Will the Elizabeth Homes Verdict Change the Due Diligence Process? Not Likely

Two stories have emerged from the Theranos collapse and the conviction of CEO Elizabeth Holmes. One story says that the collapse of – as Bloomberg’s Matt Levine called it – Elsmatherium haimatos, the Blood Unicorn – will portend the beginning of a long-overdue reckoning of the funding models of Silicon Valley and venture capitalism as a whole. The other envisions Holmes’ conviction as nothing more than a big yawn, and not only not a moment of introspection but quite the opposite: permission to continue business as usual.

The unwritten rule of start-ups has always been “fake it until you make it.” This aphorism helped countless start-ups raise obscene amounts of money with little to no repercussions for failure or overpromising results. While not necessarily outright fraud, “faking it” certainly gets close to a line that should have heightened scrutiny on the part of investors, regulators, and prosecutors.

In the first version of the story, “fake it until you make it” loses its primacy, and investors will redouble their due diligence efforts, preventing the kind of chicanery Holmes was able to get away with.

In the Financial Times, Brooke Masters writes: “This verdict will reverberate around the technology and investment communities, as well it should.” Likewise, writing in The New York Times, David Streitfeld predicts that the “verdict signaled the end of an era. In Silicon Valley, where the line between talk and achievement is often vague, there is finally a limit to faking it.”

In the last two or three decades, as venture capital became a financial behemoth, policymakers, regulators, and law enforcement have drawn a line of demarcation between defrauding investors and defrauding customers. For instance, the proverbial book was thrown at Bernie Madoff for running a Ponzi scheme, while Adam Neumann of WeWork walks free and gets interviewed by Andrew Ross Sorkin at The New York Times DealBook conference. Traditionally, investors have had a hard time collecting in court. On the other hand, Holmes was told by a jury that she lied to investors and therefore is culpable. Tellingly, part of Holmes’ defense to the defrauding investors’ charge was that her investors wanted to be defrauded; otherwise, they would have undertaken greater due diligence efforts and not invested.

That Holmes’ defense would accuse the accusers was predictable to anyone who has watched a courtroom procedural. That it would not make an impact was likewise predictable. Investors face a nearly impossible task of ensuring they (and their LPs) are successful while at the same time moving at warp speed to ensure they aren’t blocked out of the latest “hot deal.”

On January 2, The Wall Street Journal reported that nearly 79 percent more money was invested in “so-called seed-stage and early-stage startups in the U.S.” in 2021 ($93B) compared to 2020 ($52B). This was all going on after the media’s deep dive exposés into Theranos and WeWork. This suggests that investors may very well continue the status quo despite (in spite?) of the Holmes verdict.

Angela Lee, a Columbia Business School professor who runs 37 Angels, an investment network, told Bloomberg News the trial “doesn’t seem to be prompting investors to re-examine their diligence practices. “I’ve heard zero people say, ‘Oh, this should make me look differently,’ — zero,” she said. “It’s treated like salacious gossip or an entertaining story.”

The current SPAC craze or investor money pouring into cryptocurrency and NFTs suggest Lee may be on to something. If investors see a deal, they will run to it to ensure (a) they get to participate and (b) ensure their competition is blocked out. Yet, as Axios’ Dan Primack points out: “Theranos did put people’s health at risk; which is why Theranos stands apart from other tech startup frauds,” so perhaps at least health-related start-ups will be looked at more carefully in the future. With that said, not all investors run to hot deals (some avoid them altogether), and a lot of the very best VCs passed on Theranos because of diligence issues and questions that couldn’t be answered.

Will the fact that Elizabeth Holmes was found guilty on fewer than half of the crimes she was accused of result in a sea change for how investors approach start-ups? Will they take steps to improve their due diligence, or will they continue to be wowed out of their money by flashy presentations, outlandish promises, and people with gravitas on a board? Only time will tell, but one can hope this incredibly high-profile situation starting from the futuristic-sounding ability to analyze just a drop of blood, to the iconoclastic CEO, to the board stacked with heavyweights to the leaks to the Wall Street Journal, will motivate investors (or maybe their investors) to do the hard work of due diligence and research, rather than choosing to follow an in-crowd and rush into a deal they should not have.

The lines between “the aggressive marketing of a future vision,” which is what Adam Neumann would argue, and out the right misrepresentation of future business performance, which is what Elizabeth Holmes was convicted of, are ambiguous. Ambiguity equals risk.

There is tremendous value in proactive lawyering — before-the-fact as opposed to after-the-fact counseling.  This approach helps to steer clients clear of legal hazards, mitigates disputes, avoids litigation, and gives clients a better story to tell when deals and business matters go awry, and litigation arises.

The team at Rooney Nimmo has experience guiding all stakeholders through the grey mist of ambiguity to mitigate risk. If you need help or have any questions, please contact Allan RooneyTim Davis, or Elannie Damianos, or call us on +1 212 545 8022.

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