In many ways, Elizabeth Holmes looked like a typical Silicon Valley entrepreneur: a Stanford
drop-out, claiming to have a new breakthrough technology, giving Ted talks, and most importantly
wearing a Steve Jobs style black turtleneck.
Generating attention from the press as one of the few young female founders, Holmes used
the mentorship and connections of tech industry giants like Larry Ellison, to raise money
from some of the biggest names in VC.
Living amongst Silicon Valley’s elite, Elizabeth used the standard start-up playbook of hype,
exclusivity and “fear of missing out” to win over investors.
Theranos was a private company, so she couldn’t blame short sellers when negative news came
out.
But she was able to dismiss those with difficult questions as “haters”.
The company collapsed more than five years ago, before the term FUD had been coined,
so she didn’t get to use that one either.
While Elizabeth did pitch herself as a Steve Jobs style tech founder, Theranos was not
the standard Silicon Valley company.
To start with, it was a blood testing company where it’s less reasonable to believe that
you will make the “Moore’s Law” style leaps that you might make in the tech industry.
One of the reasons Theranos was able to raise so much money was that Holmes pitched to tech
investors rather than experts in blood testing.
Medical experts would have quickly seen it as a red flag that she was claiming to use
a drop of capillary blood drawn from a finger prick for tests.
Blood drawn this way, unlike the blood drawn from a vein, is contaminated with tissue and
cells that make measurements less accurate.
Additionally, blood is consumed in every test that is run on it, so the claim that 200 tests
could be run on a single drop of blood would have stretched the imagination of the most
optimistic healthcare expert.
Theranos had a very impressive board of directors, with big names like Henry Kissinger and George
Shultz, but these board members had backgrounds in government rather than in technology, biology,
or science.
A key component of Elizabeth’s trial defense was that excessive optimism and exaggeration
are standard in the tech industry, and thus her actions should not be classified as fraud.
The judge in the case agreed – at least to a certain extent - saying “It’s common
in Silicon Valley for promoters to engage in that type of conduct,” in a hearing before
the trial began.
Since the collapse, big names in Silicon Valley have tried to separate themselves from any
connections to Elizabeth Holmes or any claims that her actions were in any way linked to
“Silicon Valley culture.”
But when the Wall Street Journal first began exposing the lies behind Theranos, some of
the biggest tech investors initially rushed to defend the company.
Well, this week we learned that while the terms “Move Fast and break things” and
“Fake it till you make it” might work in Silicon Valley, they are frowned upon in
federal court.
On Monday a jury found Elizabeth Holmes guilty of conspiracy to defraud investors, and of
three counts of wire fraud.
Holmes could potentially face decades in prison, though a much more lenient sentence is expected.
After deliberating for seven full days, jurors agreed that Holmes had lied to investors over
several years about the accuracy and capabilities of Theranos blood analyzers.
Witnesses told jurors that they had been lied to and misled by Holmes.
One investor told the court that his team had been impressed by the company’s claims
of having worked with the military and their ability to run a full range of blood tests.
It turned out that Theranos never did any meaningful business with the military, and
its proprietary devices could not perform the tests Holmes had claimed to investors.
Holmes admitted on the stand that she had doctored documents to affix drug company logos
and that her “Edison” machine could perform only 12 tests, despite her public claims of
more than 200.
She was not convicted on all charges, just to be clear.
Jurors did not hold her responsible for patients who received erroneous blood test results
as the prosecution would have had to prove that Holmes herself had persuaded patients
to use her tests instead of using a traditional lab.
Although this is arguably the greatest harm Holmes and Theranos perpetrated, it is also
the toughest to convict.
The jurors also failed to reach a verdict on three counts relating to investors who
put money in after Holmes had rebuffed their requests for additional information.
Refusing to provide information is very different (and much safer in terms of dodging financial
regulations) vs. providing fabricated data.
Lisa Peterson, who managed money for Betsy DeVos’s family, testified at the trial:
that she was scared that Holmes would cut her out of the deal if she asked too many
questions, so she cut her due diligence short and invested 100 million dollars.
FOMO is not just a thing for new investors.
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Ok, So, while you might think that a fraud on the scale of Theranos would have changed
things in VC.
Angela Lee who teaches venture capital at Columbia Business School told Bloomberg news
this week that she is not seeing any more thoughtful due diligence today than in the
past.
If anything, there is a sped-up timeline for due diligence in the last couple of years.
The Theranos case – where you run an actual fraudulent business - looks almost quaint
in 2022.
Raising hundreds of millions of dollars from gullible investors who don’t do much due
diligence is no longer particularly impressive.
Today it can be done by selling them a hyperlink to a drawing of a monkey.
While many in Silicon Valley have denounced Holmes as a fraud, not everyone agrees.
Tim Draper, a well known venture capitalist who was an early investor in Hotmail, Baidu,
Skype, Tesla and Bitcoin was also an early investor in Theranos, told the New York Times
this week that the outcome of the trial made him “concerned that the spirit of entrepreneurship
in America is in jeopardy”.
“A willingness to bet on these entrepreneurs and their visions has made Silicon Valley
the innovation engine of the world,” he said.
