Many startup companies begin with either an idea or a proprietary technology. Sometimes this technology is straightforward and easily explained; other times, it is novel and revolutionary.
For some founders, the latter can be a double-edged sword, especially once they begin to seek outside financing. If your technology is new, it can be hard to explain and prove. But if it is potentially disruptive, it can attract significant attention from potential investors.
The latter is what happened with the disgraced healthcare startup Theranos. Founder Elizabeth Holmes raised massive rounds of financing on the promise of a new way to test blood that would transform medical testing for all of mankind. Investors threw money at Holmes and Theranos, leading to a valuation of $9 billion at a 2014 financing round.
As the media has recently reported though, it would appear that few of Theranos’ investors had any experience in the medical and biopharma industries. Rather, those with ties to the technology industry came from software backgrounds, and the others were strong political players in the U.S.
These investors most likely did not perform their due diligence on Theranos and its technology. Because of their backgrounds, it’s possible that they did not even know what to look for. Theranos was known to keep their cards close to their chest, and was secretive about their technology and data.
Regardless, investors kept coming and giving money to the company. Were they investing without doing their own homework on the technology, instead relying on earlier investors they believed had performed due diligence themselves? In a recent op-ed for Fortune Magazine, marketing professor Kent Grayson explained this phenomenon as trusting “credence goods”:
For Theranos, these kinds of endorsements were made by a number of high-profile investors, such as software giant, Larry Ellison, and a prestigious board, which included high-profile lawyer, David Boies, and former secretary of state, Henry Kissinger. When well-respected people buy into something, we often assume that they’ve done our homework for us. After all, would they risk their reputation without doing their own due diligence?
Some excuse Theranos’ secrecy as merely protecting their intellectual property and technology, in addition to desiring confidentiality for their company. Having worked in the biotechnology industry for many years, and having raised capital for a medical products startup, I can say that that argument does not hold water.
If you don’t trust these people to keep your secrets under a confidentiality agreement, then you shouldn’t be in business with them.
Founders must be open to the scrutiny of due diligence. If your potential investors are bringing in scientists and experts to audit your company, you must trust them as they analyze your technology and data, especially in the medical sector. There are confidentiality agreements as well as other protections that you can put in place during the due diligence process. If you don’t trust these people to keep your secrets under a confidentiality agreement, then you shouldn’t be in business with them. There’s no reason why you can’t share your data and have it externally validated.
In Theranos’ case, it’s possible that investors invested in a technology that may ultimately not deliver what was promised. Unfortunately, this scenario does happen. Companies may oversell their technology by overstating its capabilities, or they may fail to pursue rigorous scientific procedure with respect to the efficacy of their technology. Sometimes investors get caught up in the narrative of the company. Theranos, in particular, was a media darling before The Wall Street Journal’s groundbreaking report last year.
It’s worth noting that, for the most part, well-known investors in the biotechnology and life sciences spaces, especially in Silicon Valley, did not invest in Theranos. Because these investors often have the expertise and the experience in their fields, they knew what to look for. In this case, biotechnology investors thought that Theranos’ technology seemed too good to be true. Even as Theranos continued to raise money and announce new applications of their technology, they remained unwilling to share their data. This was a red flag that told savvy biotechnology investors to stay away.
For medical startup companies, being able to share your data (under proper confidentiality agreements), having your technology validated in clinical trials and peer-reviewed in medical journals should be a welcome. It is a good thing to be able to prove the effectiveness of your product. You want to be able to show investors that your product works and has valid applications.
Founders should always be open to third-party validation. We took the time to have our first product — a medical device for treatment of snoring and sleep apnea — undergo clinical testing and peer review. By the time we took the product to market, and as we raised capital later on, we had data to share that showed that our product was clinically proven and that the technology was scientifically sound.
At the same time, due diligence is the responsibility of investors. If they don’t perform their due diligence, and they’re simply relying on the credibility or the pedigree of the management team, they risk investing in products or technology that is ultimately proven unsound.