Theranos Crackdown Offers Welcome Check on Tech Startup Frenzy

Theranos did no favors for its investors, but it may have unwittingly helped the next generation of innovators.

The Securities and Exchange Commission last week accused the company and its CEO, Elizabeth Holmes, of misleading investors. According to the SEC’s complaint, Theranos lied about the capabilities of its blood-testing technology on its way to raising $700 million from 2013 to 2015.

As my Gadfly colleague Max Nisen rightly pointed out, “the sheer extent and audacity of the fraud perpetrated by Theranos’s leaders separates it from the pack.” But Theranos couldn’t have pulled off its elaborate fraud without the help of two larger forces.

The first is investors’ eagerness to throw money at startups on a scale that not long ago was available only to publicly traded companies. So-called unicorns — startups valued at $1 billion or more — raised $70 billion from 2014 to 2017, including a record $19.6 billion last year, according to financial data company PitchBook. To put that in perspective, that’s roughly three-quarters of the total net flow to all U.S. mutual funds over those four years, according to fund flows compiled by Bloomberg Intelligence.

Even more astonishing is that the 132 U.S.-based unicorns are collectively valued at $718 billion, which is roughly the total market capitalization of the 1,200 smallest companies in the Russell 2000 Index.

Easy money has been doubly indulgent for unicorns. Not only have they sidestepped the regulatory scrutiny that applies to public companies, many have also stripped investors of protections that public companies owe investors, such as transparency and oversight.

The second is the idea that every startup is a technology company. Sure, lots of startups develop crafty systems to distribute their goods and services, but that doesn’t make them tech firms. A more sensible way to think about businesses is the one jointly developed by MSCI Inc. and S&P Global Inc. to sort public companies into sectors and industries.

The Global Industry Classification Standard, or GICS, looks primarily at the source of companies’ revenues. Companies that sell groceries, for example, fall into consumer staples, and those that rent hotel rooms fall into consumer discretionary and so on. In cases where a company has multiple business lines, none of which account for a majority of its revenue and earnings, GICS may look at other factors to determine an appropriate sector.

Admittedly, some startups have little more than a handful of algorithms to their name, so it’s not always clear where their revenue will come from. As their businesses mature, MSCI and S&P must occasionally make changes to companies’ classifications.

Changes to GICS are made as needed rather than on a regular schedule, most recently in August 2016. The next round of changes are expected in September, and they’re instructive. Grubhub Inc. and Stamps.com Inc. will move from information technology to consumer discretionary because, well, they sell food and stamps, not technology. And — wait for it — Facebook Inc. and Snap Inc. will lose their technology tags and move to telecommunications, to be renamed communication services.

I’m not suggesting that unicorns need a GICS-like classification system. Investors, however, should apply a similar common-sense approach in thinking about startups’ businesses rather than blindly accept the branding hype. Uber Technologies Inc. and Lyft Inc. get paid to transport people. Airbnb Inc. and Instacart Inc. get paid for crash pads and food. Classify accordingly.

This isn’t just semantics. Sector membership can have a big impact on how much investors pay for a piece of the business. It’s no accident that startups are desperate to be thought of as tech innovators. Tech companies are currently among the most richly valued. But as I’ve previously noted, technology has been the richest S&P 500 sector in just 39 percent of years since 1990. Wait until the next time the sector sours and see how many startups are still calling themselves tech.

This ask-no-questions-invest-at-any-price mindset allowed Theranos to take its shenanigans as far as it did. But other investors are kidding themselves if they think they can’t get hurt, too. If it turns out that their unicorns were less than forthcoming, or some investors decide unicorns aren’t the sexy tech outfits they imagined, watch out.

Predictably, investors who stand to lose the most can least afford it. Seed-stage investors in unicorns include venture aces such as Andreessen Horowitz and Sequoia Capital. Four rounds later, so-called Series D+ investors include Fidelity Investments and Hartford Financial. And you know who comes next.

By cracking down on Theranos, the SEC has sent a  signal to would-be unicorn investors. And it’s a good thing because if left to run amok, the unicorn zeal could poison the money well for the next generation of innovators.

Source: Bloomberg Gadfly, https://bloom.bg/2DIt5Ik

Follow & Share:

Leave a Reply

Your email address will not be published. Required fields are marked *