Last month Theranos were back in the news, barely a few weeks after being admonished by the SEC for using lies and exaggeration to raise over $700 million from investors, this time for the CEO to announce that they were running out of cash and would likely have to close by the end of July. Approximately 100 employees will be let go in early June, leaving less than 25 who will most likely oversee a winding down of the company.
Theranos received a funding round last December, with a $100 million loan from Fortress Investment Group, which had many had been shocked to hear given the widespread knowledge of the company's difficulties. In my December article I pointed out things likely weren't as they seemed at first, and this was simply a predatory loan made in the knowledge that Theranos would in fact default, and that the lender would then take ownership of the company assets at firesale prices.
"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."
Well I'm feeling pretty smug right now, as that's exactly what looks to have happened. According to a letter Holmes wrote to shareholders (included at the bottom of this post, from Buzzfeed), despite having received $65 million from Fortress in December, they're about to miss a deadline for FDA approval on a device which will result in them not receiving the next tranche of $10 million. Most significantly though, should Theranos' bank balance drop below $3 million, they are in default of the terms of the Fortress loan, and the company predicts that will happen in July. According to Holmes:
Fortress would be entitled to control a foreclosure sale and/or monetization of the assets and to realize up to a three-times return on its investment (including, in addition to the amounts loaned by Fortress, the costs associated with Fortress’ monetization of the company’s assets).
So Fortress get three times what they loaned, including whatever legal costs they have in extracting this money. A factor of three on the loan plus costs means they won't just get most of the company, they'll get all of it.
That $65 million gets Fortress around 1,175 patents (granted and applications) in the biotech space. They can sell them, licence them out, or use them to sue other successful biotech companies for payment. Given some large patent infringement payouts can result in 9 figure cheques, a single win like that will result in a great payday for Fortress.
It may not have even cost Fortress $65 million. I do wonder if they invested saying something like "This money cannot be used for legal expenses. It must be kept separate from all other cash and used only for salaries, facilities, and equipment." Knowing that Theranos had legal troubles they may have wanted to ensure the cash was not spent on that, and then set a stipulation that if the "other cash" account dropped below $3 million, the company essentially became theirs - regardless of how much of the investment was left. $65 million gone in basically 6 months, for a company of 125 people, is a monster burn rate. Even at a fully burdened cost of $400,000 per employee that's 'only' $25 million spent in 6 months. Facilities etc can be expensive, but not $40 million worth. In that case, Fortress would be owed $195 million (3*$65m), take the ~$40 million out the bank account that remains, then start picking the best $155 million of assets left (pretty much everything else) - making the cost of the whole company $25 million. Or maybe I'm just thinking too hard and Fortress didn't care, and just let them burn through it all with legal fees, thinking $65m was still a bargain.
Regardless, barring a miracle, Theranos are headed for default on their loan, and will end up being fully owned by Fortress. TheCEO amusingly asks for further investment to stave this off, but with the SEC judgement, and a skeleton staff, it's not going to happen. It will be interesting to see how Elizabeth Holmes does without the company to pay bills for her, such as for bodyguards, and with a likely criminal lawsuit coming.
An Idiot and Their Money are Soon Parted
So who are the investors that Fortress jumped ahead of in their deal? Who put in the $700 million that got the company to this point? The Wall Street Journal recently published a list of major investors in Theranos, and it's now clear that the company was funded mostly by individual family investment vehicles, not traditional VC. Key investors were:
- Walton Family $150 million
- Rupert Murdoch $125 million
- DeVos Family $100 million
- Cox Family $100 million
So nearly half-a-billion dollars from four family investment groups, and they will probably see nothing back. (Murdoch already got out for a grand total of $4 million, a 97% loss). Pretty stunning, that. Now I'm going to bet on how much due diligence these companies did before investing, and I'm going with a number near zero. It was widely reported in March that when Theranos claimed revenues of over $100 million to investors, no audited accounts were provided, and investors failed to call a single supposed customer - and the actual revenue was $100,000. That's pretty basic due diligence that even the technically illiterate can understand. Think about the scrutiny you get when you go to the bank for a loan, and then realize that for $475 million no-one even picked up a phone and asked for a reference or a bank statement.
