On Wednesday, the United States Securities and Exchange Commission (SEC) filed charges against Theranos Inc as well as its disgraced CEO, Elizabeth Holmes, and former president, Ramesh "Sunny" Balwani. While conducting a post-mortem, it's easy to see immediate parallels between the privately-held fraudulent blood-testing company and many initial coin offerings (ICOs).
Once valued at $9 billion, Theranos claimed that it could perform a "full range of laboratory tests" using just "a few drops of blood," a breakthrough that could have transformed the healthcare industry. However, in 2015, under scrutiny from investigative journalist John Carreyrou, the supposedly-revolutionary blood-testing company began to crumble. Proprietary tests using its "Edison machine" were inaccurate, and a whistleblower notified authorities that Theranos had failed to report the results of concerning quality-control checks, in violation of federal rules. By April 2016, Theranos was the subject of a criminal probe and by October 2016, the company announced that it would shut down its blood-testing facilities.
This week, the SEC filed charges against Theranos and its executives, alleging that they raised "more than $700 million from investors through an elaborate, years-long fraud in which they exaggerated or made false statements about the company's technology, business, and financial performance." Holmes agreed to relinquish her majority voting control, dramatically reduce her equity stake, and pay a $500,000 penalty. She will also be barred from serving as an officer or director of a public company for 10 years. She may even face jail time.
It's easy to delight in justice served, but the failures of Theranos strike deeply because there are disturbing similarities between the derelict blood-testing company and many initial coin offerings (ICOs).
A Cult Of Personality
It seemed that Elizabeth Holmes had all the bells and whistles, which made her look like the next big thing. In 2004, during her sophomore year at Stanford University, she dropped out to focus on Theranos. But, it was only after her presentation at TEDMED 2014 that Holmes was crowned as the next darling of Silicon Valley. She was profiled by the likes of Forbes, Fortune, The New Yorker, Inc, and Wired among others.
Holmes positioned herself as a visionary on par with Steve Jobs. She, too, dressed in severe black turtlenecks. She, too, could captivate a room and possessed intense, analytical eyes. And she, too, had ties to the Palo Alto campus where Jobs famously delivered his enduring message: "Stay hungry, stay foolish."
In the cryptocurrency world, many entrepreneurs have quickly amassed cult-like followings through gorgeous marketing campaigns. If you disagree with one of these people on Twitter or raise doubts about their legitimacy on reddit, you'll quickly be shouted down. And if a project lacks a superstar executive, it might choose to rely on celebrity endorsements, a practice that has been denounced by the SEC.
Theranos actually had some of these superstars of its own. The company's investors and board of directors included a plethora of US diplomats, acclaimed venture capitalists, and career military men.
I would argue that many cryptocurrency entrepreneurs are well-intentioned people. Nobody sets out to be a fraud (well, not 'nobody,' but you get my point). If these developers and businessmen could truly build what they promise, many of them probably would. Unfortunately, many will try, and most will probably fail.
The major problem is that there are too many 'cryptocurrency entrepreneurs' who spend more time drinking in their 15 minutes of fame at conferences than immersing themselves in good old-fashioned hard work. So, it's critical for stakeholders to distinguish between savvy marketing (i.e., pretty websites, free t-shirts, famous 'investors') and actual product development.
Selling A Promise
Theranos vowed to change the world. The company made sick and suffering patients believe that their pain could be eased. No longer would they have to endure tests that literally drained their blood into large vials. Just a pin prick, they were told, would suffice. So, there is a deep-seated grief – a clenching and twisting of the gut – associated with the company's web of lies.
Today, various cryptocurrency projects have sold similarly grand dreams of reconfigured businesses and disrupted power dynamics. Numerous ICOs claim that they will disrupt the financial services industry by reducing the commissions charged for remittances and by banking the unbanked. But it's not just that. ICOs have promised to make industrial supply chains more efficient, to change the social media landscape, to revolutionize healthcare (sound familiar?), and so much more.
One or more of these projects may truly change the world. But, it seems highly unlikely that the hundreds of ICOs that have raised capital will even come close to delivering on their promises. Though their tokens may be listed on "cryptocurrency exchanges," what work have they done? In short, where are the cash flows?
The vast majority of ICOs do not have a clear roadmap, let alone a functional prototype for what they're building – and that's a problem. A whitepaper and a token are not enough to justify the outrageous sums of capital that have been raised.
Special Knowledge, An Absence Of Oversight
One of the key reasons that Theranos survived as long as it did is that Holmes refused to share her 'trade secrets.' Nobody got to see the man behind the curtain and as more investors flocked to the company, it reached a critical mass. Without whistleblowers and principled journalism, who knows how far things would have gone?
When a company or its founders claim divine wisdom, but cannot – or will not – share their magical potions with the masses, there is reason to be cautious, a justifiable seed of doubt. Without delving into conversation about the merits of intellectual property law, it's obvious that there exists a divide between those that produce and those that consume, and between those that create and those that invest.
These same problems plague the cryptocurrency markets. It's close to impossible for lay investors to audit code (not that many people would want to perform this level of due diligence), but there also aren't good oversight mechanisms in place for the nascent market. Instead, we find that "investors" are throwing money after projects just because others have done the same. If a token goes up in value, that's accepted as a sign of a project's success, which seems to function as a feedback loop for other speculators.
As SEC chairman Jay Clayton has noted, in the ICO world, project founders and developers have often failed to provide basic disclosure information and risk factors, which are standard operating procedure in the securities markets. "Market professionals, especially gatekeepers, need to act responsibly and hold themselves to high standards," said Clayton, as he urged responsibility. "To be blunt, from what I have seen recently, particularly in the initial coin offering space, they can do better."
Imbalanced Equity Structures
One of the many warning signs about ICOs is that their terms and conditions – if they exist – may not actually grant equity or voting rights in the project. With Theranos, Holmes apparently held more than half of the company's shares, and shockingly retained more than 99 percent of voting power.
In the cryptocurrency markets, we've similarly seen that projects have questionably reframed financial backing as "nonrefundable donations" and that many projects tell supporters that investments are not equity (while still touting the expected increase in the value of their tokens).
At least with Theranos, the damage was limited to the people who could seemingly afford it. Venture capitalists can suffer the losses when a project doesn't pan out, and that is part of why there are rules that limit certain business opportunities to accredited investors. Since ICOs are made available to – and often marketed toward – retail investors, that makes them potentially more catastrophic.
We believe in the future and that's part of what inspires us to take risks. We think that tomorrow will be better, that we and our heroes will reach the pinnacle of success. But, as we buy into those dreams, it's critical to distinguish between the people who get their hands dirty and the pretenders. And it's vital that our technological leaders do not exaggerate their chances for success past the point of rationality.
There isn't an exact prescription for capital allocation, and that's part of the mystique of investment. Still, when it's obvious that project founders cannot reasonably deliver on their promises, we need to take a step back and evaluate how the industry ought to proceed. What we have is not sustainable and it is not right.
In time, perhaps conducting blood tests with a single drop of blood will be possible, but we're not there today. Thus far, ICO executives have overpromised and under-delivered. That's a recipe for financial ruin and as has been made clear, the SEC is watching closely.
Perhaps, the director of the SEC's San Francisco Regional Office put it best. When the agency announced its charges against Theranos, she said, "Innovators who seek to revolutionize and disrupt an industry must tell investors the truth about what their technology can do today, not just what they hope it might do someday."