There’s an old joke in Northern California about the surest way to make a small fortune: start with a large fortune and invest it in a winery. It turns out that running a successful winery is very hard and requires both a tremendous amount of wine-related know-how and real world business acumen. So it is no surprise that the vast majority of the newly minted wealthy who try it fail.
Of the many hundreds of Silicon Valley venture-funded startups – and by this I mean not only those based in the valley, but also those elsewhere who exist within the local model – the number that have a legitimate business is vanishing small. By a “legitimate business” I mean one that possesses each of the following 3 attributes:
It is profitable. Or at the very least, is on a clear road to profitability. And it is profitable in reality, not just on paper. In other words, not collecting 1/4 of the the revenue officially claimed, as an enterprising journalist at Buzzfeed recently caught the well-known unicorn Palantir doing: https://www.buzzfeed.com/williamalden/inside-palantir-silicon-valleys-most-secretive-company?utm_term=.du2Zl8l8g#.kgWN2p2pv. (I was once quoted in the Wall Street Journal something to the effect that “real startups don’t run of out money. They just earn more.” I learned later that at least one startup made a copy of this and stuck it on the wall of their office. Unsurprisingly, they were in the Midwest. Unlike Palantir, they actually have to collect money from their customers, not just allegedly earn it.)
It is sustainable. Sustainability often seems like an old-fashioned and even irrelevant concept in the valley, but in the rest of the world, sustainability is an absolute requirement. It means that your startup doesn’t have “a sell by time it or else” date. Sustainability can be achieved in more than one way of course, but for technology companies, one would really like to see true technology differentiation that is one of the core “unfair advantages,” as legendary author and startup scholar John Nesheim refers to it. Clever business models are after all far easier to replicate than is some kind of deep technology. Yet in recent years, the vast majority of the valley companies are the former rather than the latter.
It is organic. By this I mean that the revenue that it has is real, that the majority of comes from satisfied customers who had a real need that is filled by the startup, and who will spend more with the company in future. Frequently, when one looks closely it turns out that the vast majority of valley startups’ customers are – drum roll – other Silicon Valley companies. That should raise red flags: a good product is a good product many places, not just in a 100-mile radius of Google.
Until recently, there was one well-understood – if rarely stated – self-preservation principle that all of the locals held to: stick to stuff that isn’t a matter of life and death, and in which the very worst thing that could happen is a civil product liability lawsuit – which are extremely rare owing to a number of factors including how most commercial software licenses are written. In short, no matter how extravagant – and usually untrue – the claims of “breakthrough” technology made to attract the all-important venture-funding are, the probability of any serious real-world blowback from them is slim to nil.
Now enter Theranos. It is no wonder that it attracted as much attention and admiration as it did. It broke that universal principle. It purported to solve a serious, real-world problem, not just enable you to chat with your friends in a cooler way. Inexpensive, easy to perform, and accurate blood tests made widely available would almost certainly save a great many lives each year. It would also reduce the cost of care substantially, and increase quality of life for people with conditions that could be recognized early and treated more effectively. In particular, poorer people who would be put off by the cost of a traditional blood test. And those morbidly afraid of big scary needles, since the Theranos technology required only a very small amount of blood.
Better still, it had a 19 year old, attractive female CEO who was the purported inventor of the revolutionary technology, rather than a bland PhD who had spent a decade or more in a lab and was considered a leader in his field (as would normally be the case with biotech investors, who operate in a very different ecosystem.) It was backed by one of the name valley firms, DFJ, that had also backed Twitter, rather than obscure biotech funds with more limited cash and connections. It was a modern day fairy tale of what was possible to achieve. Investors anywhere would salivate at the prospect of such an opportunity.
Yet, as any investor should know, that which seems too good to be true probably is. Or at least warrants very close inspection. As recent exposés in the Wall Street Journal and elsewhere have documented, no one outside of Theranos ever was given access to one of the proprietary “Edison” devices to verify that it worked. No one, not once. Promises were made by Theranos to provide the devices, but only a limited prototype was provided whose nature was such that there was no real way to benchmark it against traditional devices.
One of the main revelations in the WSJ reporting is that vast majority of the blood tests performed by Theranos were done using traditional machines. Many of the tests that were performed on Edison devices have now been voided by the company because of accuracy issues. Outside of the valley, there is a single word to summarize this situation: fraud.
Theranos offers a compelling example of a startup that achieved worldwide fame and a $9B valuation based solely on hype and braggadocio. Many different venture firms invested in it. Not only did none of these investors require a neutral expert to evaluate a working machine during the due diligence process, they failed to notice all kinds of gigantic red flags. For instance Theranos must have spent a lot of money running all of those blood tests on machines purchased from others and/or outsourcing test results. Even an investor who understands nothing at all about science should have easily spotted that.
Had they been looking. The key takeaway here is that clearly no one did. No one looked because no one cared. Not until regulators started shutting down Theranos labs, and threatening Theranos executives with a 2-year suspension from the industry. Now civil – and likely also criminal – lawsuits will be flying, and everyone involved in this particular debacle will be running for cover. If it turns out that people died because of inaccuracies in Theranos’ blood tests – and let’s hope that this is not the case – it will really get interesting.
The blowback will reach far beyond Theranos as more and more revelations are revealed. Bill Gurley recently wrote a excellent (if long and quite technical) blog post http://abovethecrowd.com/2016/04/21/on-the-road-to-recap/ . Gurley refers to the first WSJ piece on Theranos as “a seminal bubble-popping event.” The main gist of the blog post is that sensing an impending bubble burst, other unicorns will agree to so-called “dirty” term sheets. These are term sheets that preserve, in theory, the sky high valuations, but in reality are inserting fairly horrifying terms in return. The headlines however will be that the unicorn valuations remain insanely high. The proverbial can will have been kicked successfully down the road.
The real question is whether the number of current startup-related scandals and “emperor has no clothes” revelations – and Theranos is just one – starts to have any broader impact on the cash-printing machinery in the valley. That only time will tell. Maybe though, all involved – including the investors in the various venture firms – should stop to consider that the same types of abilities needed to run a successful winery are also need for a (genuinely) successful tech company.
Note to readers of this blog: Sorry for the long absence, but I’ve been too busy to keep up with it regularly. I will try to do better in future.