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Anatomy of a scam: Elizabeth Holmes and Theranos 101

One of the biggest financial stories this week was the SEC charging Theranos CEO Elizabeth Holmes with "massive fraud".  The company itself was also charged, along with former Theranos President Ramesh "Sunny" Balwani.  For those who haven't been following the company for years, the story can seem shocking.

Holmes had once been Silicon Valley's first female billionaire startup founder, defying the odds that I spoke of in my previous post about women-led firms and Venture Capital funding.  Now she is banned from running a medical lab or serving as director of any public company for the next decade, has been fined $500,000, has lost all voting rights in her company which is still teetering on the verge of bankruptcy, and has a net worth of $0.  What happened in between is a stunning tale of hucksterism, plate-spinning, and good old-fashioned investor fraud.

The company was started in 2003 when Holmes dropped out of Stanford in her second year of an undergraduate degree that she never finished, convinced that she could revolutionize the blood-testing industry by designing a machine that would run full blood workups with only a single prick of blood from the fingertip, instead of current tests which require full vials of blood taken from a vein in the arm.  While this would have been an astounding innovation - after all, actual PhDs in the field of hematology had been trying to accomplish this for decades - it turned out to be nothing more than smoke and mirrors, sustained for years by a highly secretive corporate structure, and steadfast refusal to submit the company's supposedly revolutionary technology for scientific testing.

 For a short time, Holmes and her signature turtleneck were media darlings, promising a revolution in medical technology that never materialized.

For a short time, Holmes and her signature turtleneck were media darlings, promising a revolution in medical technology that never materialized.

During its first decade in operation, the company would raise hundreds of millions of dollars to develop a miniature blood testing machine, and ultimately received contracts with Walgreens, GlaxoSmithKline, Pfizer, Cleveland Clinic, a few insurance providers, and the state of Arizona.  Board members with close ties to the US military even advocated for the military to adopt the company's flagship Edison machine for use in the battlefield.  And Holmes was hailed as a visionary, appearing on Fortune's "Businessperson of the Year" and Time's "Most Influential People in the World" lists, as well as being inducted into the Harvard Medical School Board of Fellows.  Despite this, there were still rumblings of trouble all along: investors complained about the lack of transparency, outside scientists complained that the company refused to release any data on its machine or subject it to peer review, and the company's chief biochemist died by suicide in 2013 after struggling unsuccessfully for years to make the technology work.

Everything began to fall apart in October 2015, when the Wall Street Journal published an extensive investigative piece by John Carreyrou about the company, alleging it was using traditional bloodwork machines to conducts its tests, and that the Edison machine produced wildly inaccurate results ("Hot Startup Theranos Has Struggled With Its Blood-Test Technology" - the full article is well worth the read).  Carreyrou had previously become suspicious of Theranos after reading an interview with Holmes in which, when asked to describe the science behind the Edison machine, she answered cryptically, "a chemistry is performed so that a chemical reaction occurs and generates a signal from the chemical interaction with the sample, which is translated into a result, which is then reviewed by certified laboratory personnel."  If Carreyrou's allegations were true, it meant that thousands of patients had been making vital decisions about their health using test results that were no more reliable than a wild guess.  Journalists and regulators began to dig, and quickly uncovered that the entire operation seemed to be nothing but a scam.  Over the next year and a half, the delicate house of cards which Holmes and her board had meticulously constructed quickly came tumbling down:

  • All of the company's laboratories were shut down following separate investigations, one of which found that its Newark California lab posed an "immediate jeopardy to patient health and safety" due to its inability to properly run tests meant to determine the proper dosage of a blood-thinning medication. Holmes was banned from owning or operating a lab for two years.
  • The company was forced to suspend its herpes test and withdraw a request for approval of a Zika virus test following FDA inspections which showed the results could not be scientifically validated.
  • Theranos was forced to void two years' worth of tests conducted on Edison devices, and in doing so revealed that only 1% of its blood tests were being conducted on its supposedly revolutionary machine.
  • Every major testing partner withdrew support.  Walgreens and the Attorney General of Arizona were only two of the many groups which went on to sue Theranos for misrepresenting its technology and false advertising.
  • Investors alleged that they were being unduly pressured into accepting new preferred stock from the company in return for dropping any legal claims against Theranos, saying that the company was threatening to initiate bankruptcy proceedings if they did not agree.
  • In the summer of 2016, Forbes downgraded its estimate of Holmes' net worth from $4.5 billion to nothing. 

Yesterday's announcement of a settlement between Holmes, Balwani, Theranos, and the SEC may be only the beginning of the end to this story; the US Attorney's Office in San Francisco is still investigating whether to pursue criminal charges.

Theranos isn't just a story about a Silicon Valley scam.  It holds important, enduring lessons for investors, regardless of whether they are individuals looking to build a nest egg, or large Venture Capital investors looking for the next Google.  Tomorrow's post will delve into these lessons, and discuss the warning signs that can help to distinguish between the next Google and the next Theranos.