An entrepreneur and a swindler

An entrepreneur and a swindler

In this file photo taken on November 22, 2021 former Theranos founder and CEO Elizabeth Holmes goes through security after arriving for court at the Robert F. Peckham Federal Building in San Jose, California.

Photo credit: AFP

The conviction of Elizabeth Holmes for fraud perpetrated as founder and CEO of Theranos has triggered intense debate about what the episode means for the innovation economy. Did Holmes, aggressively implementing Silicon Valley’s “fake it until you make it” credo, simply run out of runway? Is the venture capitalist and Theranos investor Tim Draper right to worry that her conviction will reduce the “willingness to bet on” the type of entrepreneurs who “made Silicon Valley the innovation engine of the world”?

Or is it more complicated? Holmes’s trial and conviction illuminate two trends at the heart of the American political and financial economy. The first is the broad retreat from prosecuting financial manipulators as criminals, a development evident since the incarceration of Enron and WorldCom senior executives following the collapse of the 1998-2000 dot-com bubble.

Consider the difference between the aftermath of the 1980s savings and loan debacle and what followed the 2008 global financial crisis. In the former case, notes ProPublica’s Jesse Eisinger, “the Department of Justice prosecuted over 1,000 people, including top executives of many of the largest failed banks.” In the latter instance, by contrast, “only one top banker went to jail”.

Eisinger’s 2017 book, The Chickenshit Club, documents a profound shift in attitudes within the US Department of Justice during the first decade of this century. He traces this development to the 2002 liquidation of Arthur Andersen, a “Big Five” accounting firm, following its conviction for obstruction of justice relating to its work for Enron. Instead of seeking to hold individual executives criminally liable for enormous financial losses, the authorities repeatedly settled the charges in exchange for fines ultimately paid by shareholders.

Irresponsible investment

The second broad trend has been the enormous flood of “non-traditional capital” (from family offices, mutual funds, hedge funds, sovereign wealth funds and individual billionaires) into venture capital-backed start-ups over the past six years. In 2021, annual capital directly committed to VC funds finally exceeded the $100 billion raised in 2000, but more than that was invested by non-VCs into VC-backed start-ups, reaching a record combined total of $330 billion, almost double for 2020.

Fuelled by this explosion, late-stage valuations have soared alongside public equity markets, driven largely by the Big Tech firms that the start-ups aspire to emulate. And investors necessarily accept illiquidity — the legal inability to sell their shares — when committing capital to private ventures. And in many cases — like that of Theranos — they have accepted terms granting founders near-absolute control, no matter how much capital is raised.

Chief among the forces driving this bubble is the unprecedentedly loose monetary-policy regime since 2008. The US Federal Reserve and other major central banks have reduced risk-free interest rates to (and even beyond) the “zero lower bound” and mobilised a range of unconventional instruments — under the heading of “quantitative easing” (QE) — to flood financial markets with cash.

Walter Bagehot, the 19th century editor of The Economist, summarised the predictable outcome of these policies 150 years ago: “The history of the trade cycle had taught me that a period of a low rate of return on investments inexorably leads toward irresponsible investment... People won’t take 2% and cannot bear a loss of income. Instead, they invest their careful savings in something impossible — a canal to Kamchatka, a railway to Watchet, a plan for animating the Dead Sea.”

Cash and Control

A machine that can perform 200 blood tests from a single pinprick is worthy of Bagehot’s list. Now that the era of QE appears to be at an end, the most likely long-term consequence will be a shift in the balance of power from entrepreneurs back toward financiers. This will be a sharp break from 2020, when over 40 per cent of tech initial public offerings used a dual-class stock structure to entrench founder control. Pre-IPO investors in these cases can neither sell their own stock nor fire the CEO. Like Rupert Murdoch and Betsy DeVos when they bought into Theranos, they are pigeons, not partners.

Some 40 years ago, I formulated a double hedge against the radical uncertainty that attends investments in start-ups operating at or beyond the technological frontier: “Cash and Control.” Investors need enough cash to buy the time necessary to understand an adverse surprise, and enough control to do something about it (which usually starts with firing the CEO).

The nontraditional investors who have piled into late-stage VC-backed firms have plenty of cash, but they usually lack the necessary control. The Uber and WeWork sagas show that, until the rules change, even leading professional VCs may have to sue to overcome the “entrepreneur-friendly” terms that they accepted.

The Theranos story serves as a reminder that raising capital for a venture akin to “animating the Dead Sea” can happen only because investors have become desperate in their search for positive real returns. Holmes seems to have been blessed by the Cult of the Entrepreneur, which enables founders to play prospective investors off against each other in pursuit of the friendliest deal. How else could a tech neophyte raise start-up money for such a venture from the likes of Larry Ellison, Don Lucas, and Draper on terms that gave her 100 per cent control?

Janeway, a PhD holder and partner at private equity firm Warburg Pincus, is an affiliate lecturer in economics at the University of Cambridge, and author. © Project Syndicate.