Theranos gets $100 million funding - is it what it seems?

Few things surprise me in the funding of startups anymore - when you see a juicer that gets $90 million that's pretty much the end of shock as to what gets money - but this week saw my jaw drop on the funding news front as Theranos, the supposed blood testing company, received a further $100 million. This scoop was from Lydia Ramsey at Business Insider, and follows John Carreyrou of the Wall Street Journal who did fantastic investigative journalism on Theranos over the last few years. Theranos are pretty much the poster child for what's wrong in tech investing. Here's a quick summary of why not to invest in Theranos:

• The technology never even vaguely met the wildly exaggerated initial claims
• Sued by investors to the tune of >$100 million for fraud (settled out of court)
• Sued by biggest customer for around $140 million for fraud (settled out of court)
• CEO/Founder banned by the federal government from running their main business line 
• Sued by Arizona AG for inaccurate blood tests on >100,000 patients
• Never/rarely subject their results to independent third party scrutiny
• Placed the safety of patients at risk
• Ongoing US Attorney and SEC investigations

Essentially, they're not "good actors" in any sense of the word - they've had to be sued by both investors (nearly unheard of) and customers, and risked the lives of patients with their blood tests. Why would you give them money? I don't think I'm alone in my initial stunned reaction, from what I see and hear the VC community is also pretty shocked by this one, even they don't want to go throwing good money after something this bad. After a day or so though, I began to think about it more, and I've come to the conclusion that it's unlikely that Theranos will ever see that full $100 million, and instead it's a savvy play for IP from a private equity firm.

The history

I've written fairly extensively on Theranos, but have not posted in over a year because I thought they were pretty much dead and the story was on hold until they went into bankruptcy or criminal prosecutions began. More fool me. A quick summary for those who haven't been following - Theranos claimed to have revolutionary blood testing technology that would identify many diseases from a  single fingerstick drop of blood, and raised >$750 million from VC (mostly non-traditional for biotech ones), had a board full of ex-government bigwigs including current Secretary of Defense Mattis, and had a Stanford dropout young CEO who the press loved. In the end it turned out to be a fraud, the technology could not do what they claimed, used heavy handed legal threats against whistleblowers and media, had to refund nearly $5 million to 76,000 patients for inaccurate blood tests, had the CEO/founder banned from operating a clinical lab for two years by the government, and eventually were sued by both customers and investors for huge amounts of money (estimated at over $100 million in settlements so far). There are ongoing US Attorney and SEC investigations, and likely other federal criminal investigations too. Having gone through some rounds of layoffs amounting to over half the company, everyone was just waiting for the bankruptcy filing and then the news of this funding dropped.

The investor

The investment comes from a group who often invest in 'distressed' companies - Fortress Investment Group LLC - that is they look for bargains and drive hard deals with companies desperate because they have nowhere else to go. There's a good history of the company here, and if you want to see a financial company where the executives make ungodly sums of money whether they succeed or fail, this is it. The five top executives took home near $1.7 billion just before they IPO'd in 2007, after which the stock plummeted by around 75% (at one point by 97%). 

The group had a turnaround earlier this year when SoftBank agreed to buy them for $3.3 billion, no doubt giving another payday to the executives at the company. For those who aren't aware, SoftBank runs the world's largest investment fund, the $100 billion "Vision Fund", and have made enormous purchases and investments such as to chip maker ARM Holdings for $32 billion, and Uber for $10 billion.

This is not a company where they invest in good social works or for the sake of humanity, they're in this deal because they smell money.

The investment

$100 million is a lot of money, even for a sizable company like Theranos. Seeing that kind of investment in a fraudulent company raises anger in those who have diligently worked to develop tech based on shoestring budgets, especially if they've been passed over for funding because they're told it's not as advanced as Theranos' smoke and mirrors pitches had people believing the state-of-the-art was. I'm not sure it's quite what it appears at first glance though, so let's take a look at what we know. Here are the key quotes from the WSJ article:

Theranos Inc. told its investors this week that it has secured a $100 million loan from Fortress Investment Group LLC

The loan from Fortress is collateralized by Theranos’s patent portfolio and the deal grants Fortress warrants for 4% of the company’s equity

The loan is “subject to achieving certain product and operational milestones,” 

This leaves the possibilities for what has happened wide open, so assuming that Fortress are savvy and seeing a deal here, I'm going to make some guesses as to what's happening.

• This is a loan, not a traditional investment such as for equity or for convertible debt. In the event of bankruptcy this takes precedence over all other investors such as shareholders - they get paid back before anyone else, so it's safer than equity investing. 
• It's a loan on certain terms and if they don't meet those terms then the company's IP (patents etc) likely become the property of Fortress. (USPTO quick search turns up 115 patents, smaller than I would have expected). They don't just get paid back first, they get the choice assets, likely the only part of the company that has value. What's the value of that IP? Have they evaluated that it could be sold to another biotech firm such as Roche for >$100 million?
• The money is conditional upon reaching milestones - that is, they don't just get handed $100 million to do with as they please, it's going to be metered out in multiple tranches if and only if they hit targets. These targets will be various steps along the way to "receive FDA approval for Zika virus test" and possibly include "not to be sued by investors, customers, or face criminal charges from any federal agencies". Basically, Fortress dole out the kid's allowance very carefully, and will have chosen the trigger points carefully.
• Fortress get warrants on 4% of stock - this means they can choose to buy up to 4% of the company stock at a set price, at a later date. We don't know what that price is, but you can expect it will be at $100 million or most likely much lower. If Theranos pulls a rabbit out of the hat and makes a success of things, becoming a multi-billion dollar company, then Fortress get to own a piece of it at a discount.

So Fortress have arranged a deal where they don't have to put the full amount in up-front, but are still ahead of any other investor, get to own the only valuable part of the company if it goes wrong (the IP), and get discounted stock in the company if it, through some miracle, succeeds. With the right milestones and triggers, this could be a deal where Fortress win no matter what happens, and may actually come out better should Theranos fail. I wonder if Fortress have essentially arranged a deal to make sure that all the good parts are gone by the time everyone else reaches the bankruptcy auction.

Why would Theranos take such a deal? Well, because they have to choice - it's this or bankruptcy.

The outcome

Can the technology succeed? Putting aside who would trust their personal health to a company with Theranos' reputation, possibly, but there's something to look at that is pretty damning as to what is happening internally. From WSJ:

In May, Theranos announced in a press release that it had hired Cass Grandone, a former Abbott Diagnostics executive, to head its product development. Ms. Holmes was quoted in the press release as saying that Mr. Grandone’s leadership would be critical to the company. However, Mr. Grandone resigned last month after just six months on the job, according to a person familiar with his departure.

When someone like this gets brought in, it's to save the product. They get given incentives and bonuses that make it very, very worth their while to see things to completion. If he's leaving after only 6 months to me it says either the technology can't make it to product, or the company is screwed up so badly that even good tech won't succeed (read: clashes with unreasonable CEO). It could be either, or both, but is irrelevant - that Grandone walked is a very bad sign for Theranos. (At least he didn't feel so much pressure he committed suicide.)

So what will happen? Who knows where this bizarre story will end, however I would not put stock in Theranos succeeding - IMO a demoralized company with technology at best no better than the competition, a CEO/founder likely to still believe she can succeed and willing to take any deal to avert bankrupty, with potential for criminal charges and further lawsuits hanging over their heads, will not be a company focused on a world-beating product. 

Perhaps Fortress will walk away from this with all the IP for $10 or $20 million, and leave the rotting carcass for everyone else who put in >$750 million. Quite the deal for Fortress if they can pull it off.