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13 January, 2022updated 12 Aug 2022 15:34

The dangers of black boxes: What can investors learn from the Theranos trial?

The Theranos trial shows just why it is important for investors not to get caught up in personality cults and hype, writes Sam Roberts of Cooke, Young and Keidan.

By Sam Roberts

As the dust settles on Elizabeth Holmes’s guilty verdict, Silicon Valley and tech investors generally will be taking stock of what it all means.  

Holmes’s company, Theranos, was at one point valued at $9bn. She counted high-profile billionaires such as Rupert Murdoch among her investors, and luminaries like Henry Kissinger on her board. The company claimed to have invented a bookshelf-sized device that could detect diseases such as cancer and diabetes in very small samples of blood, but the business began to unravel after a Wall Street Journal investigation in 2015. Since that point, and particularly after Theranos itself folded in 2018, questions have been asked about the extent to which the company is representative of a wider problem and whether lessons can be drawn from its example. Now that Holmes has been convicted of criminal charges, these questions take on greater significance for founders and investors alike.

The difficulties of investing in medtech

Medtech has always been an attractive sector for investment, and the demand created by the Covid-19 pandemic has promised attractive returns amid rapid innovation in this space. That will no doubt remain the case even as Holmes awaits what may well be a long prison sentence, and bullish investors and market commentators may consider Theranos to be an outlier rather than representative of a wider sector trend.

However, fraud exists on a spectrum. At one extreme, a pure crook may make promises without ever having the intention to deliver on them. More difficult are the well-meaning founders who get caught in a snowballing white lie. The danger for investors is that Holmes may not be an outlier if, as seems to be the case, she was not always an outright liar.

The nature of medtech contributes significantly to this risk: genuine products may be built on highly complex technical breakthroughs in niche areas. They may be innately difficult for investors to investigate, understand and evaluate. Holmes’s device, the Edison, was literally a black box – a living metaphor for a widget that turns A into B without revealing how.

Investors into businesses in all sectors will routinely require contractual warranties vouching for the soundness of the equipment used by the business – that it is capable of being used for its intended purpose – although early-stage investors may have to accept something weaker if the technology is still being developed. However, Theranos also illustrates the limitations of warranties. Once a business begins to buckle, there will rarely be enough cash left to pay out on a breach of warranty claim. Murdoch sold his $125m of shares back to the company in 2017 for $1. Prevention is therefore usually better than the cure.

Beware the personality cult

Holmes also highlights the dangers of personality cults and the lure of high-profile investors piling in. Household names on the board may give an air of credibility and legitimacy to the business, but this case underlines the risks involved in following the wisdom of crowds. If it is difficult and expensive for a prospective investor to assess the viability of the technology, it was probably difficult and expensive for the household name, too, and the greater the difficulty and expense, the less likely it is to have actually happened.

Certainly, the Theranos case will not stop medtech, and it will not stop fraud. Investors will keep investing, corners will be cut and untruths told. These are numbers games, and prospective investors should use the tools available to them to avoid becoming victims. Take notes of key things said, and take photos or videos of technical demonstrations. Records such as these will withstand far greater scrutiny under cross-examination than an investor’s memory. Deferred consideration or escrow accounts may also offer some additional protection. Most important of all, though, is peering inside the black box.

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