TherOhNos: Who Really Gets Hurt When Startups Blow Up? (And what to do about it.)

Stuart Willson
May 22, 2016 · 6 min read
Oh no…

Yesterday, Theranos announced that it would void two years of diagnostic test results from its Edison blood-testing device. Pulitzer Prize-winning Wall Street Journal-ist John Carreyrou had the scoop on this “unprecedented” recall.

If you have not been following the saga of Theranos, the once high-flying diagnostic testing company whose technology, promise, and — recently — viability have been called into question through a series of Wall Street Journal articles authored by Carreyrou and colleague Christopher Weaver, I would start here: Hot Startup Theranos Has Struggled With Its Blood-Test Technology and then Carreyrou’s full archive here.

The long and short of it is that it’s uncertain whether the company’s technology worked as advertised, perhaps the company hid that from partners, employees, and the public, and as a result:

Federal health regulators have proposed banning Theranos Inc. founder Elizabeth Holmes from the blood-testing business for at least two years after concluding that the company failed to fix what regulators have called major problems at its laboratory in California.

This is a long way (down) from where Holmes and Theranos were just a year ago. Holmes, in her black turtleneck uniform, was portrayed as the next Steve Jobs. Theranos — with a $9 billion valuation and tests priced 95% below those of incumbents like LabCorp and Quest Diagnostics — was viewed as an important disruptor of the diagnostic testing industry as Ken Auletta noted in a 2014 profile of Holmes and Theranos.

A few weeks ago, Vanity Fair chimed in and blamed the media. Thanks. (For nothing.)

As Bill Press wrote in January 2002, a few months after Enron spectacularly imploded: “In the wake of every national calamity, we rush to point the finger of blame.” All fair game: the company, founders, the press, auditors, customers, structured products, rogue employees, investors, whomever.

This isn’t really about Theranos, but about opacity. In Carreyrou’s original piece he noted:

Like most closely held companies, Theranos has divulged little about its operations or financial results.

In private markets this is the norm. It’s understandable why private companies want to keep their information well, private: competition and more specifically, the risk that if a company’s financial position or anything related gets outside the its walls that the company will be put at a competitive disadvantage. As Patrick Mathieson noted in an answer to a Quora question on privacy, there are other more nuanced rationale for keeping this information private:

If you are a very tiny company, you can’t pretend to be bigger than you are in order to appear threatening to your competitors.

If you’re a big growing company, you can’t pretend to not be a threat in order to surprise your competitors.

If you’re barely growing and very unprofitable, your competitors know that they can disregard you.

These are all reasonable arguments.

Until 1933, public companies whose stock traded on the New York Stock Exchange were not required to provide audited financial statements. The Securities Act of 1933 required audited financial data to be included in prospectuses sent to investors. The next year, Congress passed the Securities Exchange Act of 1934, which required “periodic financial statement disclosure of corporations for the first time.” Regardless of whether you believe opacity contributed to the stock market crash and subsequent Great Depression (both of which catalyzed these disclosure changes), the benefits are not in doubt. Today, all public companies report quarterly and audited annual financials, management and director compensation, legal and/or regulatory developments, executive share buys/sales, and anything else that the SEC and lawyers determine to be material.

Were some companies hurt by these heightened disclosure rules? Perhaps. Did some companies choose to stay private to avoid them? Maybe. Can you show me how/where this hurt our economy? Probably not.

i know the chart only goes to 2009

Whenever there is an implosion in the early stage private markets, besides blame, the focus tends to be on the amount of money that has disappeared, either the valuation or the amount of capital that was raised. In Theranos’ case, the company had raised $686MM and was valued at $9bn. It’s unclear whether that $686MM is worth $686MM let alone $9bn.

That is an unfortunate outcome for the investors in the company. But as a class they are accustomed to losing. 3/4 of all startups fail and a great venture capitalist aims for a 33% hit rate (here is a great investor, Fred Wilson, detailing USV’s initial hit rate assumptions). As well, before investing their capital, the investors were all able to perform due diligence of some sort. I say “of some sort” because, in general, different investors have different access to the company, and board members will have much more information than the hedge fund who bought secondary shares.

The real losers are the employees. They are investing their time and their careers without access to any information. Unlike a fund who may have a portfolio of dozens or hundreds of investments, an employee can only make one investment at a time. The cost of a mistaken investment can be unemployment and the opportunity cost of foregone opportunities. Unlike investors who are making their investments after meeting with the company and performing due diligence, interviews don’t tend to work like due diligence sessions.

In addition to being disadvantaged vis-a-vis investors when it comes to information directly from the company, finding what information is publicly available is a time-consuming and cumbersome process that requires scouring the web for fragments of information. If you have $6,000 or $50,000 a year, that task is made somewhat easier but what employee has that money and could spend it performing due diligence on a potential job?

LinkedIn notes that Theranos has between 501–1000 employees. How much information did they have before they joined? What sort of due diligence could they perform? The answer, as with most other private companies, is almost none. Theranos was particularly secretive, perhaps because of the intellectual property the company was developing and the need to protect much of this from competitors like LabCorp and Quest. However, if the company was being investigated, this most certainly should be disclosed to employees.

How about This WSJ blog piece notes that peaked at 700 employees before shutting down. Homejoy had 100+ employees before it surprisingly shutdown. Zirtual laid off 400+ employees with an email. Before these companies became no more, shouldn’t existing and potential employees have been given a better sense of what was going on?

I think so.

And so, how? Two roughly-hewn thoughts:

  1. companies of a certain size (e.g. # of employees) should publicly disclose some point-in-time or backward-looking figures (employees, last-twelve-months revenue, assets, regulatory developments). Determining which figures will require some thought. For some companies, like social networks or biotechs, revenue may not be a focus early on and therefore may not be relevant (see: Instagram before monetization). Whether it’s revenue or assets or an investigation, the goal should be to provide some basic information that helps current and future employees, investors, and other partners make better decisions.
  2. companies should privately disclose operating performance to their current employees. This could take the form of a “data room” where some information is allowed to be viewed but can’t be dowloaded or copied. This isn’t a foolproof solution. The more people who are exposed to information the greater the likelihood that it spreads. But there are companies that do this currently and try as I might I don’t see anything about their performance floating around the internet. There are also a few companies who provide tremendous transparency. Buffer, the social media start-up, is one: the company provides tremendous disclosure around salaries, KPIs, revenues, etc.

By one measure, 11% of the workforce is employed by venture-backed companies. While this figure includes companies like Staples, Costco, and Starbucks (not to mention Google and Facebook) the number of people working for start-ups is smaller. According to the Census Bureau there are ~11MM people working for technology companies that have been started in the last 10 years. Given fewer and fewer IPOs, there will be more private companies and therefore more private company employees, all making decisions on where to work with minimal information and on the back of very limited disclosure.

There is clearly some downside to providing employees with a data room and/or publicly reporting some backward-looking metrics. As in 1933, I’m not confident that that downside outweighs the benefits.

Stuart Willson

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NYC. Partner at Prehype. Co-founder Radicle. Find me @stuartawillson