Holmes’ sentencing sends a clear message that the startup ecosystem must be built on good faith

Let’s start with the supposition that the venture-founder compact is built almost entirely on trust, especially early on. Sure, due diligence matters in the investment process, but lying about your capabilities can undercut the founder-investor relationship — and in extreme cases, to the detriment of the larger, global startup market.

In the wake of Elizabeth Holmes’ sentencing on Friday for defrauding investors, I’ve seen people argue that she was only guilty of messing with the wrong people — the wealthy. The implication here is that Holmes’ rich investors deserved to lose their money. I would argue what she did helped undermine the entire venture compact, and that’s why she’s going to jail.

As TechCrunch’s Amanda Silberling wrote on Friday about the company:

Holmes founded Theranos in 2003 after dropping out of Stanford. She pitched investors and partners on technology that would revolutionize the healthcare system — instead of drawing blood intravenously and waiting days for test results, her technology would prick a tiny bit of blood and instantly conduct dozens of tests on it. Soon she was the CEO of a company with a $10 billion valuation, but it turned out that the technology didn’t work.

What Holmes did was build a company by convincing investors that she could create something she knew to be a lie.

The tech startup ecosystem exists in part because investors with capital to spare are willing to risk some of that money on a founder with an idea.

These investors can be fabulously wealthy individuals. They can be athletes like Stephen Curry or Serena Williams, or entertainers like Kevin Hart or Ashton Kutcher. But they could also be larger entities like venture capital firms, investment funds or pension funds investing on behalf of people who aren’t fabulously wealthy.

They could also be professionals with some extra cash looking to invest a few thousand or even tens of thousands of dollars as angel investors. These folks have means, but they often aren’t billionaires.

Whoever these people are or whoever they invest on behalf of, they are betting on people and their ideas, and hoping they can execute and build a valuable company.

More often than not, it’s a bad bet, not because the founders didn’t make a good faith effort to make it work, but because they failed to make that idea work for any number of reasons that could range from bad timing and lousy management to poor decision-making.

But Holmes’ fault was not a failure of judgment or leadership, at least in business terms. She was selling a vision she knew to be fake, and the people who invested in her vision lost all of their money.

As the judge in the case was widely quoted as saying, “Failure is normal. But failure by fraud is not okay.”

If you take a stab and fail, investors may still be upset, but failure is often the outcome in this startup world. Believe it or not, most investors go in with their eyes open.

The best tech ideas often sound like magic, so it is understandable that sometimes it takes a leap of faith to believe in something that might sound outlandish. That doesn’t mean investors aren’t obligated to do their own due diligence, too. But investors are relying to some degree on what the founders are pitching. Even if an idea is hard to realize, you can at least, based on your conversations, come to believe that it could one day be a viable product — and not just a fantasy.

It’s worth pointing out that early Theranos investor Tim Draper did not not appear to back down on his support of Holmes and her company, or even regret his investment. As he wrote in the court filing:

Although there is substantial popular outcry against Theranos and Elizabeth, the attitude in much of the venture world is very different. Venture-backed startup companies often announce and deliver products to the market before they are ready.

That’s one way of looking at it, I suppose. Another is that the idea was always a flight of Holmes’ fantasy.

Investors are not without fault

It’s hard to have sympathy for individual investors who continue to support Holmes in light of the evidence, proving — if you needed proof — that venture investing is by no means a perfect system.

It’s clear that all investors should actually be diligent about verifying ideas, especially when they hear something that sounds too good to be true. Had Holmes’ early investors spoken to more experts about what Theranos was claiming, they would have likely learned that its thesis — that you can execute dozens of tests from a drop of blood — sounded impossible. Some of the fault here lies with them, much like the VC firms that blindly invested in FTX and lost their money.

And investors have to admit when they make a bad call. Some investors are clearly not ready to do that.

Some people argue that these investors got what they deserved. But as my mom used to say when my sisters and I were arguing, “Two wrongs don’t make a right.” Holmes broke the compact: The basic concept that you have a legitimate idea, you’re raising money from investors to build a company based on that idea, and it has at least some chance of working.

It’s also worth noting that investors weren’t the only ones who lost here. All of Holmes’ employees, who believed in what she was pitching, also lost. People who work at startups typically aren’t fabulously wealthy individuals, and if the company takes off, they can sometimes make life-altering wealth, or at least more money than they ever thought possible.

People who join a startup to build something and be a part of something bigger deserve founders who are serious about their company and the idea behind it.

My point is that there is a whole system of individuals in the startup business, some of whom provide the capital, some of whom provide the ideas, and some who help build it. But when the company is built on a base of lies and deceit, the entire system can suffer if there aren’t consequences.

If Elizabeth Holmes had been acquitted, or even got a short time in jail compared to her final sentence, what message would that have sent? People would think it’s OK to break the compact, and then the folks with the money to invest could end up being less likely to supply it in the future. And the people with ideas and a lack of money would have been the ones to suffer for her failures and the damage she could have done to the entire system by lying about what she was capable of building.