The sobering due diligence lessons from the Theranos debacle


Due diligence went by the board at Theranos. It’s a common problem. It is an object lesson in why it is important to understand the accounts and projections of any technology investment.

therano holmes
Elizabeth Holmes, CEO Theranos

Investors thought they’d hit the jackpot with Theranos, the now failed medical technology business. Founded by Elizabeth Holmes in 2003, Theranos promised a near non-invasive general purpose blood test for many conditions. At one stage, the company commanded a $9 billion valuation, making Ms. Holmes the youngest self-made female billionaire with a personal wealth of $4.6 billion, subsequently revised to zero by Forbes.

A spectacular fall

It turns out that Theranos was little more than a hyped science project making highly dubious claims about its product and fraudulent financial claims about its prospects.

The fallout is horrific. Investors have likely lost $700 million. As a result of an SEC settlement, Ms. Holmes is banned from serving as an officer or director in any public company for 10 years, has lost voting control of the company she founded, cannot profit from her investment until investors have received at least $700 million and has been fined $500,000. The company is being held afloat by loans of $100 million secured by patents and there are ongoing criminal investigations. All of which leads me to believe there are important lessons for technology buyers.

Due diligence a must

Regardless of what technology you’re investing in, we advise buyers to undertake due diligence on the selling vendor. Without exception. Why?

High technology is a risky business. Vendors routinely place numerous bets on what they believe customers will need, many of which don’t pay off or only reap marginal value. Some are blockbusters and it is the blockbuster effect that attracts so much money from the VC community.

In the Theranos case, Ms. Homes’ venture attracted high profile investors including Rupert Murdoch, yes that Murdoch, in part because of the kudos that Theranos board member, former U.S. Secretary of State George Schultz brought to the party, but also because of the public support Marc Andreessen, so-called golden boy of Silicon Valley, gave to the venture, albeit he passed on investment, along with the rah-rah that accompanied investment from Tim Draper of Draper Fisher Jurvetson.

Regulators miss the point

In short, the so-called smart money thought that if these high profile individuals are involved then it’s got to be OK. Right? Wrong. Even now, regulators are falling for a variation of this narrative. This from the Wall Street Journal:

“The Theranos story is an important lesson for Silicon Valley,” said Jina Choi, director of the SEC’s regional office in San Francisco, in a statement Wednesday. “Innovators who seek to revolutionize and disrupt an industry must tell investors the truth about what their technology can do today, not just what they hope it might do someday.”

via WSJ

That’s not good enough.

Those who serve as directors also have a duty to ensure that correct and verified information is communicated. If the reporting is correct, then that didn’t happen in this case.

Numbers posted by the Wall Street Journal don’t add up and cast doubt on the extent to which anyone performed due diligence either as investors or buyers. Check the illustration at left.

Assuming those numbers are correct – and to be fair, no-one has published accounts that prove or disprove the SEC assertions – then there is something fundamentally wrong.

You simply cannot record revenue numbers of the kind Theranos claimed without creating a balance sheet debtor of equal amount. In the alternative, you’d have to record some kind of weird charge to the profit and loss account in order to hide the ‘debt.’

Given these are numbers that go back to 2014, and the problems Theranos faced didn’t surface publicly until late 2015, the question must be: what numbers did directors and investors see? Who performed an audit? How was this obvious mis-match kept out of the public eye for so long? How were buyers and investors so easily fooled?

Switching chairs

According to a Wall Street Journal article published in November 2016:

After the Journal published in October 2015 its first article detailing problems at Theranos, the company announced that all four men (Shultz, former Secretary of State Henry Kissinger, former Secretary of Defense William Perry, and former Sen. Sam Nunn) had been moved from the board of directors to a newly formed board of counselors.

What the actual…? This still didn’t set off alarm bells? Apparently not. It was only much later, according to a Bloomberg report in May 2017, that Schultz admitted:

Former U.S. Secretary of State George Shultz and retired U.S. Navy Admiral Gary Roughead, who served on Theranos’ board acknowledged that they failed to confront Chief Executive Elizabeth Holmes about the allegations because they believed her claims about the technology’s capabilities, according to court documents unsealed May 26 in Delaware.

“That’s what I assumed,” Shultz testified under oath April 4. “I didn’t probe into it. It didn’t occur to me.”


Accounting matters

I have long argued that dubious accounting practices that fall outside of GAAP are dangerous. Silicon Valley boosters often poo-poo GAAP accounts, arguing that the only thing that matters is growth as evidenced by sales and annual recurring revenue (ARR) etc plus cash.

These armchair accountants almost never take cognizance of what’s happening on the balance sheet other than looking at cash generated, calculating EPS and the per share price.  Viewed through that lens, it is relatively easy for any bad actor to deflect attention away from other important numbers and especially so when a company is in startup and capital raising mode.

I suspect that in this case, the board was negligent, ignorant or both. Or to put it in the words of Francine McKenna:

Harsh? I don’t think so.

There is another wrinkle to this story. According to reports, Ms. Holmes never took a salary and didn’t sell any of her shares yet owes $25 million secured on those shares. How does that get repaid?

And another wrinkle. Nothing in the SEC settlement prevents Ms. Holmes from trying another startup.

I recall a conversation where an otherwise very well respected and bright developer told me that anyone could learn the principles of accounting in a weekend. If that’s the case then I wonder what I and thousands of other number crunchers spent their time serving a three or four-year accounting apprenticeship.

Maybe we were learning to understand the very things that investors clearly don’t ‘get’ and which obscure financial reality from fiction. The stuff that many investors think is boring.

Don’t get me wrong. I’m a huge fan of innovation and love the prospect of taking risk. But risk has to be calculated and based on projections that make sense in a verifiable context. The support of high profile individuals is important but they must have a track record related to the project at hand. And yes, when it comes to accounts, I want to see them and I want answers when the occasion arises. That’s what I call due diligence and which I consider an essential element of any evaluation.

Image credit - WSJ, Fortune, Wikipedia

    1. Good reporting but uncertain buyers can undertake due diligence on the selling vendor.

      Consider many EnSW applications firms who were once public with audited books. Have since been taken private by PE vendors who pile on too much debt. Such that R&D investments can barley keep pace with computer security in light of cyber risks such as Meltdown and Spectre vulnerabilities. Leaving vendors to stick a new web skin on the front end, make astonishing claims about AI, and such. Then enlist certain industry analysts with expenses paid trips to cover flagship systems and hood wink buyers with sweet reviews.

      Maybe the SEC and other regulators need to foster more pubic companies so that auditors can certify the accounts…

    2. says:

      If they trade in the UK then regardless of whether public or private then we can get their accounts. Now – the extent to which those are a fiction is another matter but there’s usually enough with which to make an informed decision.

      In the US, I know the problem but that would never stop me asking the question and seeking to get answers under NDA.

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