Citing the infamous case of Theranos, the now-debunked blood-testing startup, a student asked me about the risk of fraud in technology-company investing. Given the complexity of new technologies and the detailed knowledge needed to assess them, how do we judge the value of new technology as a basis for investment?
The good news is that in more than 30 years of investing in technology companies, I have never personally encountered a situation where entrepreneurs consciously lied or fabricated results. What does happen is that entrepreneurs underestimate the difficulties of achieving a desired result and products don’t materialize in the time frame expected – or sometimes never, because the hurdles are simply too great. I had a similar experience when I managed electronic research at the RCA Laboratories. I found that scientists and engineers are trained to tackle difficult problems that have not been solved before and therefore err on the side of optimism. But I never knew people who deliberately falsified results.
Hence the story of Theranos stands out, given its scale and the length of time it took to uncover what ranks as the costliest venture-capital scam in recent history. The company was founded in 2003 by Elizabeth Holmes, a 19-year-old entrepreneur who had dropped out of Stanford University. Her idea was to develop and market a small device capable of doing full blood analysis on the basis of a drop of blood. Such a device promised to revolutionize the US$70 billion blood-testing industry in the United States by making it possible for consumers to do their own tests at home and thus monitor their personal health in real time.
Between 2003 and 2017, this compelling vision, potentially worth billions in revenues, attracted about $700 million in investment from funds and individuals at a valuation that reached $10 billion – without any significant revenues. Elizabeth Holmes, who was chief executive officer, attracted great public acclaim as “the next Steve Jobs,” including a cover story in Fortune.
In 2015, the real story emerged after The Wall Street Journal ran an exposé by John Carreyrou that revealed that the Theranos machine never worked and that the reported blood tests were made with generally available commercial equipment. The Theranos equipment shown to investors was bogus and financial reports were faked as well. The company closed in 2018 and the founder was indicted for fraud and will go on trial.
How could such a scam happen and last this long in technology-sophisticated Silicon Valley? There were events and situations that served as red flags to prudent people but were ignored. These include:
- No external independent validation of the claimed product was allowed by the company.
- Blood-testing experts always questioned the claims regarding reliable comprehensive tests with blood-sample sizes that were deemed by experts to be too small.
- There was huge turnover of technical personnel in the company as knowledgeable employees discovered the impossibility of making the device and left or were fired if they brought suspicious questions to the attention of management.
- The board of directors was filled with notable public figures, such as Henry Kissinger, who did not focus on their duties of overseeing the activities of the company as it continuously missed commitments. Their presence on the board gave the impression to outsiders that the claims made were validated by the board members.
- Massive legal firewalls protected internal information. Employees who left signed rigid non-disclosure agreements and the company was vigilant in legal prosecution of people believed to disclose internal information.
- Investors were lulled with patents issued to the company, but such patents did not bear on practical results. Furthermore, the company signed agreements with drugstore chains for blood-testing services that gave the illusion that the technology was being deployed.
A technological fraud of this scale is very rare, but the lessons learned deserve remembering. Having witnessed in our age so many developments that defy predictions, it is easy to believe claims without the desire to check their validity within existing knowledge. But professional investors must not avoid this arduous process. The process begins with understanding whether the technology promise violates basic knowledge. The opinions of famous people is perhaps interesting but not really relevant. Experts are needed.
In this case, blood testing is a well studied art. There is a large body of knowledge that bears on the requirements for reliable testing. This kind of sanity check would have indicated that that the proposed machine based on tiny blood samples could not perform tests reliably unless something dramatically different was discovered. This should have raised questions worthy of detailed discussion prior to investment.
In closing this subject, let me highlight a recent situation that I was involved with. An entrepreneurial team approached us with an investment proposal in a new technology to increase the solar conversion efficiency of solar cells, which is now about 20% in state-of-the-art commercial silicon devices. The proposed idea was to increase the efficiency by enhancing the internal process of converting solar radiation into electricity by adding an electrical contact and improve the efficiently overall to 26%.
This idea – if practical – had enormous value given the massive deployment of solar-energy conversion globally (it is an industry worth well over $30 billion annually). Unfortunately, a close look at the process quickly convinced me that it was not physically possible given the nature of the conversion process that is well understood. It is not that the team presenting the idea was doing so fraudulently. It is just that they had not studied their physics.