Thursday, November 12, 2015

Runaway Stories and Fairy Tale Endings: The Cautionary Tale of Theranos

I saw the new Steve Jobs movie, with the screenplay by Aaron Sorkin, over the weekend. As a long-time Apple user and investor, I must confess that I was bothered by the way in which the film played fast and loose with the facts, but I also understand that this is a movie. Sorkin clearly saw the benefit of using the launches of the Macintosh in 1984 and the iMac in 1997 as the bookends of the movie and the tortured relationship between Jobs and his daughter to create an emotional impact, and took dramatic license with the truth. As I watched the movie though, I kept thinking about Theranos, a company with a gripping narrative and a CEO who, like Steve Jobs, wears only black and who seemed headed for a biopic until a few weeks ago.

The Theranos Story: The Build Up

The Theranos story has its beginnings in March 2004, when Elizabeth Holmes, a 19-year old sophomore at Stanford, dropped out of college and started the company. The company was a Silicon Valley start-up with a non-Silicon Valley focus on an integral, but staid part, of the health care experience, the blood test. Ms. Holmes, based on work that she had been doing in an Stanford lab on testing blood for the SARS virus, concluded that she could adapt technology to allow for multiple tests to be run on much smaller quantities of blood than the conventional tests did and a quicker and more efficient turn around of results (to doctors and patients). In conjunction with her own stated distaste for the needles required for conventional blood tests, this became the basis for the Theranos Naotainer, a half-an-inch tube containing a few drops of blood that would replace the multiple blood containers used by the conventional labs.

The story proved irresistible to just about everyone who heard it, her professor at Stanford who encouraged her to start the business, the venture capitalists who lined up to provide her hundreds of millions of dollars in capital and health care providers who felt that this would change a key ingredient of the health care experience, making it less painful and cheaper. The Cleveland Clinic and Walgreens, two entities at different ends of the health care spectrum, both seemed to find the technology appealing enough to adopt it. The story was irresistible to journalists, and Ms. Holmes quickly became an iconic figure, with Forbes naming her the “the youngest, self-made, female billionaire in the world” and she was the youngest winner of "The Horatio Alger award" in 2015.

From the outside, the Theranos path to disrupting the business seemed smooth. The company continued to trumpet its claim that the drop of blood in the Nanotainer could run 30 lab tests and deliver them efficiently to doctors, going as far as listing prices on its website for each test that were dramatically lower (by as much as 90%) than the status quo. In venture capital rankings, Theranos consistently ranked among the most valuable private businesses with an estimated value in excess of $9 billion, making Ms. Holmes one of the richest women in the world. The world seemed truly at her feet and reading the news stories, the disruption seemed imminent.
Source: Wall Street Journal

The Theranos Story: The Let Down
The Theranos story started to come apart on October 16, when a Wall Street Journal article reported that the company was exaggerating the potential of the Nanotainer and that it was not using it for the bulk of the blood tests that it was running in house. More troubling was the article’s contention that senior lab employees at the company found that the nanotainer’s blood test results were not reliable, casting doubt on the science behind the product.

In the following days, things got worse for Theranos. It was reported that the FDA, after an inspection at Theranos, had asked the company to stop using the Nanotainer on all but one blood test (for Herpes) because it had concerns about the data that the company had supplied and the product's reliability. GlaxoSmithKline, which Ms. Holmes had claimed had used the product, asserted that it had not done business with the start up for the previous two years and the Cleveland Clinic also backed away from its adoption. Theranos initially went into bunker mode, trying to rebut the thrust of the critical articles rather than dealing with the substantial questions. It was not until October 27 that Ms. Holmes finally agreed that presenting the data that the Nanotainer worked as a reliable blood testing device would be the most “powerful thing” that the company could do. It is entirely possible that the data that the company has promised to deliver will be so conclusive that all doubts will be set aside, but it does seem like the spell has been broken. 

