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Thursday, August 18, 2016

Bait and Switch

Raising money from any source can be difficult - you have to persuade whoever has money that you're the best place for it to go, and you're up against a lot of competition. Sometimes you can do that by showing preliminary work and persuading your peers you have a sensible rational approach to moving forward, and the end result is worthwhile - most grants from the government are done this way. Sometimes you can show existing revenue and that market growth will easily allow the money you need to expand to be paid back, and a bank or other lender will see the value. When you are a public company, you have to show returns and potential for growth that make your stock look appealing to retirement funds and the public. With Venture Capital, the goal is to provide outsized returns, billion dollar companies that give 10x or 100x gains or more, ideally to make up for all the other bad bets made and have their VC fund be profitable. It's this last one, and the behaviours it encourages, that we are going to delve into a little deeper.

What Drives Cheque Sizes and Valuations?
When raising from VC, there are multiple things a company needs to take into account. First, there's how much you need to raise, (Many Series A round are in the $3 to $10 million range) and how much of your company you are prepared to part with to get that.  The combination of those two tells you where your company needs to be in valuation to make that possible, for example if you want to give up no more than 20% of your company and to raise $10 million, you need a $40 million pre-funded valuation (that's the value before you take the money) - as the post-value will be $50 million ($40m pre + $10m investment) and then that 20% is the $10 million investment compared to the $50 million post.

Most VCs have an expectation of owning a reasonable piece of the company, usually in the range of 20 to 25% with 15% at the low end, and 30% at the high end. The range of cheque sizes they are prepared to write depends on the size of their fund - how many companies they want to monitor sets the lower bound, and spreading risk to be sure not all their eggs are in one basket sets the upper end. For example, a $200 million fund may decide that a minimum of $3 million and a maximum of $6 million for Series A companies is their comfort zone, leaving some cash over for seed investment and reserved for later stage funding. These numbers vary with each VC, and with time as their fund matures - they typically last 10 years and what they do in year 1 is very different than compared to year 7.

While normally you'd want to boost the valuation of your company to minimize the dilution of your company, setting your expected valuation as very high will immediately remove a number of VCs from your possible pool of funders. For example, if you want a valuation of $100 million with a $10 million raise, then you need to find a VC not only able to write that cheque, but willing to accept under 10% of the company in return (actually, more than one since often there is a lead and then additional companies that split the deal). With a raise of $20 million the pool of VCs willing to fund is even less, but the % of the company on offer is much more palatable. If instead the valuation moves to $40 million then you still have the same pool of VCs as originally, but they will be much more interested in owning 20% of your company than 10%.

Incentives for the Founder to Push Valuation
You as the founder/CEO want to get the most money for the least equity so the goal is to match financial needs, with the cheque size of a VC that is in your area and likes you, and with an idea/company that justifies the valuation to keep VC ownership in the 20% ish area. Seeing as there is an inherent need in people to both raise as much money as possible, and believe the external validation that your company is worth an enormous sum of money, there is pressure to give the 'rosiest' view of the possibilities for your company. As I wrote before, I have even been chastised by a possible investor for presenting a 'realistic' view of revenue and told instead to show the most positive view regardless of likelihood.

A CEO is under that pressure to inflate values, particularly one without a real grasp of the realities of their area such as those who have little or no actual experience in a technical field - Elizabeth Holmes and the like, for example. They can claim ridiculous things to potential investors that no-one who actually truly understands would say, and say so convincingly because they believe it themselves. If you read VCs talk of what they look for in founders, it's almost always a 'fundamentalist religion type zeal and belief in what they are doing'. Notice in that article it's the last 2 of 12 characteristics that what most people consider critical - Domain Expertise and Integrity - and I've found (to my own detriment) that most CEOs I've worked for utterly fail in both of those. 'Tenacity' is the most important to VCs apparently, after all you don't want your investment to be thinking about reality, there might be a sucker somewhere who eventually buys the very dead horse you've been flogging. (Sorry, I mean "overcome the great difficulties being a founder entails")

Basically, VCs set the terms and incentivize what would normally be considered lying or fraud - why are we surprised when that's what we get? Moreover, it weeds out those experienced in a field who simply understand enough to put realistic expectations on what's possible, or have the integrity to refuse to lie.

Exaggerating or Lying?
When does 'rosiest view' change to 'lying'? There is no sharp line before which it's exaggeration and after which it's fraud, it's a grey area. Sometimes you are smart (or lucky) and what you claim turns out to be true, sometimes it's completely wrong, sometimes it kinda does but not nearly as well as you hoped - very occasionally it's massively better than hoped and you end up a Facebook or WhatsApp. Sometimes you might believe you can reach a metric you are claiming, and only have the resources to know for sure post Series A, and when you learn what you are truly capable of you have to 'pivot' and refocus the company on a different, usually smaller, market you can actually address.

What is it, though, when the company knew for a long time that what they were claiming was never achievable? Maybe they always knew, maybe they learned later once they had the staff and funding, but they kept going because to do otherwise was to admit defeat, and give up any chance of that greater fool buying you. So what does someone like that do? Well if we look to Theranos and Energous, the answer is 'Bait and Switch'.

