Theranos — Should investors have known better?

In the recent Reboot Podcast, Jerry Colonna, Fred Wilson and Brad Feld reminisce on some of the panic attacks they’ve experienced from circumstances which were out of their control as investors. Jerry recalled a time when the CFO of IXL, a public company where he sat on the board, made a substantial error in their earnings projections: “I remember getting a phone call and being told there was an arithmetic error in the spreadsheet being used to forecast our upcoming numbers, and we were going to be off by a factor, an order of magnitude.” Some situations are avoidable, like Jerry described above, other times, a lack of due diligence and expertise will leave an investor holding a worthless investment, as was the case with the latest round of Theranos investors.

Photo: Theranos/YouTube

Let’s take a look at what public evidence was available prior to the last investment round in March 2015 and see if there were any hints that should have stopped investors and partners like Walgreens in their tracks. How did Theranos achieve a $9bn valuation without anyone uncovering the deception, and potential fraud? Should investors have known better? And what about Walgreens, how did they fail to see the red flags during their diligence process? I’ve scanned through a bunch of older press articles and based on what I’ve read, I think there are few big areas of concern summarized below. If you aren’t caught up on the Theranos story, scroll all the way to the bottom of this page and you can read a quick history.

1. Intense Secrecy and Lack of Transparency

One thing you can definitely say about the news articles and interviews with Elizabeth Holmes is that her language was extraordinarily vague; often bordering on convoluted, ambiguous, and almost evasive. When asked about the technology, Holmes would reply with general statements such as the company tests used the “same fundamental chemical methods” seen in traditional testing. However, concerns were raised by many competitors, who knew that the traditional methods she referred to could not be used with such small amounts of blood.

Beyond just speaking broadly, she was also unequivocally protectionist around revealing any data or real information on how the technology actually worked. The importance of confidentiality is undeniable when it comes to any disruptive technology breaking into a large and established competitive market. However, Theranos seemingly took this secrecy to a much higher level than most. Holmes refused to display any devices and would not even allow the proprietary equipment to be photographed when idle, citing the need to protect trade secrets. Further, the company refused to share relevant data with other medical professionals, such as the results of any internal testing of the processes. Numerous medical professionals argued that it may have been entirely possible to reveal internal testing results to demonstrate effectives of the technology without giving away any trade secrets.

2. No External Validation or Peer Reviews

There was a clear lack of any research reporting providing third-party validation for Theranos’ technology. Peer reviews are extremely important in the life sciences space as this provides a route through which new developments and technologies may be tested and validated by third-party professionals who are experienced in the industry and can provide an un-biased external view of the company’s own claims. However, due to the intense level of secrecy at Theranos it was impossible for external parties to undertake the necessary research to validate the company’s processes. Lakshman Ramamurthy, a former associate director of the FDA, argued that the Edison was new technology, and new ideas should be subject to peer reviews which were not present. Theranos claimed that they did not want to submit the technology for third party review due to concerns that it could be copied by competitors. However, this is what patents are for. Peer reviews are a very well established practice for new findings in the medical community and patents are meant to protect new technologies in this review process. If Theranos has the proper patent protections, this should not have been a concern.

It wasn’t just the lack of validation from peer review journals, other types of validation were missing as well:

  • In an attempt to increase credibility, Theranos proactively applied for FDA approval for their tests. Since the company did not sell Edison to any other labs, FDA approval was not actually required so this was seen as a positive move by observers. However, when the firm applied for approval for 120 different tests, only one test for herpes was actually approved. In other words, the FDA did not approve 119 or the 120 tests that Theranos submitted.
  • Way back in 2008, when Elizabeth Holmes tried to demonstrate the Theranos technology to Novartis AG, all five testing units failed. There was also some evidence that the tests were not accurate
  • In April 2014 a formal complaint was made to the New York State Department of Health regarding the Theranos practices claiming that the Edison system had produced results that were significantly different to the traditional tests. This complaint was forwarded to the Centers for Medicare and Medicaid Services (CMS). To operate Theranos had to receive approval from the CMS, who would audit forms to ensure results given were accurate. However, it is reported that in 2014, when CMS audited the company’s facilities, they were not shown, nor were they aware of the Edison machines.

3. No Healthcare / Life Sciences Investors Participated in the Deal

Something that I’m sure gave many VCs pause was the fact that there were no experienced life sciences investors in the deal. A higher level of due diligence is required when it comes to products in the healthcare space, where people’s lives and health are affected. Healthcare investors were not in the deal because there wasn’t enough transparency at Theranos to do the proper amount of diligence as GV CEO, Bill Maris discusses in this video. Additionally, Theranos’ board of directors had only one experienced medical professional who was a former director of the CDC, but had no formal background in diagnostics specifically. In fact, there was no one on the board with formal experience in medical diagnostics.

4. Suicide of Dr. Ian Gibbons

One of the more tragic events that occurred in midst of all of this was the suicide of Dr. Ian Gibbons, who had been working for Theranos as a biochemist specializing in handling and processing small fluid quantities since 2005. In May 2013, Gibbons took his own life. According to Gibbons’ widow, Gibbons had informed her that nothing at Theranos was working. During his tenure at Theranos, Gibbons collaborated with many other employees and was involved in registering 23 patents, with Elizabeth Holmes named as co-inventor on 19. According to a Jason Calacanis interview with John Carreyrou, Theranos is notorious in the valley for its extremely high employee turnover rate, so the fact that Gibbons remained with the company for so many years suggests that he was likely very close to the technology. However, Theranos disputed Rochelle’s claims, stating Gibbons was frequently absent in his last year due ‘health and other problems’. Following Rochelle’s interview with a journalist, Theranos threatened to sue her if she continued making ‘false statements’. There’s no evidence supporting any real connection between the suicide and what may or may not have been going on at Theranos. Still, it’s hard not to wonder. And further, you might also wonder what was behind the significant employee turnover and whether that had anything to do with the technology.

