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The Theranos Files: The Red Flags

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“One tiny drop changes everything.”

That was the tagline for the now-defunct health-tech firm that claimed to have revolutionized blood testing – testing for over 200 diseases and viruses using a single fingerprick of blood.

As it turns out, that simply could not be done with the technology today – and Theranos’ founder Elizabeth Holmes and partner-in-crime “Sunny” Balwani knew it. However, they lied to investors, consumers, their Board, the media, the regulators and their own employees that it had already been achieved… while giving consumers blood-test results that were inaccurate and could be potentially harmful. Meanwhile, their valuations soared higher…

I recently finished watching the new HBO documentary on Theranos, titled “The Inventor: Out for Blood in Silicon Valley“. It was an interesting look at the rise and fall of Theranos – and centered around Holmes’ unique and somewhat other-worldly personality. In fact the Theranos scandal is so hotly talked about that ABC News also released its own documentary and podcast series titled “The Dropout“, and a movie is scheduled to be made titled “Bad Blood” starring Jennifer Lawrence as Theranos’ founder Elizabeth Holmes. The movie is based on the New York Times’ bestselling exposé of Theranos titled “Bad Blood: Secrets and Lies in a Silicon Valley Startup“. The author, John Carreyrou, was the investigative reporter who published the article that first exposed the world to how Theranos committed fraud and lied to its stakeholders about its operating and financial position.

As of this writing, Theranos founder Elizabeth Holmes is to appear in a federal court in San Jose TODAY (April 22) and go through evidence of fraud and various legal proceedings.

But – I’m not going to spoil everything for you here. Go read the book, or watch the documentary before coming back here – because I’ll be highlighting some of the red flags in these recounts and interviews, that investors should have been more aware of. To be fair, there were certainly smart investors who were skeptical enough early on to pass on funding Theranos (such as the team at Google Ventures). The next following are some of the key red flags that can be applied to public companies as well – and should act as learning points for all investors when doing their own due diligence. To clarify – I do not claim these observations to be my own – and simply emphasizing the ones which I see as potential learning points, as a potential investor looking at Theranos in its early innings before the Carreyrou story came out in October 2015.

1. Investors Did Not Know How to Interpret Theranos’ Patent Filings

According to Zachary Silbersher from Markman Advisors, most investors were satisfied that Theranos had been approved something over 200 patents by the USPTO. They didn’t bother to read what was in those filings. In fact, Theranos’ first approved patent on its invention suggests only “minor tweaks over existing technology, rather than something truly revolutionary” (Silbersher, 2019).

In the postmortem of Theranos, commentators have brought up the question of whether the US patent issuance system had failed. Some 200 patents were issued, and even after Theranos had closed shop – it was still being awarded patents. In fact, CB Insights reported that since the start of 2019 (Theranos shut operations late 2018), five patents have been issued. Silbersher argued that there is no requirement for USPTO to examine utility and enablement issues before granting a patent. In his words…

” Just because I have a patent, that does not mean that the Patent Office has determined that utility and enablement criteria have necessarily been met… investors [and commentators]… have taken the patents to mean something they are not “

Zachary Silbersher, Markman Advisors, 2019

2. Investors Did Not Have Industry-Specific Knowledge

Industry knowledge was also a key issue with many of these PE funds and Venture Capitalists. They had no in-depth scientific knowledge of how blood testing and MD/IVD (Medical Devices/In-Vitro Diagnostics) worked. In the documentary, Dr. Phyllis Gardner, a clinical pharmacology professor at the Harvard Medical School, told viewers that she was skeptical of what Holmes was doing early on – and said that she was taking a “fake it till you make it” approach with Theranos.

In the show, famed whistleblower Tyler Schultz (the grandson of former Secretary of State George Schultz) said that because the Edison (or, in later versions, the miniLab) needed to perform multiple tests, there were too many moving parts in the machine and thus created heat – which interfered with the assays and the subsequent test results. The heat could not be kept down – because the size of the miniLab was too small and heat couldn’t be dissipated quickly enough because the parts were all so close to each other.

Of course – investors wouldn’t have known these in hindsight, as Holmes kept the inner workings of the Edison/miniLab super-secret.

However, I took the liberty of searching through some scientific literature and found that many claims that Theranos made were pretty much inaccurate. According to an opinion paper published in 2015 in the peer-reviewed Clinical Chemistry and Laboratory Medicine (CCLM) scientific journal, Theranos’ claim that her testing for multiple diseases or viruses (“multiparametric testing”) would be significantly cheaper than at a hospital lab was not likely to be possible. The paper asserts that “reagents/consumables costs of centralized laboratories are, in general, likely much lower than those of Theranos” (Diamandis, 2015, p. 990).