Theranos Poisoning the Well for other Blood Test Tech
Theranos recently Punked the AACC and managed to give a marketing pitch for a new platform rather than actually give results on their old one on which they had raised $700 million. The old system was supposed to have been able to run up to 200 tests on mere drops of blood drawn from a finger rather than a vein, which if achievable would have been a huge leap forward. They were the darling of Silicon Valley, with huge coverage in the press for the founder Elizabeth Holmes (and all on her, not the tech). It turns out that they were not being very truthful in their claims, and now both the SEC and FDA are pursuing criminal complaints against the company as well as eight class action lawsuits from patients who received false diagnoses from the company. These exaggerated claims allowed them to raise that $700 million while still allowing the founder to maintain a majority holding of stock, for a while making her a billionaire until the truth came out.

So what did this new system do? Capillary blood from the finger? No. 200+ tests? No. Cheaper than existing? No. Faster than existing? No. More utility from a single box? Maybe. Essentially everything that made the company viable and worth investing in was a lie, and now they are trying to pretend the company is viable with a far less interesting concept, and one that was stated by experts to not having anything that didn't exist elsewhere. Had they done this two or three years ago, before actually providing patients with false diagnoses, then it would have been a 'pivot' - a company that made a noble and commendable effort but didn't quite work out. But they didn't, they kept the illusion of capability going far beyond when any sane person would have dropped it, and fully moved to the realm of "Bait and Switch". Turns out they get to keep that $700 million despite at some point having moved from 'exaggerate' to 'lie' in their claims - way to reward bad behaviour.

That VCs burn their money (some of which comes from pension funds remember) on a stupid bet is one thing, partly that's what they do, but because they both allowed and incentivized Theranos' behaviour, that target of a fast, cheap, small, versatile, consumer friendly blood testing was the norm for anyone else raising money in that area for the last few years. Imagine you had a product that did literally half of what Theranos claimed, and you pitched to VCs who kept rejecting you because they expected and demanded a company that exceeded Theranos. An honest founder couldn't pitch that, a dishonest or naive one could. By Theranos continuing the charade of their viability they made it harder for those legitimate startups to raise anything at all due to unrealistic expectations. It's great for a company to kill their competitors but not what we as consumers or investors (or I assume LPs in a VC) want.

Energous and the Pointless Product
Energous are wireless power company who claim to use RF (like wifi) to power small devices like phones. No independent third party has ever validated their system or performance, and some claim they are simply using a "Time to Carrot" approach to constantly keep investors thinking that the pot of gold is about 12 to 18 months out, and just put more money in. They have claimed up to 4 Watts at up to 15 feet from the transmitter but there are so many skeptics, myself included, that look at the physics and maths and show that what they claim is simply not possible. After going through an IPO, raising millions of dollars and the top three executives paying themselves almost $5 million a year total with no product or revenue, how do they answer their critics? By releasing a product, but so simple and with specs so low that it is pointless, and calling it "mini" - and now they claim they have a product, and it's just "the big pot of gold is just around the corner...".

The mini-WattUp is a small USB sized device claiming to charge devices, that needs to be in contact to an inch away (not 15 feet), and charges at a rate that would take days at best to fully charge a phone, but it does have FCC approval (because it does nearly nothing). It's like making a car for a soap-box derby and claiming that next year you'll be competing with Tesla. It achieves the goal of continuing the illusion that there is real technology, real hope of a full scale version which will always be "18 months away".

Had Energous tried to IPO the company based on the mini-WattUp then they would have fallen flat on their face - nothing interesting, useful, or better than the competition (by far). If the goal though is to raise the cash, milk it for as long as they can, then a "Bait and Switch" keeps the money flowing, and that's the most important thing. <sarcasm>It's a pity as it destroys any market for real at-distance wireless power companies.</sarcasm>

Speaking of Other "At Distance" Wireless Power Companies
For some reason, I wanted to remind everyone of uBeam's claims of how they will be wirelessly charging at a distance, and by the end of 2016 (only a few months left to wait!). Released specs are:

I can't find anything on safety or efficiency that's public from uBeam, though there are some well written articles on the safety aspect. Just keeping this in mind for comparing to the product uBeam must be releasing soon.

Bait and Switch
So looking at Theranos and Energous, if you're wondering why they make the claims they do which have never been backed up by evidence, it's because they've been paid millions of dollars to do so. The system simply encourages it, and it's basic human trait that when you reward a behaviour you get more of it. VCs by their funding approach are selecting for founders and CEOs most willing to exaggerate, and in some cases willing to lie. If we want to see less distortions in our allocation of capital and see it more go to genuine, viable technologies, then something has to change. In large part, one of the culprits is the tech media, who simply reprint PR scripts they are handed, and give up actual ability to criticise in return for access. We need more willing to ask the hard questions in the way John Carreyrou did of Theranos or Lee Gomes did of uBeam, rather than just parrot a PR line handed to them without question.

Until that happens, expect more companies to raise large amounts on the unfeasible, and then finish the "Bait and Switch".

And finally
Just as I was to publish this, I read a fantastic piece in the The Atlantic by Adrienne LaFrance about "Access, Accountability Reporting and Silicon Valley" which says a lot of what I've been trying to say on the media coverage of tech firms, but far more eloquently. I highly recommend it.

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