It took 15 years for the Theranos bubble to pop, but Friday’s indictment of founder Elizabeth Holmes on criminal fraud charges appeared to ice the cake. Holmes, the feds allege, charismatically sold herself as a brilliant Stanford dropout and sold her story that Theranos’ cheap method for lab-testing blood would turn health care upside down.
It appeared that the U.S. attorney’s office in San Francisco began by indicting Silicon Valley itself. Its buyer-beware warning noted that “investors large and small from around the world are attracted (there) by its track record, its talent and its promise.”
But Americans have traditionally cut venture capitalists a lot of slack even as they imagine that the capitalists are cutting lots of corners. Venture capitalism is a refined form of gambling in which immense sums of money produce a tiny number of incredible gushers. The average venture investor must be content with a batting average that would have him banished to the minor leagues.
As Holmes and Theranos spun their story to attract investments, they set up a line bordering on heavy promises sure to inflame deep-pocketed investors if they crashed. Even Betsy DeVos, the U.S. education secretary, was among the victims.
In this case, the U.S. claimed that Theranos knew its finger-prick blood-test technology was “likely to contain inaccurate and unreliable results.”
Silicon Valley failures rarely attract criminal charges because such allegations require knowledge of false claims, as opposed to highly improbable sales pitches.
We let these sales pitches go by because we understand them to be exaggerated. The real estate industry excuses tall claims. It uses the term “puffing” to distinguish them from serious misdeeds. Real estate trainees understand from training that a certain amount of “puffing” goes with the territory.
Business schools focus on high success stories more than the far more frequent failures. Everyone has heard about Facebook and Apple, where few recall WebVan, a promising Palo Alto startup which set out to democratize the supermarket shopping and delivery business.
It’s simple enough. You have ten start-up proposals from which to select. All have well-crafted business plans. Most feature an easy-to-swallow proposition. Some have highly qualified founders. You imagine they eat their young.
But nine of the ten will fail, some spectacularly. A few will burn through millions before crashing. Most will burn all their investors’ money. A tiny handful become the “living dead” — companies that won’t be killed because they produce profits, though never enough to justify the start-up capital. When the VCs wrap up their accounting on start-up funds that include the “living dead,” they simply send the stock to investors.
Folks who run the actual start-ups are paid with funds raised through successive “rounds.” If an initial round of fund-raising turns out to be inadequate, successive dog-and-pony shows follow in which investors are shown companies that may have lost money on paper but still show promise. Firms like Amazon take time producing “market share” before profits.
Timing is the key. The most prized position is start-up stock itself. That currency can shoot the moon and produce the buzz. As a company progresses, it may require successive rounds of fund-raising. But each round dilutes the founders’ shares. In some cases, new investors will insist that their money will come back to investors first, before earlier investors see a penny. It’s dog eat dog, but in the marketplace, that’s the only way a runway produces enough lift.
The venture capitalists appear as some sort of exalted species visiting the same clubs. They understand their compact with risk. If they stay close to the founding rounds, they won’t lose enough to doom careers. Perhaps only a few ventures work, but those that fly make the industry worthwhile. Start-up venturers also know that venture capital and offshoots like “angel investors” produce the only investors willing to take on risks that banks and other lenders won’t.
Grandstanders still get fooled. Theranos arranged to partner with Walgreens, setting up testing centers for customers (the arrangement ended last year). Inc. magazine put Elizabeth Holmes on its cover in 2015 along with the teaser “The Next Steve Jobs.”
It took a Wall Street Journal series to produce serious chinks in the Theranos story. Its reporters concluded that Theranos’ methods as “deeply flawed” or reported expert doubts about the technology.
But investor enthusiasm doesn’t die easily. Backers are left to rely on vehicles such as the New York Times or the Journal to raise doubts and expose truths, and an American president has termed the former as “failing.”
Investors flock to the table, their learning curves fortified. They reflect a broader American psychology that won’t tolerate the elimination of all risk.
The Golden Gate Bridge has been a legend since its construction in the 1930s. It is alive with traffic every minute. The suspension bridge occasionally is jammed with so many cars that its spans appear to momentarily flatten.
In 1989, the Loma Prieta quake shook the Golden Gate but it didn’t fail. The nearby Bay Bridge, with a trestle construction, broke. Cars fell in the drink. Freeway overpasses collapsed and drivers were killed.
The risk of catastrophe on the Golden Gate is considered acceptable. Every approaching driver has two thoughts upon starting a crossing. First, it won’t happen to me. Second, it won’t happen in the next two minutes.
It’s an unspoken contract — a handshake with risk.
The writer (dukeofdanforth@gmail.com)is a founder of the Aspen Daily News (and Palo Alto Daily News) and appears here Sundays.