The Lessons
Looking back at the build up and the let down on the Theranos story, the recurring question that comes up is how the smart people that funded, promoted and wrote about this company never stopped and looked beyond the claim of “30 tests from one drop of blood” that seemed to be the mantra for the company. I don’t know the answer to the question but I can offer three possible reasons that should operate as red flags on future young company narratives:
  1. The Runaway Story: If Aaron Sorkin were writing a movie about a young start up, it would be almost impossible for him to come up with one as gripping as the Theranos story: a nineteen-year old woman (that already makes it different from the typical start up founder), drops out of Stanford (the new Harvard) and disrupts a business that makes us go through a health ritual that we all dislike. Who amongst us has not sat for hours at a lab for a blood test, subjected ourselves to multiple syringe shots as the technician draw large vials of blood, waited for days to get the test back and then blanched at the bill for $1,500 for the tests? To add to its allure, the story had a missionary component to it, of a product that would change health care around the world by bringing cheap and speedy blood testing to the vast multitudes that cannot afford the status quo. The mix of exuberance, passion and missionary zeal that animated the company comes through in this interview that Ms. Holmes gave Wired magazine before the dam broke a few weeks ago. As you read the interview, you can perhaps see why there was so little questioning and skepticism along the way. With a story this good and a heroine this likeable, would you want to be the Grinch raising mundane questions about whether the product actually works?
  2. The Black Turtleneck: I must confess that the one aspect of this story that has always bothered me (and I am probably being petty) is the black turtleneck that has become Ms. Holmes’s uniform. She has boasted of having dozens of black turtlenecks in her closet and while there is mention that her original model for the outfit was Sharon Stone, and that Ms. Holmes does this because it saves her time, she has never tamped down the predictable comparisons that people made to Steve Jobs. If a central ingredient of a credible narrative is authenticity, and I think it is, trying to dress like someone else (Steve Jobs, Warren Buffett or the Dalai Lama) undercuts that quality. 
  3. Governance matters (even at private businesses): I have always been surprised by the absence of attention paid to corporate governance at young, start ups and private businesses, but I have attributed that to two factors. One is that these businesses are often run by their founders, who have their wealth (both financial and human capital) vested in these businesses, and are therefore as less likely to act like “managers” do in publicly traded companies where there is separation of ownership and management. The other is that the venture capitalists who invest in these firms often have a much more direct role to play in how they are run, and thus should be able to protect themselves. Theranos illustrates the limitations of these built in governance mechanisms, with a board of directors in August 2015 had twelve members: 
  4. Board MemberDesignationAge
    Henry KissingerFormer Secretary of State92
    Bill PerryFormer Secretary of Defense88
    George SchultzFormer Secretary of State94
    Bill FristFormer Senate Majority Leader63
    Sam NunnFormer Senator77
    Gary RougheadFormer Navy Admiral64
    James MattisFormer Marine Corps General65
    Dick KovocovichFormer CEO of Wells Fargo72
    Riley BechtelFormer CEO of Bechtel63
    William FoegeEpidemologist79
    Elizabeth HolmesFounder & CEO, Theranos31
    Sunny BalwaniPresident & COO, TheranosNA
I apologize if I am hurting anyone’s feelings, but my first reaction as I was reading through the list was “Really? He is still alive?”, followed by the suspicion that Theranos was in the process of developing a biological weapon of some sort. This is a board that may have made sense (twenty years ago) for a defense contractor, but not for a company whose primary task is working through the FDA approval process and getting customers in the health care business. (Theranos does some work for the US Military, though like almost everything else about the company, the work is so secret that no one seems to know what it involves.) The only two outside members that may have had the remotest link to the health care business were Bill Frist, a doctor and lead stockholder in Hospital Corporation of America, and William Foege, worthy for honor because of his role in eradicating small pox. My cynical reaction is that if you were Ms. Holmes and wanted to create a board of directors that had little idea what you were doing as a business and had no interest in asking, you could not have done much better than this group of septuagenarians.

My sense of Ms. Holmes's unquestioned authority was reinforced when I read a December 2013 letter that she sent to investors in the company, asking them to agree to a five for one stock split and the creation of two classes of shares with different voting rights (class A would have one vote per share and class B would get 100 votes per share), with Ms. Holmes retaining the voting shares and voting control of the company. Lest I be accused of being sexist in begrudging her this power, I have been just as harsh in my assessments of Mark Zuckerberg (with Facebook) and the Brin/Page duo (with Google) for their desire to raise money from investors but not give them a proportional say in how the business gets run, and Ms. Holmes has not quite earned the rights (that Zuckerberg and Brin/Page have claimed) to be a corporate dictator.

