The next Theranos should be short – TechCrunch

A jury will soon decide whether former Theranos CEO Elizabeth Holmes is guilty of a federal crime. But the deeper questions about government policy that Theranos raised remain unanswered. How did a startup built on a technology that never worked grow to a $9 billion valuation? How could the company hide its fraud for so long? And what can be done to prevent the next Theranos before it grows big enough to do real damage and burn capital that could have been invested in real innovations? I explore these questions in an upcoming Indiana Law Journal article titled: tame unicorns.

While Theranos was publicly exposed in October 2015 by investigative reporter John Carreyrou of Wall Street Journal, insiders knew it was committing fraud many years earlier. For example, in 2006, Holmes gave a demo of an early prototype blood test to Novartis executives and falsified the results when the device malfunctioned. When Theranos confronted CFO Holmes about the incident, she fired him. In 2008 about seven years before Carreyrous Exhibits Theranos board members learned that Holmes had misled them about the company’s finances and the state of technology.

Over time, a remarkable number of people, both inside and outside the company, began to suspect that Theranos was a scammer. A Walgreens employee tasked with vetting Theranos for a possible collaboration wrote in a report that the company was overselling its technology. Doctors in Arizona became skeptical of the results their patients were getting, and a pathologist in Missouri wrote: blog post questioning Theranos’ claims about how accurate his devices were. Stanford Professor John Ioannidis published a article in JAMA raise more doubts.

Meanwhile, rumors had circulated in the VC community. Bill Maris of Google Ventures (since rebranded as GV) claimed that his fund invested in Theranos in 2013. According to Maris, the company had sent an employee to do a Theranos blood test at Walgreens. The employee was asked to give more than the single drop of blood Theranos claimed his devices needed. After refusing a conventional venous blood draw, he was told to come back and give more blood.

So why did none of these doubts slow down Theranos’ fundraising? Part of the answer is that it was a private company and it is almost impossible to bet against private businesses.

Until the last decade, most startups that grew into high-value companies chose to become public companies. Late-stage startups with reported valuations of over $1 billion used to be so rare that VC Aileen Lee called them unicorns in a 2013 TechCrunch article. At the time, there were only 39 startups claiming a valuation of billions of dollars. By 2021, despite the increase in companies going public through SPACs, the number of unicorns had passed 800.

The rise of unicorns has been accompanied by scandals over corporate misconduct. Of course, public companies also commit misconduct. Research has not yet determined whether unicorns are systematically more prone to misconduct than comparable public companies. We do know, however, that the ability to profit from information about a company by trading its securities creates incentives to expose misconduct. Since the securities of private companies are not widely traded, it is easier for private company executives to hide wrongdoing.

Think of the electric truck company Nikola, formerly a unicorn. in 2020, Nikola went public through a SPAC. Once it was made public, short seller Nathan Anderson decided to investigate and eventually gave a report claimed a pattern of corporate misconduct. He showed that a video Nikola had shot with his prototype truck traveling at high speed had been staged. Nikola had towed the truck to the top of a hill and filmed it rolling down in neutral. After Anderson released his report, the SEC and federal prosecutors launched an investigation into whether Nikola had misled investors. The share price lost more than half of its value. In 2021 Nikolas was CEO Trevor Milton charged by the SEC and sued by a federal grand jury. Nikola wouldn’t have been exposed so quickly if it had remained private.

The securities regulations restrict both the sale and the resale of shares of private companies in the name of investor protection. Startups usually attach a contractual right of first refusal to their stock, which basically requires employees to get the company’s permission to sell. Many late-stage start-ups take advantage of selective liquidity: cashing out key employees in private placements, while preventing a robust market from developing. Consequently, those who have information about private company misconduct have little reason to publish it, even though the Supreme Court has held that an investor who trades on information shared to expose fraud cannot be convicted of insider trading.

VCs may seem well positioned to police unicorn misconduct. But their asymmetric risk preferences undermine their incentive to expose wrongdoing. VCs invest their money in a portfolio of startups and expect most bets to return a modest or negative return, and only a small number will grow exponentially. The outsized growth of the few successful startups will offset the losses in the portfolio’s balance. For VCs, the difference between a startup that implodes in a scandal and the many startups that fail to develop a product or find a market is insignificant.

Venture investing is an auction with a curse problem of the winners. Startups pitch to many VC firms in each fundraising round, but they only need to accept funding from one bidder. If most investors in public capital markets decide that a company is fraudulent or excessively risky, the share price will fall. However, if most investors in VC markets decide that a startup is fraudulent, the startup can still raise money from a gullible contrarian. Successful VCs do not share their negative rating with the public because they want to maintain a founder-friendly reputation. Maris only told the press that GV had passed on Theranos after Carey article.

Congress and the SEC could strengthen deterrents to unicorn misconduct by creating a three-step market for trading private company securities.

Firstly, the rules restricting secondary trading in securities of private companies should be liberalised. The SEC should eliminate the holding period of Rule 144 for resale for accredited investors, the individual and institutional investors that the SEC deems advanced and most able to bear risk. Congress must remove the Section 12(g)s requirement that effectively forces companies to go public if they acquire 2,000 record shareholders who are accredited investors, a rule that leads private companies to restrict trading.

Second, the SEC should attach a most-favoured-nation (MFN) regulatory clause to all securities sold through the safe havens commonly used for private placements. An MFN clause would require that, if a company allows any of its securities to be resold, it must allow: all its securities are resold, so long as the resale is otherwise legal. A regulatory MFN clause would prohibit the practice of selective liquidity and encourage companies to trade their shares.

Third, the SEC should require all private companies that trade their securities on a large scale to make limited public disclosures about their operations and finances. A limited disclosure mandate would protect investors by ensuring they have basic information about the companies they can invest in, without burdening unicorns with the costly disclosure obligations imposed on public companies.

The net effect of these reforms would be to create a robust market for unicorn stock trading among accredited investors. Most large, private companies would probably decide to trade their shares. Short sellers, analysts and financial journalists would be attracted to the markets. Their research is said to amplify the deterrent to misbehavior of unicorns. The limited disclosure mandate, combined with the requirement for investors to be accredited, would protect investors.

When large, private companies commit misconduct, the natural response is to increase the penalty for the underlying misconduct, not to disrupt the marketability of the company’s securities. But the problem is not lax punishment. Holmes faces 20 years in prison, a punishment more cruel than anyone deserves. The problem is that penalties only work if offenders expect to be caught. Acting creates incentives to expose wrongdoing more quickly.