Anatomy of a Scam: Lessons from Theranos

The spectacular implosion of former Silicon Valley unicorn Theranos, and the fall from grace of its founder and CEO Elizabeth Holmes, places it in the rare category of multi-billion dollar business scandals, like Bernie Madoff and Enron.  But lessons from Theranos can be valuable whether you are a venture capitalist, or a private investor looking to save for retirement.  In fact, many of the features that drew VC funding to the firm were the same warning flags that led journalists to investigate the company.  Here are some key factors that were overlooked until it was too late:

The Leadership was Unqualified

Theranos' troubles started at the top.  The company founder and CEO, who notoriously kept a tight control over every aspect of the company's operations from routine hires to product development, did not hide the fact that she was not a scientist by training.  Yet in profiles of Elizabeth Holmes published before the explosive Wall Street Journal article, this was presented as a positive - after all, Bill Gates had dropped out of university to found Microsoft, and he ushered in the era of the personal computer.  The key difference between iconoclasts like Gates who revolutionize a highly skilled industry after dropping out of school and Holmes, however, is that Gates had already learned virtually everything that was known at the time about computers and programming, and school curricula had not caught up to his personal expertise.  Holmes, by contrast, was in a field with more than a century of advanced knowledge and innovation, without even acquiring a general level of mastery.  In many fields, it is possible to revolutionize an industry without a high level of professional certification through sheer creative innovation, but that is generally not the case in disciplines like medicine.

Theranos did hire some experts in hematology and molecular biology to help develop the Edison, but none of this scientific expertise was reflected in its leadership.  In fact, a large part of the company's erstwhile success can be attributed to its star-studded board, which at one point included former Secretaries of State Henry Kissinger and George Schultz, former Senate Majority Leader Bill Frist, former Secretary of Defense William Perry, and current Secretary of Defense James Mattis, who had actually told investors that the military was taking the Edison onto the battlefield (which was true, but they weren't actually using it because the technology did not work).  This who's-who of American leaders lent the project a veneer of respectability and credibility that convinced investors that a university dropout had managed to do the impossible, by willing what would have been a revolutionary technology into existence through sheer force of will.  The company's board of directors were overwhelmingly drawn from either the diplomatic world or the military - an odd choice for a medical technology company.

Warning Signs:

  • Key roles in the company leadership are filled by people who lack professional qualifications in a field usually dominated by highly specialized experts
  • The company's board may be experts, but in fields other than the one in which the company operates
A diagram of the miniLab, complete with disclaimer that the technology had not been approved by the FDA.

A diagram of the miniLab, complete with disclaimer that the technology had not been approved by the FDA.

Excessive Secrecy

The company never really told either investors or patients how the Edison worked.  In fact, while putting together these posts about Theranos, I was unable to find any images purporting to be the Edison.  What images do exist are of the miniLab, a new machine developed by Theranos after Holmes and company President Ramesh "Sunny" Balwani were banned from running a medical laboratory for two years after due to failed lab inspections.  Even then, the supposed technology at work is unclear.

Theranos' policy of complete secrecy was enforced by Balwani, who had previously worked at Microsoft and Lotus.  Balwani barred scientists and engineers from speaking to one another, and required any visitors at the company's offices sign a non-disclosure agreement before being allowed inside.  The company's siloed structure was modelled after Apple under Steve Jobs' leadership.  Yet where a technology firm can enforce that level of secrecy in order to protect valuable intellectual property without necessarily detracting from the quality of the final product, scientific research generally relies upon the free exchange of ideas, at least within the same laboratory during the development phase.  Even venture capital investors were denied access to key information about either the company's technology or financial records.

Warning Signs:

  • A high level of secrecy in a field that usually requires extensive external peer review by neutral third parties
  • Investors are not able to access information which will allow them to independently verify claims about technology or finances

The Technology Was Bunk

Much of the company's secrecy probably stemmed from the need to hide the fact that its technology did not work.  For years, Theranos was selling a technology which did not exist, and got away with it by skirting normal scientific procedure.  Under regular conditions, a new technology - especially one as supposedly revolutionary as Theranos' Edison machine - would be subject to extensive peer review and government regulation, yet because of Holmes' insistence upon secrecy over intellectual property matters and the fact that the company did not sell the Edison to third parties, the machine never underwent peer review and the company never had to prove the machine's functionality to the FDA.  The firm attempted to avoid criticisms by citing its secrecy policy, and publishing its own clinical results.  However, these studies lacked basic features of legitimate scientific studies, like double-blind conditions, or even statements about sample sizes and margin of error.

Had the Edison undergone testing, it quickly would have become apparent that the technology simply did not - and, given current knowledge about human physiology, could not - work.  Hematologists have been working towards a less invasive mechanism for blood testing for years, but consistently ran into the same troubles:

  • The smaller the sample size, the easier it is for the sample to become contaminated, or a natural random variation to result in error.
  • Some blood tests have to be conducted with larger amounts of fluid, meaning that small samples would have to be diluted.  Any contamination in the fluid being used to dilute the sample could result in error.
  • Pricking a fingertip instead of a vein meant that the sample was being drawn from tissue, not directly from the bloodstream, and so would inevitably pick up some fluid from surrounding tissue and cells. 

A Theranos "blood test" would actually, in effect, be a "blood, tissue, and contaminants" test, with no way to control how much of each sample was actually blood.  When tests started coming back showing impossible results and false positives for serious diseases, the results were never made public, and the firm increasingly switched from using its own machine to traditional blood testing machines without ever making an announcement to that effect.  These tests would be run either by diluting the pinprick samples, or by using larger samples drawn from veins at the same time as the pinprick samples.

Warning Signs:

  • New technology which hasn't undergone peer review or government testing
  • Only studies conducted internally at the firm are available to the public, with no independent peer review conducted under scientifically valid conditions
  • Scientists are unable to identify a credible mechanism for overcoming known problems that the technology would have to solve in order to be workable
Information supplied by Theranos to potential investors and partners published after the initial Wall Street Journal article acknowledged the use of traditional blood-testing machines, but did not admit that most tests were being conducted on these.

Information supplied by Theranos to potential investors and partners published after the initial Wall Street Journal article acknowledged the use of traditional blood-testing machines, but did not admit that most tests were being conducted on these.

Lessons for Investors

The key takeaway from Theranos is to be skeptical about your investments.  This doesn't mean to be overly cautious, but to be wise about your risk.  If a firm is promoting a product that you don't understand, talk to someone who does understand it, and will see through the promotional babble to evaluate the underlying value.  "If it sounds too good to be true, it probably is" may be a cliché, but it's a cliché for a reason.