Thursday, October 20, 2016

Theranos: The Silicon Valley Case The SEC Has Been Waiting For

From TechCrunch:

The SEC gets the case it’s been waiting for in Silicon Valley
Not so long ago, Theranos was flying high, its claims that it was upending the medical diagnostics business largely accepted by the public. Behind the scenes, however, some employees were growing wary of those claims, with at least one eventually reaching out to regulators to report the company’s failure to report its questionable test results.

A stinging series of articles by the Wall Street Journal soon followed, and in recent months, the government agency that oversees U.S. labs has banned founder and CEO Elizabeth Holmes from operating a blood-testing laboratory for two years, and Theranos has shuttered its clinical labs and wellness centers. To make matters worse, the company was last week slapped with a lawsuit by one of its biggest investors, which claims that Theranos knowingly lied to it.

It’s a nearly ideal scenario for the SEC, which is investigating Theranos and widely expected to use a case against it to expand its mandate into Silicon Valley’s startup ecosystem. The truth is while the SEC has long been viewed as a force in the public markets, it also has the authority to chase after private companies that engage in any “act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.” And lately, Wall Street’s top cop is finding Silicon Valley too high-profile a target to resist.

“If you’re only raising couple million bucks, everyone expects your huffing and puffing,” says one San Francisco-based securities attorney. “But if you’re raising hundreds of millions to billions of dollars, why would the SEC ignore that when they’re auditing the financials of some piddly company that’s raising $50 million in an IPO?”

In many ways, the startup world has been working toward this moment since 2002, with the passage of Sarbanes-Oxley, a law that established new accounting standards for publicly traded companies. SarBox was designed to safeguard public market investors from the likes of Enron, an energy-trading company that perpetrated one of the biggest accounting frauds in history.

VCs grumbled over the additional expense the new regulation created, calling it a deterrent to going public. Whether or not their claims were valid, the rise of Facebook soon after marked an undeniable shift toward staying private longer. Startup founders admired and looked to emulate Facebook cofounder and CEO Mark Zuckerberg, a then twentysomething who wasn’t answering to anyone, yet growing his company at a nearly unprecedented clip.

Facebook’s private shares similarly seduced accredited investors everywhere. Because of secondary marketplaces that mushroomed around the growing social media giant – the platforms enabled many far-flung participants to trade Facebook’s then-private shares – many who were new to startups were rewarded, and they looked to repeat the scenario.

Facebook wasn’t alone in its early ascendance in the Boston area. A year after it was founded in 2004 in Mark Zuckerberg’s Harvard dorm room, a nearby outfit called Y Combinator was being created by entrepreneur Paul Graham and his wife, Jessica Livingston.

It was unlike anything Graham had ever done — and by design. When earlier in his career, Graham cofounded a software company called ViaWeb, few doubted his engineering prowess. But Graham was much weaker when it came to fundraising. In fact, though Yahoo wound up purchasing ViaWeb for $49 million in stock in 1998, it was after being encouraged by a third party to kick the tires a second time.

Y Combinator alums would be different. From nearly the outset, participants in the now-famous accelerator program learned to frame their growth metrics as compellingly as possible. Their pitches proved so irresistible to VCs over time that the mantra of “ramen profitable” gave way to “growth hacking,” which involved burning cash to expand — and figuring out profitability later.

Against the backdrop of these shifts, the SEC’s interest in Silicon Valley was growing. One early, motivating factor was a report in the WSJ in 2006 that questioned whether executives at a variety of healthcare and software companies were manipulating options pricing. Investigations were launched, including into Apple; the SEC even set up a related “Stock Options Task Force” and filed charges against two former Apple execs for their alleged roles in backdating Apple options — both of whom settled without admitting wrongdoing. But the investigations came to be viewed as much ado about nothing, with disagreement even among the government’s experts about how stock options should be issued....MUCH MORE
HT: Matt levine@BloombergView