Bottom Line
I would like to believe that I would have asked some fundamental questions about the science behind the product and how it was faring in the FDA approval process, if I had been a potential investor or journalist. However, it is entirely possible that listening to the story, I too would have been tempted to go along, wanting it so much to be true that I let hope override good sense. Some of my worst mistakes in investing (and life) have been when I have fallen in love with a story so much that I have willed a happy ending to it, facts notwithstanding.

The question of whether Theranos makes it back to being a valuable, going concern rests squarely on the science of its product(s). If the Nanotainer is a revolutionary breakthrough and what it needs is scientific fixes to become a reliable product, there is hope. But for that hope to become real, Theranos has to be restructured to make this the focus of the business and become much more transparent about the results of its tests, even if they are not favorable. Ms. Holmes has to scale back many of her high profile projects (virtuous and noble though they might be) and return to running the business. If the Nanotainer turns out to be an over hyped product that is unfixable, because it is scientifically flawed, Theranos has a bleak future and while it may survive, it will be as a smaller, low profile company. The investors who have put hundreds of millions in the company will lose much of that money but as I look at the list, I don’t see any of them entering the poor house as a consequence. There is a chance that the lessons about not letting runaway stories stomp the facts, never trusting CEOs who wear only black turtlenecks and caring about governance and oversight at even private businesses may be learned, but I will not hold my breath expecting them to have staying power.

YouTube Version

Blog Posts in this series
  1. Divergence in the Drug Business: Pharmaceuticals and Biotechnology
  2. Checkmate or Stalemate? Valeant's Fall from Grace
  3. Runaway Stories and Fairy Tale Endings: The Theranos Lesson
  4. Value and Taxes: Breaking down the Pfizer- Allergan Deal


Rahul said...

Dear Prof Damodaran,

You have summed it up so well that there is not much too add. May be one thing - Sometimes all the companies need to do is sell Powerpoint presentations. There is such a big appetite for this product that people get delusional and think it is the actual product. Oh one more thing- with holidays around the corner, sometimes the gift wrapping is more exciting than the product itself.

I don't mean to undermine the importance of revolutionary approach to addressing healthcare issues but I do object to calling the revolutionary idea the product itself.

best, rahul.

Anonymous said...

Great post. We've been actively following and working backwards from the glowing, almost irrationally exuberant Theranos narrative since the WSJ articles and the ensuing fallout (and that has been remarkable - a total reconstitution of the board, terminations or withdrawals from partnerships, the notable failure to release data despite an indication the company would do so, FDA instructions about stopping the use of ineffective or unreliable tests, etc.). Your comment that "[w]ith a story this good and a heroine this likeable, would you want to be the Grinch raising mundane questions about whether the product actually works?," is what particularly struck us. Rather than discouraging more skepticism, we found that the whole "story" seemed steeped in hyperbole and near fantasy and merited even more scrutiny. And that's the thing about real, hard science - you just can't fake it. Either the technology works or it doesn't. How Holmes and her backers (we personally think that it was one of her professors at Stanford that set up the whole thing) were able to continue what appears to be a charade for so long, attracting massive amounts of venture capital and an absurd valuation in the process, continues to surprise us.

steve said...

Since this may be more storyland then reality i will only say this: Once upon a time so called sophisticated investors engaged in an activity called "due diligence". It all seemed to come to a stop with the development of the spreadsheet and powerpoint which can make any proposal look good. It is unfortunate that those who engaged in old fashion due diligence probably are older than the members of this Board, assuming they are still with us.
It is shocking that no one has seen independent verification of the reputed results of the Company's product before investing a single dollar.

Lesson to all: Do your homework, and keep in mind a spreadsheet and powerpoint presentation can sing any song the artist wishes it to sing; it is how you hear and question the song that counts

Anonymous said...

