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Thursday, March 15, 2018

Theranos - Will VC Change Following SEC Charges?

Those of you following any tech news will have read the major announcement by the SEC yesterday, that charges Theranos, its founder/CEO Elizabeth Holmes, and former President Ramesh Balwani with "massive fraud". To quote: 

"raising more than $700 million from investors through an elaborate, years-long fraud in which they exaggerated or made false statements about the company’s technology, business, and financial performance."

While originally a darling of Silicon Valley and the media, Wall Street Journal's John Carreyrou exposed their fraud in 2015. This resulted in vehement denials from the company, threats of litigation, and vocal support from prominent valley investors such as Tim Draper. The announcement from the SEC vindicates Carreyrou, and highlights the value of high quality investigative journalism, along with publications that stand by their staff, to society.

Holmes has been stripped of much of her stock, barred from serving as an officer of a public company for 10 years, has to pay a $500,000 fine, and loses voting control of the company. Further, she cannot make any profit from the company until over $750 million has been returned to defrauded investors and shareholders. Holmes did not admit any wrongdoing and will not, from this complaint, face jailtime. Balwani faces charges in federal court.

To summarize, for defrauding investors she will lose the financial benefit of that fraud, lose control of her company, pay a fine, but nothing more. The SEC pursues civil actions, while the Department of Justice pursues criminal charges, so jail time is still possible for jeopardizing the health of millions of patients with under-performing blood-tests that informed diagnoses and treatments, among other things. 

There's also no word on what this means for those directly impacted due to Theranos' aggressive legal tactics against those who raised the possibility of fraud. Tyler Schultz, the original whistleblower on the company, incurred over $400,000 in legal costs defending himself against what are now clearly valid claims of fraudulent behavior. It's a clear message to any potential whistleblowers out there - keep your mouth shut if you don't want a lifetime of debt to be the reward for your ethical behavior. Hopefully there is a civil suit coming from Mr Schulz that results in the company fully compensating him, and more, for these actions.

I've been writing extensively on Theranos since 2016, mainly to use them as a clear example of how the system of venture capital is in many ways broken - that the entrepreneur community is responding to incentives from those with money, the VCs, to tell them what they want to hear in return for that funding. While there are many ethical and diligent VCs, there are those who do not rise to those standards - and what they want to hear is not realistic development of a product that will produce a solid company and return them 5 to 10x investment in 5 years, but a 'disruptive' technology that will 'change the world' and get them 100x return in 2 years. Investors need to realize that by funding the most fantastical and improbable, that the realistic and viable are often crowded out and never see the light of day. There's millions of dollars at stake here, with a bias to reward those who paint the rosiest picture despite reality, so it's no surprise that those willing to push the limits of truth are found in high numbers. This final point was addressed head on by the SEC in their release:

“The Theranos story is an important lesson for Silicon Valley,” said Jina Choi, Director of the SEC’s San Francisco Regional Office.  “Innovators who seek to revolutionize and disrupt an industry must tell investors the truth about what their technology can do today, not just what they hope it might do someday.”

If that wasn't a direct enough statement to Silicon Valley that they should be aware that small startups seeking to "fake it 'til they make it" are not too small to be of notice, they also made sure to say:

“The charges against Theranos, Holmes, and Balwani make clear that there is no exemption from the anti-fraud provisions of the federal securities laws simply because a company is non-public, development-stage, or the subject of exuberant media attention.”

I had hoped that the Theranos story would result, finally, in Venture Capital taking a long hard look at itself and re-evaluating its model. In Theranos they would realize that the "Move Fast and Break Things" model that seemed to work in social media just cannot be applied to hardware, and healthcare in particular. That they would realize that yes, they were responsible for providing the system of rewards, and failing to provide a system of checks, that would encourage those willing to represent where they might be able to eventually go, as where they actually are. Is the attraction of investing in the next Uber, with all the questionable legal activities too, now something to be carefully considered, or is it a "no-brainer"?

Sarah Cone of Social Impact Capital Tweeted what I feel was the most appropriate response I have read:

I don’t need the companies I invest in to be perfect, but I do need them to be honest about where they are at. Confusion in the deck between where the company could be and where it’s at (happens often) gets an immediate pass. I want to invest in founders that I know can fundamentally see reality.

