What lessons does Elizabeth Holmes' fall have for startup investors?

This week, Theranos founder Elizabeth Holmes was charged with defrauding investors. Holmes now faces at least 20 years in prison.

The way she established and sold her startup story offers valuable lessons to investors across the globe now. Even to Rupert Murdoch, one of the investors who believed in her idea. 

Startups can command hefty valuations, very quickly. As venture capital and private equity firms in the US’ Silicon Valley place a premium on ideas that promise disruptive innovation, new-age tech companies can raise millions of dollars in funds, even before coming up with a product-market fit, or in some cases, even a workable prototype. 

However, in this glitzy world of innovations and disruptions that are waiting to happen, some founders, like Holmes, are spinning a web of lies and charting their path to success by leveraging the greed of investors. They exemplify the “fake it till you make it” philosophy.  

Theranos was founded by Holmes, a Stanford chemical engineering dropout, when she was 19 years old. It was once valued at over $9 bn.

And how did she pull it off? 

Holmes claimed to have developed tests that could help in early detection of ailments ranging from high cholesterol and high blood sugar to liver dysfunction and cancer from just a couple of drops of blood drawn from a finger prick at any pharmacy.

The small amount of blood was collected in a nanotainer tube and analysed in a Theranos lab on a proprietary analysis machine called “Edison”. 

The “invention” was believed to have the potential to revolutionise healthcare and slash diagnostic costs. That was until it came to light that Theranos’ Edison machines weren’t providing accurate results. 

The company knew this. So it was diluting blood samples and subjecting them to “traditional tests”, instead of using its famed Edison machines.  

Soon, issues arose with the US Food and Drug Administration. And as more information emerged about Holmes’ deceitful pitch to investors, many of them terminated their partnership with the company. 

In 2014, Holmes was at the top of Forbes’ list of America’s Richest Self-Made Women with a net-worth of $4.5 Bn, with her company valued at $9 bn. 

 At its core, the Theranos tale is about a bevy of high-profile investors, from media mogul Murdoch to venture capitalist Tim Draper, not carrying out the adequate due diligence but being seduced by what they must have believed to be a “disruptive innovation”. 

The Indian startup ecosystem, now the third-largest in the world after the US and China, is also maturing at a rapid pace. Some of these upstarts even have a base in Silicon Valley. 

Last year, 42 Indian startups entered the unicorn club. Thrasio-style Mensa Brands achieved the unicorn status in just six months of starting up. Indian startups raised over $42 Bn across 1,583 funding deals. This was more than 3 times the total funding of $13 Bn raised in 2020. In fact, the total startup amount for 2021 was more than the total funding of $37 bn for the last three years combined.

But in this rush of capital, are our venture capital and private equity investors carrying out their due diligence into the health of these new-age companies? 

There’s reason to be a little suspicious on this front. Consider cybersecurity. Over the last two years, several Indian companies from BigBasket, Dunzo, Haldiram’s, Domino’s, Airtel, and Juspay, among others faced cyber attacks, which compromised the data of their users. 

Cybersecurity experts have claimed that in their pursuit for rapid growth, startups often ignore the importance of building a robust cybersecurity posture. So shouldn’t investors include checking the cyber health of a company in their due diligence?

Let’s take another example. Indian edtech startups raised over $4 Bn in the last two years, compared to $500 Mn in 2019. The bigger players are acquiring smaller startups to build edtech super apps of sorts.

However, a recent government advisory cautioned the public against trusting the “success stories” advertised by these online educational companies.

While startups obviously need to be ethical in their practices and avoid the temptations of the “fake it till you make it” model, investors, for their part, also need to do their due diligence. 

To get a better understanding of how private equity and venture capital firms can ensure that their money is safe and learn the right lessons from the Theranos episode, we spoke to Parth Gandhi, founder and chief investment officer at Bombay Capital. 

Clearly, it is not easy to spot the unsafe firm or the one involved in fraud. But as Mad-Eye Moody's favourite saying goes, “constant vigilance”, is the axiom investors should follow. 

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