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:

• 4 meter range in every direction
• At least 1.5 Watts and often 'faster than a wire' (that's over 10W if true)
• Charges while in your pocket

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.

Inflection Points and Hockey Sticks

The term "Inflection Point" is used repeatedly during startup pitches, and is one of those overused terms you grow a little sick of when you have to deal with that world, in part since it is rarely used to describe an actual inflection point. So what is it? 

In mathematics it's the point at which the curvature of a curve changes direction, like below:

But since we're talking about investing and startups, what's usually meant is that it is a moment of dramatic change, a sudden upturn (or downturn) in sales or growth. (Obviously, when business use the term they rarely want it associated with a downturn, but it is equally applicable!) It's pretty obvious where the inflection point in the below image is, and tends to be more of the business meaning.

When you're doing a pitch-deck in fundraising, you have to come to your predicted sales graph, and if you want funding, it better be a "hockey stick" - that is, flat for a few years, then around year 3 to 4 starts to uptick significantly, then leaps hugely in year 5. Without that, you get no funding. So pretty much every pitch deck for a startup shows a loss in year 1, a smaller loss in year 2, breakeven in year 3, modest profit in year 4, and $10 billion of revenue in year 5. Small exaggeration, but not much. Here's WeWork's numbers, with which they raised a substantial amount of money, nearly $1.5 billion

As an example of how this can play out, in a former life I was pitching for funds for a company that was developing software for retail. Creating a business plan, I thought that conservatively we could be at around $25 million a year in revenue by year 5, and as we were asking for $250k to $500k from angels, it seemed reasonable. Of all the slides in the deck, I got grilled on that on in pitches more than any other, and was flat out told that the company wouldn't grow big enough for it to be of interest. So I reran the numbers, changed some assumptions to be more positive, and pitched at $40m by year 5. Same result, and detailed questions on that slide, and disbelief.

At this point I really was struggling, as I simply couldn't justify moving much past that $40m number (which, for those of you who don't do this kind of thing, is a pretty damn good number to get a return for a ~$500k investment). Without money, we were going to have to stop work, but how to get it without plain lying?

My solution was this - I still showed the "$40m by Year 5" slide, but then had a second chart with the caveat "If extended to multiple verticals" and the numbers reached $150m a year by Year 5, and then made no claims as to the chance of achieving that. This was ridiculous, it was never going to happen, but here was the interesting thing - as soon as I did that, not a single question on the financials, we just moved smoothly on. It was amazing.

Finally, I asked one of the potential investors why he hadn't questioned me on that slide as it was clearly never going to happen and his answer was this:

It's not your role to decide to be conservative for me or to decide my risk. I decide that. You show me as good as it can get, I'll factor in my acceptance for risk. Investors expect to see curves like that, just show them.

So there you go - if you wonder why the funding goes to the charlatans that are prepared to lie or make outrageous claims it's because the people with money demand that you do. If you don't they think there's something wrong with you.

And if you wonder why startup CEOs use "inflection point" for things it's not even vaguely appropriate, it's because saying it got them millions in funding, so they just keep using it on everything else as it must be a Harry Potter-esque phrase of magic power.

Theranos 101 - One Tiny Drop Changes Everything

Theranos and Elizabeth Holmes have been discussed multiple times on this blog, and for those not familiar with them I thought I'd give a very quick summary of them and the controversy surrounding them.

Elizabeth Holmes was a chemical engineering student at Stanford when she dropped out at age 19 to start the company - the goal was to create accurate medical tests based on drops of blood rather than vials, so it can be from just a finger prick and not a full vial draw. If it can be achieved, it's a great simplification of the whole blood testing process, and the company hoped it would spur an increase in the number of tests given how easy it would be.

This is not an easy task, and there were significant questions over the ability to accurately do testing on small drops of blood - the drop itself may be so small that even with a perfect test the result may not be accurate or reproducible - but it's a worthy goal for research.

They received some initial seed funding from a regular VC and over the next 12 years developed tests for over 200 conditions, and inked a deal with Walgreens to use the tests in-store, with the PR machine claiming that a revolution in blood testing was coming. By mid-2015 they had raised nearly $700 million which valued the company at around $9 billion, with Elizabeth Holmes as the youngest self-made billionaire. (Note Theranos is a private company so it can be hard to gauge exactly the funds raised, this article estimates $750m)

Holmes was front and center with the company, synonymous with Theranos, and painted as a role model for others. To be compared to Elizabeth Holmes was a great compliment, and entrepreneurs everywhere vied to be 'the next Holmes' - such as this up-and-comer:

@DeanZ_Kellogg @ubeam @theranos @msuster @OurCrowd wow, what a compliment! Thank you so much!

— Meredith Perry (@meredithperry) June 24, 2015

It was something of an odd company, with a non-medical board full of former Senators, Admirals, Generals, Secretaries of State and Defense - but not a single person capable of understanding the technology - and going against the grain of almost all biomedical companies never published peer-reviewed results on their tests, simply instead saying (in effect) "trust us".