As for technical due diligence, they could have found a few well qualified scientists and executives in this area, and paid them a few thousand dollars each for technical and business evaluations. Total cost, less than 1% of the investment, but nope they couldn't do that either.
I've got no sympathy for them, they deserved to lose that money through their own carelessness - it's just frustrating that there are so many genuinely great companies out there that could work wonders on just a few million. That ~$500 million could have funded >100 hardware startups to a prototype/proof point, and made some genuinely useful advances - but the people that run those types of companies don't lie like Holmes, or exaggerate their technology, just to get a cheque signed (or, as in Holmes case, have well connected parents).
One bright side for Silicon Valley VCs, they can now say "See, wasn't us!", they really weren't the ones funding most of this decade's biggest fraud.
We'll definitely be hearing more about Theranos in the coming months, with the June layoffs, the July default, the inevitable bankruptcy and the possible criminal charges, but next up is John Carreyrou's book "Bad Blood". He's the WSJ journalist who broke the Theranos story, and his book is a history of the company, and will be out in two weeks (May 21st). My copy is on order, and looking forward to it. I fully expect a tale of insanity, greed, selfishness, and stupidity, and I'll review it as soon as I read it.
Holmes' Letter to Theranos Shareholders
April 10, 2018
Dear Theranos Stockholders,
We last wrote on December 22, 2017, shortly after closing a secured debt financing transaction with Fortress Investment Group. We said that the transaction provided us runway to continue work on the miniLab and to position the company for additional financing events—but acknowledged the narrow path forward.
Unfortunately, we are behind schedule on our first product milestone under the Fortress loan, and as a result will soon face a cash shortage. Below we detail our situation, apprise you of our options, and ask for your help as we continue to work to realize value for your investments. As we describe below, we are evaluating parallel paths, including potential investment terms that would provide a large stake in the company at what we believe to be a favorable price.
The Fortress financing, which closed on December 11, 2017, provided Theranos with up to $100 million of liquidity, subject to product and operational milestones. The first funding tranche of $65 million gross was released at closing. The release of a second tranche of $10 million gross was contingent upon FDA approval or CE marking of the Zika assay for use on the miniLab. Achieving that milestone within the first half of 2018 was crucial to our business plan.
Development of the Zika assay has taken longer than anticipated. While the miniLab hardware and software have progressed steadily since we last wrote, we continue to face issues with the reliability of the Zika assay chemistry itself. As a result, timing for finalization of our FDA submission remains uncertain. We have raised with Fortress the possibility of releasing the second tranche of funding despite the lack of regulatory approval, but its willingness to do so is not assured and we understand that in any event it will likely depend on our securing additional commitments from our existing investors.
These developments leave the company in a difficult situation. Taking into account the substantial cost-cutting measures we are implementing today, including the reduction in force described below, our best current projections indicate that—absent further funding—our cash reserves will by the end of July fall below the $3 million minimum liquidity threshold required by the Fortress loan. Under the terms of our credit agreement with Fortress, our failure to maintain this minimum liquidity would constitute an event of default. Such an event of default, or other events of default that may accompany the company’s decreased liquidity, could precipitate an exercise of remedies by Fortress, including Fortress’ taking full control of our assets to satisfy the company’s obligations to Fortress. We expect that path would negatively impact the amounts, if any, available for distribution to our stockholders.
To avoid or delay a default under our credit agreement, we intend to take every step we can to preserve our remaining capital. Accordingly, today we provided notice, consistent with the WARN Act and other applicable law, to all but a small group of employees that their jobs will terminate in 60 days, on June 11, 2018. Difficult though that action is, we estimate that the associated cost savings will help conserve capital sufficient to fund our operations through approximately the end of July, without default under our credit agreement. After June 11, our remaining staff will consist primarily of financial, legal and administrative personnel alongside a core technical team, who will dedicate their efforts toward generating the maximum near-term return achievable for our stakeholders, likely through a sale of the company or its assets.
The most viable option that we have identified to forestall a near-term sale or a potential default under our credit agreement is further investment by one or more of you. In light of where we are, this is no easy ask. However, given your support of the company over the years, we wanted to provide this opportunity before we proceed too far down the current path.
