A jury will soon decide whether former Theranos CEO Elizabeth Holmes is guilty of a federal crime. But the deep public policy questions raised by Theranos remain unanswered. How did a startup built on a technology that never worked soar to a valuation of $9 billion? How was the company able to hide its fraud for so long? And what, if anything, can be done to stop the next Theranos before it grows big enough to cause real damage – and burn away the capital that could be invested in real innovations? I explore these questions in an upcoming paper in the Indiana Law Journal titled Taming Unicorns.
While Theranos was publicly exposed in October 2015 by Wall Street Journal investigative reporter John Carrero, insiders knew it was fraudulent years ago. For example, in 2006, Holmes gave Novartis executives a demo of an early prototype blood test and faked the results when the device malfunctioned. When Theranos’ CFO confronted Holmes about the incident, he fired him. In 2008—nearly seven years before Carrerou’s revelations—theranos board members learned that Holmes had misled them about the company’s finances and the state of its technology.
Over time, a notable number of people, both inside and outside the company, began to suspect that Theranos was a fraud. A Walgreens employee tasked with investigating Theranos for potential partnerships wrote in a report that the company was overseeing its technology. Physicians in Arizona were skeptical of the results their patients were getting, and a pathologist in Missouri wrote a blog post questioning Theranos’ claims about how accurate its tools were. Stanford professor John Ioannidis published an article in jama raising more doubts.
Meanwhile, rumors spread in the VC community. Google Ventures’ Bill Maris (since rebranded as GV) claimed that his fund went on investing in Theranos in 2013. According to Maris, the firm sent an employee to Walgreens to take a Theranos blood test. The employee was asked to give more than a drop of blood that Theranos claimed required its equipment. After refusing a traditional venous blood draw, he was asked to come back to give more blood.
So why didn’t any of these doubts slow Theranos’ fundraising? Part of the answer is that it was a private company, and it is nearly impossible to bet against a private company. companies.
Until the last decade, most startups that had become valuable businesses chose to become public companies. Late startups with reports of over $1 billion used to be so rare that VC Eileen Lee dubbed them “unicorns” in a 2013 article in . At the time, there were only 39 startups claiming billion-dollar valuations. By 2021, the number of unicorns had grown to over 800, despite companies going public through SPAC.
The rise of the unicorn has been accompanied by corporate malpractice scandals. Of course, public companies also commit misconduct. Research has not yet established whether unicorns are more prone to systematic misconduct than comparable public companies. However, we know that the opportunity to profit from information about a company by trading its securities creates an incentive to uncover misconduct. Since the securities of private companies are not widely traded, it becomes easier for the executives of the private company to conceal the misconduct.
Consider electric truck company Nikola, formerly a unicorn. In 2020, Nicola went public through a SPAC. Once it became public, short seller Nathan Anderson decided to investigate and eventually released a report alleging a pattern of corporate misconduct. He staged a video showing Nikola traveling at high speed with his prototype truck – Nikola driving the truck to the top of a hill and filming it rolling downhill in neutral. After Anderson released his report, the SEC and federal prosecutors launched an investigation into whether Nicola misled investors. Its share price lost more than half of its value. In 2021, Nikola CEO Trevor Milton was indicted by the SEC and indicted by a federal grand jury. Nicola would not have been exposed so soon if she had stayed private.
Securities regulation prohibits both the sale and resale of private company stock in the name of investor protection. Startups typically attach a contractual right of first refusal to their shares, which effectively requires employees to obtain permission to sell the company. Many late-stage startups practice “selective liquidity”: allowing key employees to cash in on private placements, while preventing a strong market from emerging. As a result, those who have information about a private company’s misconduct have little incentive to publicize it – even though the Supreme Court has held that an investor who trades on the information shared for the purpose of uncovering fraud. does not, cannot be held guilty of insider trading.
VC Unicorns may seem well positioned for police misconduct. But their asymmetric risk preferences undermine their incentive to uncover wrongdoing. VCs invest their funds in a portfolio of startups and expect that most bets will produce modest or negative returns, and only a small number will grow rapidly. The outsized growth of some successful startups will offset the loss of portfolio balance. For VCs, the difference between a startup that is embroiled in a scam and several startups that fail to develop a product or find a market is insignificant.
Venture investing is an auction that has the problem of a winner’s curse. Startups pitch to multiple VC firms in each fundraising round, but they are required to accept funding from only one bidder. In the public capital markets, if a majority of investors decide that a company is fraudulent or too risky, its share price will fall. However, in VC markets, if a majority of investors decide that a startup is fraudulent, the startup can still raise funds from a credible adversary. Passing out VCs will not share their negative assessment with the public because they want to maintain a founder-friendly reputation. Maris only told the press that GV was passed on to Theranos. after Carrierou’s article.
Congress and the SEC can strengthen unicorn misconduct prevention by creating a market for trading private company securities in three phases.
First, the regulations prohibiting secondary trading of private company securities should be liberalised. The SEC must eliminate the holding period of Rule 144 for resale as accredited investors—individual and institutional investors whom the SEC considers to be sophisticated and able to bear the risk. Congress should do away with the Section 12(g) requirement that effectively compels companies to go public if they acquire 2,000 record shareholders who are accredited investors—a rule that allows private companies to continue trading. encourages you to limit.
Second, the SEC must attach a regulatory most preferred nation (MFN) clause to all securities sold through safe harbors commonly used for private placement. An MFN clause would require that, if a company permits to resell any of its securities, it must allow All Its securities are to be resold, unless the resale is otherwise legal. A regulatory MFN clause would put restrictions on the exercise of selective liquidity and prompt companies to allow trading of their shares.
Third, the SEC should require that all private companies that allow their securities to be widely traded make limited public disclosures about their operations and finances. A limited disclosure mandate would protect investors by ensuring they have basic information about the companies they can invest in, without bothering unicorns with costly disclosure obligations imposed on public companies.
The net effect of these reforms would be to create a stronger market for the trading of Unicorn stock among accredited investors. Most large, private companies may decide to allow trading of their shares. Short sellers, analysts and financial journalists will be attracted to the markets. Their investigation will strengthen the prevention of unicorn misconduct. The limited disclosure mandate, combined with requiring investors to be accredited, would protect investors.
When large, private companies commit misconduct, the natural response is to increase the penalty for the underlying misconduct, not to interfere with the traditionality of the company’s securities. But the problem is not that of lax punishment. Holmes is facing a 20-year prison sentence – a sentence that no one deserves. The problem is that punishment only works when wrongdoers expect to be caught. Business increasingly creates incentives to uncover misconduct.