The fraud trial of Elizabeth Holmes, the founder and former CEO of life sciences company Theranos, shows how perilous the world of deep tech investment can be. (Photo by Nick Otto/AFP via Getty Images)

The conviction of Silicon Valley-based Theranos founder Elizabeth Holmes on fraud charges is a cautionary tale for entrepreneurs everywhere. However, it also highlights the perils of deep tech investing when due diligence is overlooked in favour of magical thinking.

Theranos claimed its proprietary blood testing device could deliver hundreds of diagnostic results from just one tiny pinprick. High-profile investors including media mogul Rupert Murdoch and former US Education Secretary Betsy DeVos were sold on the promise of a technology that never existed.

Accusations over the inflating of product capability is also a factor in the case of Trevor Milton, founder and former CEO of US-based electric truck-maker Nikola. The entrepreneur was charged in a securities fraud scheme in July 2021, which alleged he misled investors about the development of products and technology. US Attorney for the Southern District of New York Audrey Strauss said in a press conference at the time: “Milton lied about nearly every aspect of the business.”

More recently, deep tech synthetic biology company Zymergen saw its share price plummet in August 2021 as it announced that several potential customers were having problems implementing Hyaline, a high-quality flexible film used on the screens of electronics. The company said it “no longer expects product revenue in 2021 and expects product revenue to be immaterial in 2022”. Founder and CEO Josh Hoffman stepped down after the share price plummeted.

Overpromising and under-delivering

In each case, overpromising market-ready technology to investors not only meant failing founders, but investors were burned by believing in the possibility of unproven technology. Silicon Valley is famous for its ‘fake it ’till you make it’ approach, often raising vast amounts of capital before any meaningful technology breakthrough. In the case of Theranos, however, run-of-the-mill opportunism veered towards undeniable deception. During her trial, Holmes admitted that Theranos’s Edison machine only had the capacity for 12 diagnostic tests, not the 200 that it claimed, and even admitted to tampering with documents to add company logos for increased credibility.

Deep tech is notoriously hard. It requires vast amounts of capital for research and development with little prospect of any short or medium-term return. This is why many deep tech success stories originate from government-funded programmes.

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To raise equivalent levels of private capital, some start-up founders rely on overhyping their technology. Investments are sometimes made solely on the basis of a charismatic founder’s compelling origin story and a convincing promise of world-changing technology. In many cases, as seen in the unravelling of Theranos, belief trumps logic.

Problems arise when the narrative spins too far ahead of the curve and cannot meet the necessary technology milestones. Add an investing environment in which investors are lining up for the chance to bet on the next decacorn or hectocorn, and you have a perilous combination open to fraud.

According to CB Insights, global venture funding reached an all-time high of $158bn in the third quarter of 2021, representing a 105% year-on-year increase from $77bn, compared with the same quarter in 2020. The sheer amount of money swilling around and a growing stable of global unicorns means investor competition is so fierce that some investors consider the risks of inadequate due diligence outweigh the potential for profit.

Unicorn numbers in healthcare are growing. According to CB Insights, the third quarter of 2021 saw the creation of ten new healthcare unicorns, bringing the industry’s total to 91. This follows peak figures of unicorn creation in the healthcare sector in the first quarter of 2021 (19) and second quarter of 2021 (12). The ten latest additions are all from the US and valued at a cumulative $18.7bn in total.

How can investors protect themselves from fraud?

Apart from huge losses of investment capital, the Theranos case has caused much embarrassment for those who were seen to have championed the charismatic Holmes. Former US President Bill Clinton and Henry Kissinger are among those who will now struggle to distance themselves from the scandal.

Many of the investors had little or no experience in health or technology investing. The antidote to this knowledge gap and inflated founder claims is milestone-based investing alongside effective due diligence. Primarily, it avoids the spectacular implosions, usually around deep tech, as seen in the examples of Theranos and Nikola, by requiring proof of progress at each stage – this would not have allowed Holmes to continue her ‘smoke and mirrors’ deception and in the case of Zymergen, a closer look at the company’s product would still have saved massive investor losses even though there was no fraud involved.

Michael Kauffman, a principal at US technical due diligence consultancy Tech DNA, says that in the hundreds of deals the company has worked on to assess technical quality, actual falsehoods – as in the Theranos case – are rare, but underlying technical weaknesses that affect a deal’s validity are not. “In many cases, these are fixable and simply increase deal cost, but in some the underlying technical debt we find is significant enough to fundamentally call into question the deal theory – even for products or services already in market," he says.

In an investing environment in which major capital sources are making $500m seed investments in massively overvalued companies with no product and no revenue, the burden of proof is no longer weighted as heavily on start-ups. For example, the SoftBank method of investing runs antithetical to milestone investing. Responsible investing means requiring start-ups to prove incremental progress so that capital-raising is scaled according to tangible progress. Otherwise, an abundance of available capital alongside a lack of governance is a recipe for disaster.

Bridging the knowledge gap

According to the Boston Consulting Group’s May 2021 report The Deep Tech Investment Paradox, deep tech suffers from a knowledge gap between innovators and investors. Venture capital funds often lack the expertise needed to understand advanced science and engineering risks, and to effectively support deep tech ventures.

To bridge this gap, investors need to grow their in-house knowledge, including the hiring of both postdoctoral scientists and engineers, as well as develop strong ties with research and innovation ecosystems. According to Boston Consulting Group’s survey of deep tech investors, 79% needed to leverage external expertise, 42% have hired PhDs and 37% have hired people with Master of Science qualifications or engineer profiles to assess deep tech potential.

A simple business evaluation of company financials and due diligence around product development would have stopped Holmes defrauding investors. Boston Consulting Group estimates that deep tech investments could exceed $200bn by 2025 if more effective investor models are adopted. That is a lot of capital at stake. Without following the basic tenets of milestone investing, talking to customers to understand the proper product market fit and doing the required due diligence, deep tech investors are laying themselves wide open to risks of this kind.