Now, there had been rumblings from inside the biotech community for sometime that something was not right at Theranos, but the press loved their story of the self-made founder/CEO, and everything was going wonderfully until October 2015 (Fun Fact: Same day I left uBeam!) and the Wall Street Journal released a bombshell story questioning the accuracy of these tests and whether Holmes had been exaggerating the capabilities of the tests. Wired released an article raising the questions that "exposes a deeper problem with the way Silicon Valley tries to spin hype into startup gold."

Startling among these revelations was that Theranos weren't even using their own technology for the tests, but standard off-the-shelf equipment other companies use, as their equipment gave highly variable results.

This was soon followed by other more detailed analysis by the press, along with apologies for prior poor reporting, but more importantly the FDA got involved and stated only one of their many tests was approved (a Herpes test, which is a simple yes/no), and then Centers for Medicare and Medicaid Services wrote to Theranos stating its tests "pose immediate jeopardy to patient health and safety." 

This Business Insider article gives a great timeline of events for Theranos. It has made Elizabeth Holmes, who rode the publicity all the way up and took more of the spotlight than the Company itself, a household name beyond just Silicon Valley and for all the worst reasons. She even has her own parody Twitter account 'NotLizHolmes'

It's been a rollercoaster of negative press for them since then, with damage control from Theranos in the forms of expressing surprise and lack of knowledge, of claiming that data on their tests will be released for public assessment (not happened to date), and that they are working with the authorities to deal with these issue. They added a well qualified medical board too ("look, big names with titles, stop asking questions!"). From an article in the NYTimes, there were some sections that stood out as very familiar to me:

"She (Holmes) stays relentlessly on message, as a review of her numerous conference and TV appearances make clear, while at the same time saying little of scientific substance."

As I've pointed out before - even when you are exposed, stick to the message is the best game plan. But this next section from Professor Frank Partnoy of University of San Diego School of Law was just a stunning quote, what I have been trying to put into words and say in this blog:

“We’re deluged with information even as pressure has grown to make snap decisions. People see a TED talk. They hear this amazing story of a 30-something-year-old woman with a wonder procedure. They see the Cleveland Clinic is on board. A switch goes off and they make an instant decision that everything is fine. You see this over and over: Really smart and wealthy people start to believe completely implausible things with 100 percent certainty.”

You can have experts in the field publish peer reviewed papers, or simple maths that demonstrates the engineering near impossibility of it all, but show a TED talk and an article in Marie Claire and the chequebooks still come out. To quote myself regarding Energous:

"We had, through the use of physics, mathematics, and reasoning, completely demolished their claims and proven that what they are saying is unachievable ... but it got complicated and so you just switched off, ... overall you just didn't care."

To be blunt - technology has gone beyond the capacity for most people to be able to comprehend, even some otherwise very intelligent and educated ones. That deluge of information 'overloads' most people and they fall back on the simplest of solutions - they look for authority figures who have already made decisions for them, or rely on the 'wisdom of crowds' and simply go along with the majority. Actual reasoning shuts down, and following that the idea that someone as smart and educated as you could have got it wrong just can't be entertained (or in the case of existing investors, ever acknowledged).

Something needs to change in how billions of dollars of funding, much originating from retirement funds, is distributed. The system is setup to reward certain behaviours, and good stewardship of this money, and the efficient application of efforts of thousands of workers to benefit our society, in my opinion are not among them. 

Theranos, and others like it, were simply inevitable and the symptom of a much deeper problem.

Do We Have a Deal?

So it seems I was wrong about Energous, they announced a deal. I retract everything I said about them, because clearly based on what they say in their press release, there must be something to their technology.

"Energous ... today announced a partnership agreement with a market-leading specialty battery company in the hearing devices and wearables market. The company has signed a joint development and licensing agreement with Energous and anticipates shipping WattUp receiver technology as well as a Miniature WattUp transmitter.

In order to preserve competitive advantages, the partner has requested confidentiality. "

A Joint Development Agreement as well as a Licensing Agreement? That proves they are a legitimate company that will have products.

Well, no.

A JDA is basically an agreement between two parties that says "We'll try to develop something. What you develop is yours, what we develop is ours, and what we develop together we share." That's it. Doesn't guarantee a product, and it's all still at a research phase. More importantly, there's no requirement for funds committed from either party - other than the time to write it, a JDA is 'free'. I've worked with companies where they almost seemed to collect JDAs - drawers full of them and never a product, or a dollar of revenue, from a single one.

A licensing agreement is a little different - usually it says "One of us has some Intellectual Property. We agree not to sue you if you have a product with it in a specific field of use, a specific region of the world, for a specific period of time." In return the other side usually does something in return - license back some of their technology, pay some cash, pay a % of everything they sell with this IP, or sometimes nothing at all. You want this in place before you put a lot of work into a product, or even know if it's ultimately viable, as you need to know upfront the costs and business impacts.

In other words, licensing agreements are no guarantee of a product or revenue. What is valuable for revenue is when a legitimate company announces "We are releasing a product with Acme Corp technology and paying a license fee." Now this may happen with Energous and this unnamed battery company, but I doubt it. Notice this other company has not necessarily committed funds, or even sullied their name, with this technology. If they were certain it was going somewhere, they'd be announcing their exclusive benefits over their competitors in a press release themselves.