I don’t 100% disagree with him.
It is important to have a business culture where entrepreneurs are willing to take business
risks and potentially fail, in fact that is why things like bankruptcy law exists.
Investors in start ups usually understand that they are dealing with optimistic entrepreneurs.
They know that most startups do fail.
But of course, there is a big difference between a start up founder saying “I’m sure I
can get this new app coded up and working” versus someone outright lying and claiming
to have a working technology that the Science has not yet been established on.
Elizabeth Holmes wasn’t just overly optimistic, she specifically lied to investors and customers
that her technology worked when it didn’t.
One of the reasons that retail investors are excluded from investing in private companies
like Theranos is that much higher standards of disclosure must be met when pitching to
retail investors – or to the general public.
Technology companies, particularly those that have not yet sold shares to the public, have
historically enjoyed more leeway on their promises, even as their valuations soared
into the billions.
Venture capital investors and high net worth investors or “accredited investors” are
expected to have sufficient experience, knowledge and expertise to understand the risks that
they are taking, and to be able to weather potential losses from business failures.
They are not protected by securities regulations like regular investors – the SEC doesn’t
care is Betsy DeVos loses 100 million dollars – she still has enough for a comfortable
retirement.
The best book I have read on VC investing is zero to one by Peter Thiel.
He talks about investing in companies that make completely new things, and thus have
no competitors, but the difficulty in that space is that the majority will fail.
VC investors understand this and are not upset about an honest failure.
But there is a difference between failure and fraud.
Thiel’s argues in zero to one, that when you know that many of your investments will
fail, you can only invest in companies that have the potential to return the value of
the entire fund.
Thus one or two successes will make up for all of the failures.
We are in a unique time in financial history right now where most investors are protected
from frauds like Theranos, because they are prevented from investing in private companies,
they equally can’t invest in Hedge Funds or Private Equity.
But because of gaps in securities laws, there are much riskier products that retail and
institutional investors can put their money in.
There are grey areas like SPACs that work around IPO disclosure requirements, and then
there is the world of crypto which is completely unregulated.
I often see comments online after a crypto pump and dump, or rug-pull, along the lines
of “when will the SEC step in and protect investors”.
I have even seen people claiming that they feel less likely to get ripped off when investing
in crypto than in the stock market.
Fraud trials of corporate executives have been rare in the United States in recent years.
Some argue that this is due to the deterrence provided by the Sarbanes-Oxley reforms, that
came in the wake of a series of scandals in the early 2000s.
Others argue that the Department of Justice has simply turned a blind eye to white collar
crime over the last twenty years or so.
Former Nikola CEO Trevor Milton is scheduled to go on trial for criminal fraud shortly.
He has pleaded not guilty to lying to investors about the electric truck company’s technology.
Nikola Motors went public through a SPAC merger under Milton’s leadership.
With SPACs, the deal that takes the private company public is classified as a merger rather
than as an IPO.
This allows founders to pitch their financial projections and sell the dream, rather than
relying on actual, historical audited, financial statements as is legally required for a traditional
IPO.
With SPACS though, retail investors end up holding the bag rather than experienced venture
capitalists who might be expected to know better.
While the Holmes verdict, and the Trevor Milton trial will likely make start-up founders more
cautious about their promotional statements, I don’t believe it will put the American
spirit of entrepreneurship in jeopardy.
There is a big difference between being confident about your ability to deliver and fraud.
When I first began managing money, I spent a lot of time capital raising meetings, explaining
my investment process, the risks, and what the likely expected return might be.
Once in a while I found myself in awkward situations where potential investors would
try to extract a promised rate of return.
Of course, giving guarantees like this is not only inappropriate, but quite foolish.
No one knows how the future will unfold, and while I might have been confident in my methodology,
different market conditions that arise can cause your performance to be significantly
higher or lower than you expect.
On this note, a famous active ETF manager raised some eyebrows last week by announcing
an expectation to deliver “a 40% compound annual rate of return during the next five
years.”
Statements like this from a fund manager are highly unusual, and have the potential to
breach securities regulations.
There is a difference between saying I have a portfolio of great stocks that I expect
to outperform, and I’ll return 40% a year over the next five years.
So where does all of this this leave us?
Well, over the last 90 years or so, the evolution of securities regulation in the United States
has helped the country to develop the broadest and deepest capital markets in the world.
This has allowed investors to grow their savings by investing in innovative companies and has
allowed great companies to raise capital and provide needed goods services and jobs to
the country.
In the 1920s – before securities regulation existed, publicly traded companies didn’t
even provide investors with accounting statements.
In many parts of the world whit poor investor protections in place, people don’t invest
in stocks at all, viewing markets as a scam.
They are left with things like real estate as their only place to store wealth.
This is not good for individuals or economies.
Some of the problems that we are seeing today is that due to patchy regulation, people have
been lulled into a false sense of security.
They have become used to the investor protections of highly regulated markets, then expect the
same level of investor protection in unregulated markets.
If you enjoyed this video, you should watch my video on the biggest corporate frauds in
history next.
Don’t forget to check out our sponsor Morning Brew using the link in the description below.
Have a great day and talk to you again soon, bye