Shorting the Next Theranos: Identifying and Profiting from Fraud

The Unanswered Questions of the Theranos Saga

A judicial decision regarding the guilt of Elizabeth Holmes, former CEO of Theranos, is imminent. However, the broader policy concerns brought to light by the Theranos case persist. How did a company founded on unproven technology achieve a $9 billion valuation? And what measures can be implemented to prevent similar occurrences, safeguarding capital that could be directed towards legitimate innovation?

Early Warning Signs and Internal Cover-Ups

Although publicly exposed in October 2015 through reporting by John Carreyrou of the Wall Street Journal, fraudulent activities within Theranos were known to insiders years prior. For instance, in 2006, Holmes presented a prototype blood test to Novartis executives and manipulated the results when the device failed to function correctly. Subsequently, she dismissed the CFO who questioned her actions.

By 2008, approximately seven years before Carreyrou’s exposé, Theranos board members became aware that Holmes had misrepresented the company’s financial standing and the status of its technology.

Growing Skepticism from Outside Observers

Over time, a significant number of individuals, both within and outside the organization, began to harbor doubts about Theranos’ legitimacy. A Walgreens employee responsible for evaluating Theranos for a potential partnership documented concerns about the company’s exaggerated claims regarding its technology.

Physicians in Arizona expressed skepticism regarding the accuracy of patient results, and a pathologist in Missouri published a blog post challenging Theranos’ assertions about its devices’ precision. Further doubts were raised by Stanford Professor John Ioannidis in an article published in “JAMA”.

VC Community Rumors and Missed Opportunities

Rumors of potential fraud circulated within the venture capital community. Bill Maris of Google Ventures (now GV) stated that his firm declined to invest in Theranos in 2013. Maris explained that a GV employee underwent a Theranos blood test at Walgreens and was requested to provide more blood than the technology purportedly required. When the employee refused a standard blood draw, he was asked to return with a larger sample.

Why Doubts Didn't Halt Fundraising

A key factor enabling Theranos to continue securing funding was its status as a private company, where opposing investment is exceptionally difficult.

The Rise of the "Unicorn" and its Implications

Historically, companies achieving substantial valuations typically transitioned to public status. The term “unicorn” – denoting startups valued at over $1 billion – was coined in 2013 by VC Aileen Lee, as such companies were then rare, with only 39 existing. By 2021, despite an increase in companies going public via SPACs, the number of unicorns had surpassed 800.

This proliferation of unicorns has coincided with an increase in corporate misconduct. While public companies also experience misconduct, research has not definitively established whether unicorns are systematically more prone to it. However, the lack of a liquid market for private company securities makes concealing misconduct easier.

The Nikola Case: A Parallel to Theranos

Consider Nikola, an electric truck company that was once a unicorn. After going public through a SPAC in 2020, short seller Nathan Anderson investigated the company and published a report alleging corporate misconduct. He demonstrated that a promotional video showcasing Nikola’s prototype truck traveling at high speed was staged – the truck had been towed to the top of a hill and filmed rolling downhill.

Following Anderson’s report, the SEC and federal prosecutors initiated investigations into potential investor deception. Nikola’s stock price plummeted, and in 2021, its CEO, Trevor Milton, faced charges from both the SEC and a federal grand jury. This exposure would likely not have occurred had Nikola remained a private entity.

The Challenges of Policing Private Companies

Regulations governing the sale and resale of private company stock are designed to protect investors. Startups often include a right of first refusal in their shares, requiring employee approval for sales. Late-stage startups frequently practice “selective liquidity,” allowing key employees to cash out privately while restricting broader market access.

This limited liquidity discourages individuals with knowledge of misconduct from coming forward, despite legal protections for those exposing fraud.

VCs and the Asymmetric Risk Profile

Venture capitalists, while seemingly positioned to monitor unicorn behavior, face incentives that undermine their willingness to expose wrongdoing. VCs invest in a portfolio of startups, anticipating that most will yield modest or negative returns, with only a few achieving exponential growth. The success of these few offsets the losses from the rest.

For VCs, the difference between a scandal-ridden failure and a startup that simply fails to gain traction is often negligible.

The Winner’s Curse and Reputation Management

Venture investing operates as an auction with a “winner’s curse” dynamic. Startups solicit funding from numerous VC firms but only accept one offer. In public markets, a declining stock price signals concerns about a company’s value. However, in VC markets, even if most investors suspect fraud, a credulous investor can still provide funding.

VCs who decline to invest typically refrain from publicly sharing their negative assessments to maintain a founder-friendly reputation. Maris only disclosed GV’s decision to pass on Theranos after Carreyrou’s article was published.

Proposed Reforms to Enhance Oversight

Congress and the SEC could strengthen deterrence of unicorn misconduct by fostering a market for trading private company securities through a three-pronged approach.

Liberalizing Secondary Trading Regulations

First, regulations restricting the secondary trading of private company securities should be relaxed. The SEC should eliminate the holding period requirement in Rule 144 for accredited investors. Congress should revise section 12(g) to remove the threshold that compels companies to go public upon reaching 2,000 record shareholders, thereby encouraging broader trading.

Implementing a Regulatory Most Favored Nation Clause

Second, the SEC should introduce a regulatory most favored nation (MFN) clause to all securities sold through safe harbors used for private placements. This clause would mandate that if a company permits any resale of its securities, it must allow the resale of all its securities, provided the resale is otherwise legal. This would discourage selective liquidity and promote wider trading.

Requiring Limited Public Disclosures

Third, the SEC should require private companies with widely traded securities to make limited public disclosures regarding their operations and finances. This would provide investors with essential information without imposing the full disclosure burden on public companies.

The Benefits of Increased Transparency

These reforms would establish a robust market for trading unicorn stock among accredited investors, likely prompting most large, private companies to allow trading. This would attract short sellers, analysts, and financial journalists, enhancing scrutiny and deterring misconduct. The limited disclosure requirement, coupled with investor accreditation, would protect investors.

Addressing misconduct requires strengthening the incentives for detection, not simply increasing penalties. While Holmes faces a substantial prison sentence, the key issue is ensuring that wrongdoing is exposed. Creating a trading market incentivizes faster detection.