Dear Professor,

I agree with much of what you have written in your blog post. I would like to clarify one point, however. You (and many others) make reference to the “Nanotainer” as the so-called revolutionary product that requires additional scrutiny. The Nanotainer is a red herring. Although it is an integral part of the testing process and does require FDA approval, the collection tube is just that: a collection tube. The real scientific scrutiny should be focused on the testing methodology--Edison, or whatever other supposedly proprietary analyzer they claim to be using for all this small-volume testing.
It’s a shame that the situation with this company got to a point that people are pointing out the “red flags” in hindsight. As a pathologist and laboratory director, I was highly skeptical about this company when it first hit the news two years ago. Even then, it was fairly obvious to me and to my colleagues that their claims were at least grossly exaggerated, if not blatantly false. The fact is, unless Ms. Holmes has rewritten every chemistry, hematology, microbiology, and molecular textbook, the things she is claiming to be able to do on a single testing platform are simply not possible. That this was obvious to those of us in the field speaks to the fact that investors need to do their research. Ask someone who actually knows something about the science (in this case, a pathologist/laboratory director would be a safe bet) before investing in a biotech company making grandiose claims. It will save a lot of hand-wringing and questions of “how could we have known?” down the road.
Tess Karre, MD

Obu Sama said...

Dear Prof,

I would rate this article very highly amongst most of yours. Its unlike your other articles with data and focus on valuation but an article worth front page read/editorials on WSJ/business papers. Very memorable and impactful on the readers

Anonymous said...

The investors identified are smart and successful people and organizations. Why, How and Who hoodwinked them should make a fascinating story. Perhaps you can create a "Bernie Madoff" prize and award it to this master con-man!

Anonymous said...

Just want to second what steve already said:
Once upon a time so called sophisticated investors engaged in an activity called "due diligence".

I've seen and heard some VC "due diligence", I've been the guy who presented for the startup, and to a mere mortal that "due diligence" seems shamefully shallow, it wouldn't pass muster as an audit for one second. Even so, one has to assume that all the VCs know what there is to know about Theranos, as well as most or all of the employees. If that knowledge is that it's been no more than a fantasy from day one, then, well, what's wrong with a little fantasy, hey? Who would have thunk that 140 character messages would work so well? LOL

Shan said...

Taking a step back, the real reason such things are happening is because of the incentives. If your PowerPoint presentations and black turtlenecks can make you a billionaire wouldn't you go for it? I would. I bet most everyone would take the chance. The payoff is just way too high. In fact, in a capitalistic society, not taking such a chance is a failure by itself. I don't blame a 19yr old for having starry eyed dreams. We were all dreamers in that age. And I don't blame the VCs for funding her either. It's a calculated risk. If the VCs don't fund such moon shots, who will? It's in their charter to fund disruptions knowing fully well that 90% of such companies fail.

As long as no fraud has been committed and no laws broken, this is all business as usual. How many politicians have gone to jail for not keeping their promises? It's the same with entrepreneurs. Blaming them for making promises is pointless.

Anonymous said...

Dear Mr. Professor,

Your analysis doesn't make any sense and is not up to the mark. There are many reasons for that:

1. Nanotainer is just one of the technologies developed by Theranos. There are various chemistries, hardware and software all of which are proprietary to Theranos which has been kept secret to protect Intellectual Property. However all these technologies are not secretive to the regulatory bodies like CLIA (which certified Theranos way back in 2011) and now FDA to which Theranos has been submitting data about their tests. How was Theranos able to be CLIA certified or how could FDA approve the Herpes HSV test using fingerstick and other proprietary technologies if it was inaccurate? Can you explain please?

2. Talking about her attire is really petty (as you yourself have pointed out). Did Steve Jobs had a exclusive right on wearing black turtlenecks? It was only overly excited media's doing that when someone is successful they try to focus on the trivial aspects of their life like they did with Steve Job's personal life or Holmes's black attire.

3. About the Board - The particular group of people on the board of directors are there for a very good reason whether they be Kissinger, Schultz, or others. The healthcare space is highly regulated and stuck in the old ways. The extraordinary group of people in the board at Theranos are there for their tremendous strategic insights in public policy. As for the absence of doctors or scientists in the board, the company has a lot of PhDs who can take care of the technological and medical aspects of the company. Do you think it's so easy to fool the legendary Professor Channing Robertson of Stanford into joining Theranos? (Do you know that earlier he testified as an expert in case against Big Tobacco). All these people have lifetimes of reputations to worry about. I don't think they would have joined Theranos had it not got major breakthroughs in technology.

Unknown said...

