Theranos is a Symptom of a Larger Problem within VC Backed Startups
BY: Caroline Estey, RBFL Editor
Early last year, Elizabeth Holmes was charged with wire fraud for lying to investors about the capabilities of her company, Theranos. After news broke of the massive fraud, many wondered how and why it was able to happen. The answer to these questions appears to be connected to the regulation (or lack thereof) of “Unicorns.” Unicorns are private companies with a valuation of over $1 billion. They were once a rather rare occurrence, as indicated by their name, but in recent years they have become increasingly common. This is due to a noticeable shift in the lifecycle of startup companies. Initial Public Offerings (IPOs), which among other things bring companies into the public eye and help hold them accountable for their actions, were previously quite common. Most private companies knew they would eventually go public because of a need for more capital and/or because they would grow past a certain threshold which would trigger mandatory reporting. Because they had an impending IPO looming over them, these companies usually acted by the book while they were still private to prevent issues from popping up when they had to disclose company information during the IPO. In more recent years, regulations have changed and subsequently made it much easier for companies to stay private. These regulations have made it easier for companies to increase their capital while remaining private and have upped the thresholds that trigger mandatory reporting. Thus, the pressures of an impending IPO have disappeared for many private companies, which has in turn removed the pressure to keep everything by the book for the inevitable future disclosures. With no one watching them and no threat of future scrutiny, it has become increasingly easy, and probably tempting, for these private companies to make morally, ethically, and sometimes legally, questionable business decisions to increase the company’s success.
In addition to these regulatory changes, there has been an influx of new kinds of investors looking to invest in private startup companies. These investors have come onto the scene with a lot of money and a lot less interest in controlling the companies they are investing in. This is in great contrast to the traditional source of funding for such companies, Venture Capital funds (VCs), who would essentially trade money for control of the company. With this new competition, VCs had to change their structure to entice founders to still work with them. They did so by implementing a more “founder friendly” model, which often gives founders special shares of the company that hold extra voting power, allowing the founders to retain at least some control of the company. Thus, the founders of these companies are now simultaneously being given excessive amounts of money to use within the company as they please, and being released from any oversight, by regulations and investors, on how they are running the company. It is no wonder things have begun to spiral out of control.
Further compounding this issue is the “fake it till you make” mindset that runs rampant through Silicon Valley. Entrepreneurs and innovators in this space are encouraged to talk up their ideas and stretch the truth of their innovations in order to get them off the ground. It is such a well-accepted practice that some VCs have said they expect founders to lie to them about the capabilities of their products. This practice would not be too concerning if the companies had to later prove themselves and the abilities of their products, but because of the lack of oversight and accountability discussed above, this practice is proving to be rather dangerous.
Between Theranos and the multitude of other private companies, including Zenefits, Nikola, Uber, and WeWork, that have recently been caught engaging in questionable corporate governance practices, it seems clear that the current structure of regulation and oversight for these companies is not working. One potential solution is to require companies to start reporting at least some information about their company after they finish their first or second round of funding. This would allow the company a chance to establish itself through wooing investors with big promises, but it would also hold them accountable much earlier, which would likely push them to produce a legitimate product instead of pretending they have one hidden away. Some may feel this timeline would not give the companies enough time to create a working product, and that certainly could be true, but I believe at that point the investors have the right to know the true status of the invention and whether or not the product is likely to ever come to fruition. It would still be up to the investors to decide whether they want to believe in the future success of the idea and continue funding the company, but they would be able to make an informed decision about it, something they are often not able to do right now.
Sources
Renee M. Jones, The Unicorn Governance Trap, 166 U. Pa. L. Rev. Online 165 (2017), http://pennlawreview.com/online/166-U-Pa-L-Rev-Online-16.
See Michael Ewens & Joan Farre-Mensa, The Deregulation of the Private Equity Markets and the Decline in IPOS, 33 Rev. Fin. Stud. 5463, 9-11 (2020).
Amy Deen Westbrook, We(’re) Working on Corporate Governance: Stakeholder Vulnerability in Unicorn Companies, 23 J. Bus. L. 505, 505-74, 507 (2020).
Therese Poletti, The government tried to encourage IPOs, but it helped create the Age of the Unicorn, MarketWatch (Dec. 31, 2022 at 2:44 pm), https://www.marketwatch.com/story/the-government-tried-to-encourage-ipos-but-it-helped-create-the-age-of-the-unicorn-2017-12-26.
Erin Griffith, Theranos and Silicon Valley’s ‘Fake It Till You Make It’ Culture, Wired, (Mar. 14, 2018), https://www.wired.com/story/theranos-and-silicon-valleys-fake-it-till-you-make-it-culture/