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I think most money managers would agree, putting hundreds of millions of dollars into a company that had such secretive methods and such a lack of transparency does not afford a good risk/reward profile on the face of it. On the other hand, VCs (particularly those that invest at early stages and especially in the case of disruptive technologies) are paid to choose winners often before the product is fully developed and when thorough diligence is not always possible. Some of the most successful VCs achieve incredible returns by taking huge chances on new technologies at such an early stage. These are very high risk investments which rely on what essentially comes down to a leap of faith resting on a prediction of the future and the belief that you’ve chosen the best team of founders to execute on that future. These investors are making portfolio bets with full knowledge that most of the portfolio companies will fail, while one success could outweigh everything else. In that sense, to say that the investors should have done more work and should have asked more questions, in some ways goes against the nature of the investment thesis. However, later rounds might have no excuse, but were likely swayed by a number of factors:

  • The fact that Draper Fisher Jurvetson was a lead seed stage investor gave Theranos a certain level of credibility and likely helped feed the “FOMO” (fear of missing out) for other investors
  • Elizabeth Holmes’ compelling story (child prodigy, taught herself mandarin and programming in high school, dropped out of Stanford to pursue her unwavering vision full-time) is the stuff that Silicon Valley dreams are made of when it comes to picking out an ideal founder to invest in. In short — the valuation may have had at least as much to do with Holmes herself as it had to do with the viability of the product she was touting
  • Holmes’ polished and charismatic image along with her fierce conviction and speaking style was very convincing; employing selectively vague language with no obvious lies and rhetoric sprinkled with technical jargon which both made her sound highly adept in the technical arena of her product, while also masking any true meaning (or lack of meaning) in what she was saying. Her style, manner of speaking, and image all added up to support confirmation bias on the part of investors, journalists, and the public. Add to that the frequent comparisons to Steve Jobs (thanks to her expertly chosen attire of the classic black turtle neck) which supported a strong mental association with one of the most successful and proven founders of our time and made it hard not to trust her.
Elizabeth Holmes, TEDMED2014. Photo, Jerod Harris, TEDMED

Taking those things into account, it’s not surprising that the Theranos’ valuation ran up so quickly despite the questionable facts around the actual product, and it certainly makes for a quintessential case study of hype leading to willful blindness and confirmation bias on the part of investors. On the other hand, Walgreens is in the business of serving people, not placing bets on unproven or unfounded concepts. So perhaps the more important question is why did Walgreens agree to partner with Theranos in 2013 despite the facts outlined above? As a side note, in his conversation with Jason Calacanis, John Carreyrou mentioned that the Theranos/Walgreens contract was negotiated by the Ex-Walgreens CFO, Timothy McLevish, with apparently very unfavorable terms to Walgreens. Timothy, was asked to leave Walgreens after making a major prediction error that cost Walgreens $1 billion.

These facts are obviously crystal clear in hindsight, with countless news articles detailing quotes from skeptical scientists and healthcare professionals. But these facts were also true and publicly available prior to that first WSJ article in October 2015. However much of the skepticism was often chalked up to reactionary language from protectionist competitors, as Tim Draper said “Here’s what happens every time I have a huge winner, the first thing that happens is that the competition sort of pooh-poohs it. Then the next thing that happens is they go, ‘Uh-oh, this is threatening our business.’ … She’s opened the kimono, and it’s scaring the pants off the competition.”

Still, Walgreens should have recognized the lack of third party validation and the secrecy around the technology as red flags. It’s one thing to invest in an imperfect technology in the hopes that a very committed genius founder along with a team of pros will work out the kinks eventually. It’s something else entirely to agree to put that product in your retail stores and allow customers to rely on its results for their healthcare decisions before the efficacy has been thoroughly established and proven. In my opinion, this was more a failure on the part of Walgreens than a failure on the part of the early VCs. Investors are bound to make bad investments along with the good, but it’s not necessarily their duty to protect consumers from a harmful and fraudulent product.

Background Info

Recently, consumer healthcare technology company, Theranos, has been in the news as it seems their flagship product, Edison, doesn’t actually work, may have never worked, and the company may have been deceiving investors, customers, and the media all along. To date, Theranos has raised nearly $700 million in funds with its latest $348 million round raised in March 2015 valuing the company at $9 billion and making it one of last year’s most prominent unicorns — that is, until an October 2015 Wall Street Journal article exposed the questionable efficacy of Theranos’ technology and the highly secretive and evasive practices of the company’s executives. This sparked a rippling effect leading to a tornado of negative press around the company and its 32 year-old founder, Elizabeth Holmes, a one-time darling of the media and VC world.

Following further investigation, the Centers for Medicare & Medicaid Services (CMS) revoked the certificate for Theranos’s California laboratory and banned Holmes from owning or running a lab for at least two years. Walgreens eventually suspended its partnership with the company following CMS reports citing jeopardy to patient health and safety. The partnership with Walgreens, which was announced in 2013, established Theranos Wellness Centers at forty Walgreens stores across Arizona, as well as locations in Palo Alto, and was an important step in catapulting Theranos into the public eye and into the lives of consumers. Theranos has now voided two years of worth of blood test results and faces and will face numerous law suits. Consequently and not surprisingly, analysts now estimate the valuation at below $1bn, a significant drop from the $9bn value ascribed to company at its March 2015 investment round.