Which is exactly the behavior any VC should always have exhibited, and I was very glad to see. If I were a Limited Partner, one of the people who puts money into a Venture Capital fund and expects returns, it's the ethical and pragmatic behavior that I would expect.

What about other investors? Maya Kosoff of Vanity Fair spoke to multiple investors for their reaction. Some blamed the company, investors, and board members for not doing their job. One said that the temptations to cut corners and grow quickly were so large that may have led her astray, while another went further and explicitly said that investors were part of the problem.

“I actually think that the V.C. business model has changed and encourages this type of behavior."

While these investors all seemed to say there was a problem at least somewhere in the system, not one went one the record and would be named. Even when there is a statement from the federal agency charged with overseeing investment that there has been massive fraud, a reporter can't get an investor to put their name behind a bland statement like "This is a terrible black-eye for the industry and we should revisit our practices to ensure this never happens again".

Some were unhappy with the SEC action and were willing to put their name to that. Here's part of the reaction from Paul Kedrosky of SK Ventures, also on Twitter: 

"Many of the things the SEC is whinging about in its complaint will seem painfully familiar to any longtime startup investor or founder - did that! did that! did that! -- and everyone forgets them if you go bust, or you get bought/big.

I'm no Theranos/Holmes fan, but if the SEC is going to start banging startups for hubris and for getting their promise cart before their product horse, well ... let's just hope Steve Cohen does something wrong and distracts the SEC from startups first."

Now I have to wonder that if the federal government came in and enforced massive legal penalties on what I consider "standard operating procedure" of my industry, I might start taking a long hard look at my industry practices before saying it's just "whinging". Clearly this behavior is so endemic in the industry that even an egregious example can't make some sit-up and say "Maybe we should review our practices?". Moreover, I wouldn't be sitting admitting that I or any of my investments had been repeatedly guilty of committing many of the acts that had just been found illegal!

Kedrosky makes valid points that investors have a burden of due diligence (more, it's a fiduciary duty to their Limited Partners) and if they didn't do that, then more fool them. When pitching to investors in the past I have been prompted by them to increase my financial projections again and again until I literally told them "You know it's unrealistic, why are you telling me to say that?" and the answer was "It's not your job to tell me what's reasonable, I want to know what the biggest upside is, and then I'll decide". And they are right - it's up to them to do the due diligence, and decide the level of risk they are willing to take - but in part that due diligence depends on how much the startup is willing to 'exaggerate'. 

That "exaggeration" has been the norm for so long that it has moved from "painting the most positive picture facts allow" to "claiming what you wish were possible as the current baseline truth", and now it's simply accepted in the community. Like seeing an alcoholic waking after their latest blackout saying they'll never drink again, most sober people watching are skeptical. It seems that, at least in private, the investment community knows something went badly wrong here, but are some convincing themselves this was a 'one-off' and return to their old ways the next time someone offers them a 'drink'? 

And there is the problem - as long as there are "Ubers" out there, who, in the opinion of many, managed to use breaking the law to grow so quickly they could afford to fight the legal actions, there will be investors willing to put money in and turn a blind eye. Until there are criminal actions against board members, or VCs themselves, for failing in their fiduciary duty, I'm not sure there will be real significant reform. I hope I'm wrong.

Addendum: I'm going to add responses from other VCs to this as I find them. Searching online three days after the announcement, and either people are keeping their heads down, or my Google-fu is not what it used to be.

Here's Bilal Zuberi of Lux Capital:

"Big lesson SV can learn from Theranos: Don't peddle bullshit, and don't allow others to peddle bullshit. Don't lend credibility to people and ideas you know nothing about. And call out fraud when you see it."

Prominent Silicon Valley VC Tim Draper declined to comment to the press. Previously he had been a vocal supporter of Theranos, even as evidence mounted of "exaggeration". In 2016 he said:

"Taxi companies attacked Uber. Hotels attacked Airbnb. Car companies attacked Tesla. Telecoms attacked Skype. Fortunately for humanity, the transformative technologies made it through the attacks and we are all better off. They should be ashamed to try to take down this woman who is trying to do so much for health care. ... She should be hailed as a hero"