybe Sam has it?

The story gets crazier and crazier the more you read

But it really goes to show how even some of the brightest people can fall for a scam like this

I think SBF has done irrevocable harm to crypto and trust in crypto

In Enron type fashion, FTX, a crypto currency exchange once valued at $32 billion who had some of the top VC firms as investors like Sequoia, who said things like "when I met him, I realized I was talking to a future trillionaire" got scammed and saw the value of their investment go to $0

If you are not familiar with how bankruptcy works:

In bankruptcy, all of the creditors (debt holders) get paid out first, and if there is any money left after that, the equity investors get paid out

So, firms like Sequoia who are equity holders know there are 100,000 creditors who FTX owes to and they will not being seeing a $ come their way

I'd highly highly recommend watching this video from a month ago about some of the signs people noticed that raised red flags about FTX, their CTO Gary Wang, and Alamada

- Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.