The Danger of Theranos

(sorry for the ad in front of the video)

Yesterday, Theranos got a little worse.  If you don’t know about them, the company was a high flying Silicon Valley medical startup.  Theranos is now the subject of a criminal investigation.  Give credit to the Wall Street Journal for doing the investigative journalism that broke this.

Theranos raised $88.4M in 4 rounds. They had a paper worth of $9B. They had a blue ribbon Board of Directors and Advisory Board that gave them credibility-but few of them were medical investors or medical experts.

As my friend said, “Initial signaling such as seed or early seed money by a prominent investor who wanted to back a brilliant idea. It turns out, that initial investor was a family friend.  Then, along came other investors who piled on due to fear of missing out (FOMO) and relied on external signaling to invest more. Once the company reached unicorn status, all due diligence went out the window as FOMO really catapults the company into an untouchable league.  More investors pile on.”  It becomes a competition to get in a hot deal and feature it on your VC website-and brag to limited partners.

FOMO can break your investing discipline.  I have seen it many, many times in markets.  Fear can manifest itself as greed.  The herd rushes in.  When it’s time to get out, the exit door isn’t big enough.  Conversely, fear causes them to rush in, and when they get in they realize it’s a Roach Motel and they are stuck.

In 2013, I wanted to do a deal so badly.  I worked on it extremely hard.  In the end, my attorney saved my ass.  The person I was going to do the deal with bounced a check for $350,000 and almost killed three startups.  In saving the deal, I made mistakes again. The three companies are all still in business today.  They may or may not be successful but we navigated the waters and learned a lot in the process.  Two actually have positive revenue.

You will find that when you are weakest, it’s when the real sharks come to play.

Investing in highly technical companies is hard.  I have done it two times.  I invested in UICO and in NuCurrent.  I can assure you that their technology works.  Check out their websites.  What they do is revolutionary.  They both are moving society forward in their own way.  It’s been commercialized already and they have top line revenue.   Their technology is the kind of tech that goes inside things.  It took longer to do diligence, but it was worth it because I really understood where they could go and who their target market might be when they got going.

Doing diligence takes time with infant technology because you have to find out if it’s going to work.  Generally, a VC firm will have someone that really understands it inside their firm-or they will hire an outside consultant to do it.  For angels, it’s really hard because unless they have the knowledge, or have a network with knowledge, it’s hard to find a person to verify that it works.  This is one big reason angel groups need to be diverse, and that they do better investing in packs.

You might be thinking, “That’s great Captain Obvious, but where is the danger?  A bunch of rich guys lost some money.  They didn’t do their homework.  Big deal.”

We could leave it there and you’d be right.  But, there is a bigger picture I see.

We are entering a brave new world when it comes to financing startups, and exiting startups.  Crowdfunding is here.  I like the innovation crowdfunding brings.  As a seed investor, I can build a syndicate and get companies funded.  It’s another source of funding.  It adds to competition.  It makes it easier for average people to make an independent decision with their own money and assume some risk.  Crowdfunding can allow individuals to build wealth they might not otherwise had an opportunity to do.  Someday, it might make exits more competitive.  It may eventually become a catalyst for early stage investors to get liquidity on investments that other later stage investors might want in on.

Crowdfunding doesn’t work if there are a lot of companies like Theranos out there.  Exchanging money for equity involves a high degree of trust.  When I invest at a seed stage, I don’t just “invest in the team”.  I build a trusting relationship with them.  At seed, I also try to build a trust relationship with other investors.  I want to invest with them again.

When big money is involved, shady characters always show up.  They are just looking to milk the system for some cash.  They pose as coaches.  They pose as experts.  They pose as connectors.  Instead, they are leeches.

It’s not only VCs that should be outraged about Theranos.  VC’s can protect themselves by doing their homework and not just throwing money at the “hot deal”.  It’s entrepreneurs.  That’s who I have a high degree of empathy for.

When people get hurt in financial games, a hue and cry comes up to regulate to stop it again.  Populist policies get passed-and they are almost poorly designed 100% of the time.  They make it harder to get things done.  Harder means “more expensive and longer”.

How are entrepreneurs going to recruit new employees to risky technology if everyone thinks the game is a fraud?  The money part is only one part.  The human part is bigger.

I think the other thing that has to come out of this is transparency. You need to be clear, not opaque.  If something wrong is happening and you know it for certain, it needs to be called out.  I have heard stories that people were employed at Theranos and didn’t see the technology until after they signed a strict employment contract.  Why didn’t they talk and blow the whistle?  I have heard investors weren’t allowed to see the tech until they signed the term sheet and wired the money.  Why didn’t they say anything publicly if they thought something was up?

One hard thing for investors is that you never know if something is actually going to work or not until it’s out of the lab and live.  I have seen some really cool things at iBio/Propel, Chicago Innovation Mentors,  Jump Simulation, Research Park and at Matter.  They are ideas, software and devices that will drastically make your world a better place to live in.  It takes time for some of these things to get a foundation to understand if they are going to work or not.  Companies pivot, and change.  So, investors might be reticent to say something is a fraud.

Science isn’t like finance.  Here is an example of fraudulent finance.  That’s generally pretty easy to catch.  But, as we have seen with Enron, Bernie Madoff and others, it sometimes takes a lot of pouring over obscure financial statements to find.  Good accountants can cook books.

What this really comes down to is relationships.  The moment an entrepreneur and an investor sit down together, they are beginning to build a relationship.  When an entrepreneur hires an employee, there has to be a culture of trust.  When an investor refers another deal to an investor, there has to be trust that the other party isn’t getting a bad deal.  If it’s not built on trust, it is guaranteed that things will go badly.

  • Pingback: Morning News: April 20, 2016 Crossing Wall Street()

  • CliffElam

    The thing that kills me about Theranos is that my wife was able to do a better job in terms of a regulatory compliance and test validation on, bascially, founder cash and early sales. So, quite aside from the “does the machine work” part, the operational train wreck is completely a mystery to me.

    -XC

  • JLM

    .
    A very well written, reasoned, and presented article which is worthy of a read by anyone who is a serious student of finance, VC, or startups.

    Thank you.

    JLM
    http://www.themusingsofthebigredcar.com

  • Pingback: Mattermark Daily - Wednesday, April 20th, 2016 - Mattermark()

  • JDanaH

    While I can see that it could make sense for some people to invest in Theranos before they saw the technology, what I cannot see is how they could do so before seeing the *results* of the technology. Specifically, I would never, ever invest in such a venture before I saw credible lab data indicating that assay results from their tech were comparable to assay results based on methods in current use. (When I say “credible lab data” I mean data in which a 3rd party researcher sends a sample to Theranos, a sample from the same blood draw to another testing facility, and compares the results — and does this enough times for the results to be statistically meaningful.)

  • Pingback: 04/26/16 – Tuesday’s Interest-ing Reads | Compound Interest-ing!()