Not too long ago, the press heralded Elizabeth Anne Holmes as the youngest female entrepreneur and billionaire. But, last night, a group of journalists and spectators gathered outside the San Jose, CA, courthouse to report on one of the most controversial tech trials in recent history.
After more than 50 hours of deliberations and four months of court proceedings, the jury found Holmes guilty on four out of 11 federal fraud and conspiracy charges. Now, we all have to wait for the sentencing hearing to see if—or for how long—she spends any time behind bars. In any event, she’s expected to appeal.
Fairytale or a nightmare
Holmes dropped out of Stanford University to start her own firm, Theranos, a blood- testing startup. She quickly raised billions of dollars from investors by using private placements, offerings of securities that are exempt from registration with the Securities and Exchange Commission (“SEC”) and not subject to broad disclosure requirements, such as audited financial statements.
The investor groups were sophisticated, accredited institutional and individual investors. Thanks to the large amounts of capital that Theranos raised from these investors, the company joined the prestigious “unicorn” club. At its height, the firm was valued in excess of $9 billion. Indeed, Holmes seemed to be living in the fast lane.
Holmes appeared on the covers of magazines, while Theranos enjoyed the benefits of an “all-star” board of directors which included former secretaries of state Henry Kissinger and George Schultz, former Senator Majority Leader Bill Frist and former Wells Fargo
Cinderella was a witch?
Theranos’s funding bubble burst when Holmes was charged with massive fraud. How did Holmes fool so many people? Patients, doctors, investors, journalists, White House officials, military generals, and employees all seemed to be caught by surprise.
To my astonishment, the jury’s not-guilty counts were related to wire fraud and conspiracy against patients and doctors. I’m not surprised, perhaps, that the four guilty counts were tied to wire fraud and conspiracy against investors.
But were all of the investors really left out to dry? Some of the largest players admitted they conducted little due diligence. Dan Mosley, a lawyer whose clients include the Walton and DeVos families, asked for audited financials, never received them, and invested $6 million of his own money anyway. The DeVos family invested $100 million without consulting any outside experts on science or regulatory matters.
Maybe this was part of the driver for the investors to settle with Holmes in their civil case against the firm four years ago. The terms were not disclosed.
Access to investments in unicorn firms, which are illiquid high-risk privately held firms, is usually reserved for sophisticated accredited investors, such as ultrarich individuals and large institutions. But this is changing. Many are concerned that ordinary retail investors are missing out on investment in unicorn firms. Perhaps this case will send some warning signs to politicians and policymakers, but I wouldn’t hold my breath.
Investors are still fighting over opportunities to get behind unicorns. And the SEC and other regulators have been willing to open the door to allow more of them in, even if its indirectly.
Silicon Valley\’s troubled unicorns
Holmes, unfortunately, is not the only unicorn founder making headlines for breaking the law. The chief executive officers of WeWork, Uber
These stories attract public attention to the operations, management, corporate governance structures and financings of unicorn firms. Despite these reports, various investor groups, including retail investors, are still demanding a piece of the action.
As unicorns continue to stay private longer and grow even larger with continued rounds of capital raising, we’ll likely hear more stories like Theranos. More private investments allow founders to more easily maintain control. Unicorns are private firms, and as such are not subject to broad disclosure requirements, such as audited financial statements.
What’s the solution?
For decades, debate has raged on whether we should force a company to join public markets and at what point the line for obligation is crossed. Congress and the SEC have recognized that once this genie is released from the proverbial lamp, there’s no going back. Instead of popping the cork, regulators have instead adopted the carrot-and-stick approach, gently nudging companies in the direction of the path countless firms have taken on their own accord: an IPO.
However, with the dramatic acceleration of capital formation in private markets in the past two decades—as well as slackening in regulatory requirements—much of the reason to go public has evaporated. Capital formation in the private markets is considerably easier and is preferred for a variety of reasons by large private firms. All of this accompanied by the simple fact that being public is expensive. Firms need to ask themselves if access to the public’s capital is really worth the price tag associated with our disclosure regime.
No longer do these firms, predominantly unicorns or soon-to-be unicorns, need access to the public’s capital to continue their growth. The creation of secondary markets, like NASDAQ’s
Potential reforms are wide ranging, with many requiring Congressional action. Given the divisions we currently face in Washington D.C., substantial reform is unlikely. However, there are actions the SEC can take under its independent rule-making authority, giving way to a bare-minimum-increase in protective measures.
John Livingstone and I are working on a new piece that outlines the reforms requiring Congressional approval and then move on to those under the SEC’s rulemaking power. Stay tuned for more soon.