You made a point. In complete agreement. Such things are more about systemic failure. Incentives have been a major reason for risk taking. The problem is that risk is not proportionately distributed across all risk takers. Highest payoff is associated with lowest risk and viceversa.

Aswath Damodaran said...

1. How do we know about all these other technologies that you talk about? The company is run like a CIA operation, secretive and closed. Perhaps, you are on the inside and know about these technologies, but are any of them blockbusters? (If not, the $10 billion value does not fly.
2. No. It is actually the other way around. People dress up like Steve Jobs for media attention and Ms. Holmes seems to have pushed the Jobs comparison implicitly and explicitly. If you are telling a story that you want me to believe, I am more likely to do so, if you are just being yourself.
3. I don't think that this even deserves a response. What type of strategic insight are you getting about being a health care company from a 92-year old Henry Kissinger or a 94-year old George Schultz? As for the legendary Professor Channing, I will let him address the question of what it is about the story that he found alluring and why it got so out of control.

Anonymous said...

Do you know that Holmes helped to draft a legislation that became law in Arizona empowering individuals to order their tests directly without required requisitions from physicians? Kissinger n Schultz have lifetime of valuable goverment experience to give Holmes appropriate advice in changing the system. Is it so difficult to fathom that those people could have valuable insights? Do you believe people aged 90+ are brain dead and nothing valuable to contribute?

Anonymous said...

What is your answer to FDA approval of Herpes HSV test using Theranos proprietary technologies? Isn't that a validation of their technolgy for atleast one test? And it makes logical sense that more tests would become approved. They had the confidence to submit data to FDA for 120 more tests whose results would soon be visible to the whole world. You don't do that if you are not sure about the integrity of your technology. Also Holmes has been very vocal about FDA oversight of Lab developed tests which traditional lab companies are actively resisting (as they are already CLIA certified). If Theranos was a scam, would Holmes go for such unprecedented support for regulation?

Unknown said...

HI Aswath,
Talking as a chemist, what Theranos is claiming with sample volumes may be technically unfeasible. The fact that they haven't published much in the literature gives me a serious pause. If one has a good patent estate, there is very less reason to maintain such secrecy.

We chemists (be it in big companies like Quest or Lab Corp. or in new/smaller ones like Theranos) are always trying t o reduce sample volumes. This is nothing new for us. The problem is if you cut corners in sample volumes, you cut corners in quality (after a certain limit).

Something doesn't add up putting on a trained scientist hat.

Mayank J. said...

Hi Aswath, After reading your post I came across this post The author claims to have taken a test at Theranos and states that the results were inexplicable, especially the huge divergence with the results from more prevalent tests. It is a single person account so can not be used to draw a general conclusion but thought of sharing with you and your readers.

Unknown said...

Anonymous, the point is why is there so much unnecessary secrecy? The best disinfectant is sunlight. Also, the best way to protect IP is through enforceable patents.

If they can't get patents granted because Theranos approaches are too obvious or are following prior art, that is different. Lets be real, nanotainers are just collection tubes, call it any name you want, I will call it Rockettainer or Spacetainers, just joking-but it is no different from an Eppendorf tube we have used for eons, just smaller volume. What SW and hardware solutions, robotic liquid handling systems have been around for decades that can manipulate samples to low microlitre amounts. Did Theranos reinvent/improve these systems? May be they did.

Publish so that the world can look at the brilliance of your innovation. Shut our mouth's up with data- that is the cool way to prove innovation. Why do we need to ascertain innovation/reliability based on anecdotal "submission to FDA" or "press releases". There is a system in place for peer reviewing and accepting/crediting innovation.

Anonymous said...

The only thing that I'll add.. is there competition among VC's to get in and close the deal? If so that might be a contributor to the lack of due diligence. "Yeah Yeah I know.. but Theranos is hot. If we don't invest someone else will and then we can't get a piece!" From day one it read like its doing the impossible, innovation by cutting corners. Not having an ex-Pathologist or ex-Director of Clinical Laboratory operations from a national lab network is a HUGE red flag.

Unknown said...

Have you heard about the Mast Brothers Chocolate story? It's uncanny how many parallels there are with the Theranos story. Here is a summary.

The detailed exposé is here. I found Part 2 and Part 4 particularly interesting in light of the Theranos events.