Even when you get an actual product, the licensor might just have gotten lucky and bamboozled a legitimate company into releasing a loser. Witness Theranos, with their tests being performed in Walgreens, and used to help justify the $9 billion valuation - yet now it's looking like those calling Theranos a con game are right, and Walgreens are now realising their mistake and ending the deal.

So in my opinion, Energous get what they want - the veneer of legitimacy to keep the money flowing.

Interestingly, their press release doesn't say what technology was licensed and who the licensor was. The way it's worded, it could be that the battery company is licensing their battery tech to Energous, even though you would think it's the other way around. If devious, Energous could pay the battery company, say $50,000, and include onerous confidentiality clauses in the contract, then announce the agreements, making it seem like it was an agreement in their favour - and never lie and get into trouble with the SEC.

Why do that? Well a 2% bump in stock value of a $170m market cap company is $3.4 million. Do that once a month for a year, and you've added around $45m to the cap, which some shareholders will take a nice cut of. And the $50k that was spent to make the deal, along with the lawyers fees? All from the company funds (paid for by other investors). (Looking at the ticker for WATT, Energous climbed about 2% after this announcement)

For some, it's about just doing what it takes to make it look like they're a legitimate company on the verge of releasing products. Just keep the party going as long as possible. Sometimes it's a real product and all above board. Some do it because they are simply trying to get as much money for themselves as they can, while they can, and they know it's a con. Some do it because they truly believe (rightly or wrongly) that the product is viable, but they just need more time and money to get it working, and when they prove everyone wrong it will all be justified.

But, hey, at least Energous have announced a JDA/licensing deal. Where are uBeam's announcements on that front?

Those Other Guys, Pt II

So back to Energous. Where we left them was that we had, through the use of physics, mathematics, and reasoning, completely demolished their claims and proven that what they are saying is unachievable - that is they are either idiots, or liars (or maybe I'm the idiot!). That's where we'd be in a sane world, but it got complicated and so you just switched off, maybe you heard 'blah blah' or sounds like the Peanuts' teacher, but overall you just didn't care. 

So let's take a look at the business side of Energous instead. You can find lots of information out by looking at their S-1 or their 10-K/Q, because they're now a public company - more on that later.

Energous was formed in late 2012 by an MIT graduate with lots of experience in wireless communications. His parents even invested $10,000 to get him started. Normal startup so far, but then it gets weird. Just three months later, an investment bank, MDB Holdings, come in and start advising and investing. Barely a year after that, they then file for an IPO - that is, selling shares to the public. A company with no product, no revenue, nothing at all, is filing for an IPO. They do have great publicity and a great story, however, and are talking about world changing products coming later that year. Who wouldn't want to get in?!

In March 2014, 18 months after forming, it sells $24 million of shares. That $10,000 his parents put in is now worth $26 million. Nice return. The company is worth well over $100,000,000 - remember, no product, no revenue. But you know someone's making money in all these transactions.

And now the SEC is involved - there are major penalties for lying in any statements from a public company, so they must be being honest, right?

Since then, two years on, and there's still no product, in fact they are backtracking and pushing dates further out, and drastically cutting performance specs on their product. But they've added lots of big names as boardmembers and advisors! These smart advisors and big name board members wouldn't join unless there's something there!

And recently, they admit that they still haven't demonstrated a commercial level product, even in their lab. Uh-oh, they must be collapsing and in terrible trouble.

Well, no. The CEO now makes $2 million per year - for a company under 4 years old, with no product, and no sales. The VP Engineering and VP Sales/Marketing each make $1.5 million.

That's $5 million per year in salary for three people, once again for a company with no product and no revenue. So let me summarise:

• Come up with a really good story for a product people just have to have
• Just make it believable enough, and for people to want to believe, for the skeptics to be ignored
• Create massive hype in the media to boost interest
• Announce fantastic products somewhere out in the future
• Never quite directly answer the critic's questions over the practicality, always dodge and claim 'proprietary'
• When eventually it gets to that time you need to show product or demos, get in some 'big names' instead and make them public to make outsiders think it's all still great
• Keep it going long enough someone eventually buys you and cash out

Remember I said earlier that in my opinion those behind the company are idiots or liars? Well, they made $5 million in one year from it. Which do you think they are?

Here's the genius of Energous. Normally a startup cycle works with the early investors trying to get it to the point where there is a product revenue, or more likely a buyout where they cash in. It usually takes several rounds of financing, with lots of dilution along the way, along with a big chance of failure. Energous bypassed that and went straight to IPO, and got their money out at the beginning. No risky and long slog to return - just jump straight there. It looks to me like they gamed the system, and did so brilliantly.

Now they had better hope they didn't lie in anything the SEC related, but otherwise, they're laughing. They don't even need to make a product to earn more money from this, each, than most people earn in a lifetime of 9 to 5.

But, hey, there has to be something there. People wouldn't just make stuff up to make money, that never happens. And if they did, it would be a one-off, an aberration. There couldn't possibly be other hyped technology companies following that bullet point list from above, could there?