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Moreover, Theranos also claimed that each test required its own tube of blood. However, Diamandis stated that “with a 7mL tube of blood, 10-100 analytes can be routinely measured by conventional technologies” (p. 990).

Next, Theranos claimed that conventional tests took 3 days to receive results, while the Edison could do it in a few hours. Diamandis says this is inaccurate – and centralized hospital labs can, and have been delivering results within a few hours. Moreover, he says that “faster analysis will not have a major impact on patient outcomes” (p. 990).

Lastly, Theranos saw a future for “decentralized” blood testing, where patients receive their results and could identify what diseases they do or don’t have. However, Diamandis suggested that most patients do not know how to self-interpret their own results accurately. First, the patient is not aware that certain tests are weak in predictions and other factors might confound with her scores. Second, the patient is most likely not aware about false positives and thus might undergo potentially harmful treatment for something she doesn’t have. Third, the patient “has no knowledge of the simple concepts of biological and analytical variation” (p. 991). Diamandis cites a certain tumor marker test for breast cancer (reference range <30 U/mL). The patient would not have known that her readings of 24 jumping to 26 are “practically the same” and would therefore start to panic due to the increase.

More scientific papers say that unless there was peer-reviewed evidence that Theranos’ invention worked, they would continue to be skeptical. In fact, Jotwani et al. (2017) found only one such analysis… which proved to be “significantly deficient” (p. 435).

3. Not Probing Deeper into the Question of “Why Didn’t Theranos Need FDA Approvals?”

The other red flag was how Theranos avoided FDA approvals. Rationally, a potential investor would be curious if Theranos had those approvals – and would dig deeper.

The reality was that they didn’t need one. Instead of registering as a commercial medical device/test, Holmes initially registered Theranos’ blood tests as a Lab-Developed Test (LDT). LDTs are intended to be used solely within their own labs, because a commercial one was not available. These tests (because they were not used in a commercial setting) – did not require FDA approval (and the strict disclosures that go along with it). Thus, this was how Theranos escaped data disclosure of the validity of its tests to investors.

The red flag here is not directly and explicitly obvious. A few critical questions need to be asked. Firstly, why did they choose to file for LDT instead of a normal, commercial lab test? Did they have something to hide?

The probability of a “yes” should already be about 70% – solely because Holmes’ goal with Theranos was not aligned with FDA’s original intention of an LDT. According to Lab Tests Online…

“These tests, called “laboratory-developed tests” or “LDTs” are used solely within that laboratory and are not distributed or sold to any other labs or healthcare facilities to perform on their own. Often, a lab will choose to develop and use an LDT because a commercial test is not currently available.”

On the contrary, Holmes’ wanted Theranos to be used on as many people as possible, which would mean installing Edison devices all across the state through various point-of-care facilities… which is almost impossible with just a LDT approval.

That probability should go up to 90% when Theranos announced it would be partnering with Walgreens to offer in-store blood tests across the country. This was back in September 2013, when the fraud was just in its early innings. According to Jotwani et al. (2017), such decisions “exceeded the spirit intended by the FDA’s enforcement discretion of LDT regulation” (p. 435), and thus, should pose a huge red flag for investors.

3. Management and Board Consisted of Non-Scientific Persons

Holmes had a power team behind her.

“Sunny” Balwani, joined Theranos as COO. He apparently made his fortunes exiting a startup he co-created while working at Lotus Software and Microsoft.

Her A-list Board of Directors included George Schultz and Henry Kissinger (former Secretaries of State), William Perry (former Secretary of Defense), Richard Kovacevich (former Wells Fargo Chair and CEO), and Gary Roughead (retired US Navy Admiral)… among many others.

The major red flag was that all these men did not have biomedical or scientific-related industry experience. They were government or military officials that didn’t have the clinical knowledge regarding Theranos.

Granted, Holmes assembled a Scientific & Medical Advisory Board (SMAB) which consisted of experienced individuals like William Foege (former director of the US Centers for Disease Control and Prevention), and former high-ranks of the American Association for Clinical Chemistry (AACC) such as Susan A. Evans.

However, it was only a few months after that most of the SMAB and Board members left. In fact, key leadership changes were constant at Theranos… which should signal a big warning sign for investors.

