In California, a trial is underway which poses some interesting questions for the rarefied world of finance and technology called Silicon Valley. It also exposes failures of due diligence and shortcomings – or worse – of governance, and these should be heeded as warnings for investors, regulators and consumers in New Zealand.
It is Elizabeth Holmes who is on trial. Once heralded as the youngest female self-made billionaire, she is now charged with wire fraud relating to allegations that she engaged in a multi-million-dollar scheme to defraud Theranos investors, partners and customers.
Theranos promised to revolutionise healthcare, with Holmes claiming her new technology could run multiple diagnostic tests from a single drop of blood. To exploit this opportunity, Holmes assembled a high-powered board with former US Secretaries of State George Schultz and Henry Kissinger, established commercial partnerships with Walgreens and Safeway, and raised nearly US$1 billion from investors including Rupert Murdoch. At its peak in 2014, the company was valued at US$9b.
The problem? It was all smoke and mirrors. The Theranos prototype, far from revolutionary, was unreliable and inaccurate. The company used existing diagnostic technology to assess blood samples it collected, and passed them off as having been analysed on its own tech.
The Wall Street Journal broke the story despite strenuous efforts by Holmes and Theranos to suppress it and discredit the reporter, John Carreyrou. Theranos collapsed in 2018, the same year Holmes was charged.
I do not propose to debate whether Holmes will be found guilty. My interest was sparked primarily by the approach taken by her defence attorneys and what the case has revealed about the methods of sophisticated financial experts with stewardship over billions of dollars from global investors. In other words, supposedly some of the smartest guys in the room.
First, the defence. A key argument here is that Holmes and her co-defendants were not economical with the truth but were merely following a well-trodden path of exaggeration and hyperbole when talking about the company, its products and prospects. To support this contention the defence has referenced Steve Jobs and Larry Ellison, who were both accused of exaggerating the capabilities of their respective Apple and Oracle. Normal founder behaviour which should not be punished, in other words.
Some elements of this are clearly defensible. An entrepreneur should be expected to put the good aspects of their company and products in the best possible light, but it is a long bow to argue deliberate lying about the business is an acceptable standard. Here Nikola, the electric vehicle start-up, is instructive. Under investigation by the US Securities and Exchange Commission over information relating to its capital raise, the company has admitted that nine statements made by founder Trevor Milton about Nikola's progress and technical abilities were wholly or partly inaccurate. Nikola is now contemplating a US$125 million provision for civil penalties, yet the company remains valued at over US$5.7b.
Given the apparent rewards of "exaggeration", it should hardly be surprising if entrepreneurs (risk-takers by definition) do not take every opportunity to talk up their business, based on a strategy to attract investment, get high enterprise values, and cash out, having transferred the risk to other investors. This should not be possible; after all, most early stage investors are highly sophisticated, and capable of exercising due diligence on the claims of entrepreneurs. Surely such hyperbole could be found out?
It is here the evidence submitted at the Holmes trial becomes so interesting. One after the other, investors representing billions of dollars used to back Theranos have been cross-examined, and their process has been shown as little more sophisticated than placing a large sum on red or black. Lisa Petersen, who invested US$100m of DeVos family money in Theranos, admitted on the stand she had done no review or investigation of the business, prompting Holmes' defence attorney to question whether she had heard of the concept of due diligence.
It is difficult not to conclude that this is one large charade. Far from sophisticated analysis, follow other high-profile investors, place your bets and cross your fingers! Most of the billions of dollars of enterprise value created in Silicon Valley is attached to a small number of businesses, and every investor wants to be an early backer of the next unicorn.
The game is: overhype the outcomes and ensure that early investors get protected positions – this often means they can take money out before later investors while ostensibly investing at the same, inflated level – and then attract unsophisticated investors to pay up for garbage before exiting quickly.
The Amazon part-owned Rivian EV delivery start-up reveals the process. Amazon CEO Jeff Bezos announced an order for 100,000 electric delivery vans, which based on current retail pricing could approximate a US$7b contract but may be closer to $4b to $5b. The exact value of the contract is irrelevant; what matters is that Amazon has placed an order with a deposit of (say) $1000 per van, for a total of $100m, and now has an asset that is worth multiples of whatever deposit it does pay. Amazon has raised the value of Rivian, and therefore of its own stake (to about US$17b), on the back of a contract whose terms we do not know, and which could at any point be modified, delayed or cancelled. No problem: the value has gone up already. The contract itself is immaterial to Amazon, because more value has been created for Amazon than for other investors.
What are the solutions to discourage hyperbole, exaggeration and flat-out lies destroying investor value? Clearly, there needs to be stronger, independent (i.e. experts not appointed by the company in question) analysis of claims, especially when tapping the capital markets. Misleading statements should lead to disqualification of directors as well as fines. This should focus the minds of professional or "name" directors to do the job they are paid for. New and up-and-coming directors should take advantage of mentorship and professional education of the likes offered by the Institute of Directors in New Zealand.
Also, following clear failures of due diligence by individuals with fiduciary responsibilities, investors should have recourse to redress from the fund managers and promoters themselves. The high fee structures of private capital and investment banking should require minimum standards of work at the very least.
When the rewards are so high – and safeguards faulty or missing – the temptation to cut corners and to be economical with the truth becomes too strong. As always, it is retail investors who end up losing out.
• Andrew Barnes is a businessman and philanthropist. He is the founder of Perpetual Guardian.