Shellanoo’s announcement last week that it was canceling its plan to float stock in Tel Aviv ended a saga centering on a bloated evaluation and a startup that’s in the red. Shellanoo’s prospectus revealed financials that made the company look pretty risky for widows and orphans, and spurred criticism over how the company hawked itself.
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Shellanoo’s management accused the media of pouncing after the company canceled its initial public offering. But the thing is, the company simply revealed figures that it had to in order to comply with regulations, figures the startup sector doesn’t like to talk about but which are hardly unique to this firm.
Startups spending money on research and development before there’s any revenue to speak of are nothing new. Nor are shareholders who try to paint their startup’s situation in rosy colors in order to increase its value. The thing is that most people aren’t privy to the real numbers.
In fact, lying, or at least hyperbole, is routine for a startup if it wants to grow. The public hears only about extreme cases. How are the startups inflating their value, and does it do real damage? The case of Theranos, which said it was a disrupter in blood testing, demonstrates what can happen.
The fall of a woman who raised $400m
For a moment in mid-2014, Elizabeth Holmes was on top of the world. Dubbed the most successful young entrepreneur by Forbes, her startup Theranos, which developed home blood-testing kits, raised $400 million according to an astronomical company value of $9 billion. Her investors included Larry Ellison, and Henry Kissinger sat on the board.
Holmes founded Theranos in 2003, at age 19, out of her own aversion to needles. She dropped out of her chemical engineering program at Stanford University the following year. She’s been called the Steve Jobs of lab tests. Like him, she sported black turtlenecks and was estimated to be worth $4.5 billion.
Her fall was hard and fast. Theranos claimed to have developed a technology to perform home tests using blood taken from the finger. In January 2015, a medical journal noted that the product had been covered by the business and technology press but not the medical literature. In February 2015, the Journal of the American Medical Association ran an editorial criticizing Theranos for operating in “stealth mode” for over ten years without publishing results in peer-reviewed medical literature.
That October, The Wall Street Journal ran the first in a series of investigative reports questioning the accuracy of Theranos’ tests and raising suspicion that results had been faked using traditional blood tests and equipment made by competing companies. They questioned Theranos’ ability to do what it said it could — test blood samples taken from tiny finger pricks. The U.S. Food and Drug Administration ordered Theranos to stop using “uncleared” medical devices. Investors fled for the exits.
In June, the U.S. drugstore chain Walgreens, which had offered the company’s tests at 40 stores in September 2013, closed its testing centers at once. The prestigious Cleveland Clinic also withdrew from a collaboration, suspending use of the Theranos flagship product except for tests of the herpes virus. The U.S. military considered collaborating with Theranos but discovered problems in test results and asked the FDA to look into the company. The request was turned down after a retiring Marines commander joined the Theranos board.
Come July, the company’s value evaporated and Forbes estimated Holmes’ holding to be worthless. The company’s lab in California had its license revoked and Holmes and the company’s other owners were forbidden to operate blood-testing labs in California for two years. Theranos today is under federal investigation for allegedly misleading investors and Holmes herself is contending with a criminal probe, though she appeared at a conference of clinical chemists in August and made a 90-minute presentation of a new blood-testing array, the miniLab. She made no mention of the claims against her previous device.
Also in August, as the month rolled to a close, Theranos withdrew its request for FDA Emergency Use Authorization for its miniLab testing kit for the Zika virus, after an FDA inspection concluded that the company’s patient safeguards were deficient.
Holmes and Theranos took the fantasy all the way but their case is less rare than one would like to think.
From the get-go, startup entrepreneurs are required to tell a story, and paint the picture as rosier than it really is. They describe the product before its development has even begun. The stories are designed to raise money in order to develop the product. Without faith, Silicon Valley couldn’t exist. The entrepreneurs really do believe in the dream they’re hawking. They believe they can do it against all odds, and the line between truth and fantasy can wax thin.
Here are some lies to investors from discussions on the internet forum Quora: Our sales forecasts for next year are conservative. We operate in a $100-billion-a-year market with no competition. My partner received a job offer from Google but preferred us. We have a long list of people who want into our next financing round. We’re about to launch a closed beta version.
The most common feint is much more basic, says Yaniv Golan, managing partner at Lool Ventures: It’s the business model. Since it’s a model of a future business, the figures in the spreadsheets are made up. There’s no product yet, let alone sales or revenues or return customers or users who become buyers. But there’s a spreadsheet with projected figures. “I never saw a business plan come true, not even close or in the same direction,” Golan says.
Of course, investors aren’t morons. They know the models aren’t realistic. “The question is the magnitude of the fantasy. But if the plan forecasts sales of a million dollars in three years, apparently they won’t reach $100 million. Maybe half a million, or $100,000. But if somebody fantasizes about $100 million a year, that is not realistic. It will never happen. But if he achieves a tenth of his fantasy that’s still more than a million so I’d pick him,” says Golan. He adds that all entrepreneurs tell him the forecasts are conservative.
Startups also hire public-relations agencies to gussy up their image. Unlike investors who expect a high degree of transparency from the entrepreneurs, journalists are accustomed to a certain craftiness, especially in regard to the startup’s financial situation. Also, many reporters lack the technological background to really examine the company’s products, forcing them to rely on information from the entrepreneurs, which can result in overly flattering coverage.
To a degree, these principles underlie startup management models. Take the model described in Eric Ries’ 2008 book “The Lean Startup,” which argues that startups have to test their underlying assumptions cheaply, fast and simply. For instance, even before having a technology or product, a company may set up a website describing its (presently nonexistent) activity, to test interest in the market, see if people will leave contact information and so on. Does that constitute misleading of customers or investors, as in Theranos’ case? The answer lies in the magnitude of the deception.
Critical thinking could have helped the Theranos story to end differently. The company’s investors should have been suspicious from early on that they were funding a startup without proven technology, argues Faye Flam in a column published by Bloomberg. “After all, they poured hundreds of millions of dollars into Theranos, though Holmes refused to explain how its revolutionary technology worked,” she wrote. “Maybe they didn’t know what to look for,” she added.
“Holmes did not tell any obvious lies,” Flam explains: her sins were of strategic omission — “creating holes that people tend to fill with faulty assumptions. Instead of lying, she prompted people to lie to themselves.”
Successful investors usually do their homework, writes Prof. Kent Grayson of Northwestern University in Fortune. “But what happens when a company’s product is so new or so technical that it’s hard to judge whether it’s good or not, even after lots of research? These are what economists call ‘credence goods’— things whose quality is difficult to judge, even after you pay for them.” What lawyers and car mechanics are selling us is credence goods, for example: and doctors too.
Theranos offered a low-cost blood testing kit that worked on a few drops of blood, but was secretive and opaque about its technology. Getting names like Kissinger and Ellison on board gave the company a sheen — but they too had relied on this defective information.
Official confirmations are also supportive of credence goods. In Theranos’ case, it did have FDA clearance for some of its tests. Holmes also built up a strong personal story, including the comparisons with Jobs. For all these reasons, investors thought they were onto a good thing.
Some industry insiders have confidence in investor ability to identify fraud. But the case of Theranos and Elizabeth Holmes raises questions about the relationships between startups and investors, the media, and the regulators. This is an industry in which most of the startups ultimately fail, and where entrepreneurs constantly need money to pursue their next big story, which is several sizes larger than the reality. Investors have to get tougher and cagier about asking questions.