Of course, even with new capital, the future of the company would remain highly uncertain. Nevertheless, additional investment may come with some meaningful benefits. A further investment could help protect your current one by providing the company time to continue developing the miniLab and/or to monetize its patent portfolio (subject to the terms and conditions of the Fortress loan). Further investment could also help us to avoid a sale for an uncertain amount—including a foreclosure sale following a liquidity-based default under the Fortress loan. Any such sale could significantly diminish the net realizable value of our assets. Moreover, in certain scenarios, Fortress would be entitled to control a foreclosure sale and/or monetization of the assets and to realize up to a three-times return on its investment (including, in addition to the amounts loaned by Fortress, the costs associated with Fortress’ monetization of the company’s assets). As a result, those scenarios would significantly reduce or eliminate any prospect of distributions to the company’s shareholders.
Our patent portfolio—which provided substantial support for the Fortress financing—contains more than 1,175 granted or pending patents worldwide. We believe our patents cover broad and important technologies, including: (i) the core technologies in the miniLab; (ii) technologies underlying point-of-care devices currently on the market and generating sizable revenue; and (iii) still-emerging technologies, such as an ingestible digital sensor that recently received regulatory approval for use in monitoring medication compliance. We also believe these patents have the potential not only to eventually protect the miniLab, should it receive FDA regulatory approvals, on the market, but also to support a licensing campaign that could generate significant additional revenues.
We have real progress to build on. Having rebuilt our quality system and implemented process-oriented safeguards for development and manufacturing, late last year we were granted a California Manufacturer’s License following an audit of our manufacturing facilities. Last month, representatives of a third-party notified body conducted an audit of our Quality System; we understand that the auditors will recommend issuance of the ISO 13485:2016 and MDSAP (Medical Device Single Audit Program) certification for the Theranos Quality System. We have also engaged a financial auditor, which expects to complete work on an audit of our 2017 financials by the end of June.
We recognize that the vision of distributed laboratory testing is what inspired many of you to invest, and we strongly believe that continuing our work toward that end could increase the near-term value of the company, and could provide the basis for building significant long-term value.
Although not yet set, the investment terms we are considering would provide a large stake in the company at a favorable price, in light of what we estimate is the intrinsic value of the company’s assets. We expect that new investment would take the form of a senior class of preferred stock, which would also feature substantial governance rights, allowing participating investors a significant role in steering the company forward.
Please note that if we offer new equity securities at a price per share less than the applicable conversion price of our existing series of preferred stock, the resulting anti-dilution adjustments could cause significant dilution to our existing stockholders. Such an offering would likely require the consent of the holders of a majority of our existing Series C-1B and Series C-2A Preferred Stock. The interests of these stockholders, who are senior to all other classes and series of stock with respect to payment upon a liquidation or deemed liquidation of the company, may differ from holders of other classes or series of our stock. Holders of Series C-1B and Series C-2A Preferred Stock should also be aware that their failure to participate in a financing having a purchase price of less than $5 per share would result in mandatory conversion of their shares into nonvoting Series C-1B* or Series C-2A* Preferred Stock.
Subject to our compliance with the preemptive rights of certain investors, we will offer this opportunity to all stockholders who are accredited investors within the meaning of Rule 501(a) under the Exchange Act of 1933, as amended. For any accredited investor who is interested in exploring it, we can provide a term sheet and are available to meet at any time. Irrespective of your future investment intent, we value your engagement as stockholders and welcome your questions and comments.
This letter and its contents are confidential. We request that you not share or discuss this letter with others, except your attorneys, accountants and other advisors bound by confidentiality obligations. The unauthorized disclosure of this letter could violate the terms of agreements between you and the company, and could additionally depress the amount realizable upon a sale of our assets. This letter shall not constitute an offer to sell or the solicitation of an offer to buy securities, nor shall there be any sale of our securities in any state or jurisdiction in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state or jurisdiction or a valid exemption therefrom. Any offering that we conduct will be made only to accredited investors and only pursuant to definitive offering documents, including a disclosure package.
Thank you again for your support.
Chairman and CEO