4. Key Operational Employees Were Suddenly Disappearing

While researching for this point, I put myself in the shoes of a VC or PE investor and found it difficult to pinpoint this particular red flag, before Carreyrou’s exposé piece in October 2015. The suicide of Ian Gibbons, Theranos’ chief scientist, only came to light after Carreyrou’s piece – thus it would be a hindsight bias to cite that as a red flag for investors.

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However, those PE and VC investors would have noticed that there was no CFO starting from 2006 onwards (when Henry Mosley, then CFO of Theranos, was fired) if they did their due diligence. Why weren’t questions being raised then? I’m looking at investors which included funds like Partner Funds and Draper Fisher Jurvetson (DFJ), and individuals like Ryan Orr and Thomas C. Hawes.

If that wasn’t enough proof, in early 2017 (around 1.5 years after Carreyrou’s article), Bloomberg reported that 41% of employees were being laid off, explaining that the move “allows Theranos to marshal its resources most efficiently and effectively”. This should signal a huge red flag to any investor still believing the Theranos story – almost HALF of Theranos’ workforce was being cut. This situation could only be seen in an economic recession/crisis… not when the economy was at full sail in 2017! It could only mean one thing – that Theranos was facing some HUGE cashflow and profitability issues and was on its way to blackout.

5. Vague and Un-audited Financials

This last red flag is particularly straightforward – but also interesting to write about – because Theranos was a private company. As such, it did not have to disclose its financials to the public, or file with the SEC. Investors in public companies can do their due diligence on the financials fairly easily – it’s all filed with the SEC and EDGAR.

However, this picture posted by Quora member Tirumalai Kamala shows the amounts that were invested early on in Theranos’ growth.

Credit: Tirumalai Kamala (Quora)

We can see that post-seed rounds of funding, investors poured over $50 million to over $300 million from 2010 to 2015 (before the exposé). You would think such large amounts would require audited financial disclosures from Theranos’ management, right?

Wrong. Instead, investors got “financial projections on spreadsheets created from scratch by Balwani” (MarketWatch). Those projections, according to SEC statements, claimed Theranos would breakeven by 2014 and generate $1 billion in revenue by 2015. Ding ding ding… Red flag alert!

If this had been on Shark Tank… I think Mark Cuban would flip his table.

MarketWatch reported early this year that none of the Theranos investors, who invested more than $700 million with Holmes between late 2013 and 2015, had ever requested audited financial statements or asked whether the company even used an outside accountant to verify the financial information that was distributed.

Furthermore, Francine McKenna at MarketWatch also made this statement – which was particularly interesting:

If a company will have more than $1 billion in revenue by the time it files its S-1 with the SEC to go public, as Theranos claimed it would by 2015, then it is required to provide potential investors with three prior years’ financial statements audited by a firm registered with the Public Company Accounting Oversight Board, the audit-industry regulator, when it files for the IPO.

Many believe that Theranos was due to go public in 2015 – as “biotech IPOs have been hot this year”, and early investors were eager to cash out after 10+ years of seed funding. That said, some Quora-ians have opined (the earliest being late 2014) that there is only a low possibility that Holmes would bring Theranos public, as that would mean giving up some of her power.

Nevertheless, it should be noted that audited financials that are “clean” or “unqualified” do not necessarily mean that a company is free of fraud. In this article by CPA Journal, auditors are only meant to look for fraud if “the fraud… misstate[s] the financial statements, and the misstatement must be material”. Therefore, investors would still have to do their due diligence to spot signs of management “massaging the numbers”.

That said, the lax-ness by the investors to even ask for audited financials had indicated that the first step in financial due-diligence had already failed.

Bottom Line: If You Find A Unicorn in Your Stable… You’re Most Likely Asleep.

To conclude… everyone wanted to believe in Theranos’ narrative. Everyone wanted in on the pie that was to become the “next Apple of blood testing”. But no one wanted to look at the hard facts and what was actually happening… until Carreyrou did – and publicly exposed Theranos.

Thus as investors – due diligence involves much more than taking management’s reports at face value. It involves much more than accepting their earnings guidance and having a charismatic leadership. It involves much more than having powerful backings like an “all-star” Board of Directors and making stunning deals (with Walgreens, in Theranos’ case). And finally, it involves separating price from value – and critically asking ourselves “Is this $X market valuation reflective of fundamentals?“.

By asking these critical questions – we can (and should) avoid 99.99% of frauds, bad deals, MLMs and pyramid schemes out there.

PS: I found this comment from 2014 which I thought was pretty amusing.

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