What investors are really thinking when a unicorn startup implodes

Just when you think things can’t get any worse for Elizabeth Holmes — they do.

The 32-year-old founder and CEO of Theranos, Holmes withstood months of negative press about her questionable blood testing technology. Now her startup is the target of a full-blown federal criminal investigation and official inquiry by the Securities and Exchange Commission.

Both the government and the SEC want to know the same thing: Did Holmes lie her way into a $9 billion valuation?

To anyone outside of the Silicon Valley bubble, the Theranos fallout is not only hard to believe, but hard to understand. How could a startup with nearly $100 million in funding potentially be a giant fraud? How could her investors not see the writing on the wall before the SEC started banging down the door? I talked to some prominent venture capitalists to get their take on how they deal with a Theranos-like implosion. Obviously, VC is built for failure: their entire business model assumes 9 of their 10 investments will tank. But that 10th, if it’s a Facebook or Uber, can produce life-changing fortunes.

Still, there’s a massive chasm between watching your investments run out of cash (say, Homejoy or Shuddle) or seeing its big idea turn out to be a small one (for instance, Path or Whistle) and watching your star investment land on the front page of the WSJ for all the wrong reasons.

“When we get started in any one of these ventures, we think they are going to change the world and that they are going to be large public platforms,” said Kleiner Perkins General Partner Ted Schlein. “The reality is that most do not — that could mean anything from shutting them down or finding them another home.”

Theranos’ extraordinary burnout couldn’t have come at a worse time. As Benchmark General Partner Bill Gurley outlined in a post last week, we are witnessing a “fundamental sea-change” in venture capital fueled by the excessive amount of capital that investors poured into the market last year. To survive, Gurley advised unicorn startups to get cash-flow positive as quickly as possible, a reality that looks more and more impossible for Theranos as the days pass by.

None of the investors that I spoke with put money behind Theranos or would talk about the startup directly: The blood-testing startup is famous for having no big institutional VCs on board. Still, their comments paint a clear picture on the dangers of backing a high-flying startup in boom times.

‘Almost nothing is in your control’

Every investor I spoke with started our discussion with some version of the same truth: Almost nothing in venture capital investing — particularly in early stages — is in your control. I asked all the investors I interviewed how often an investment goes “according to plan.”  Unilaterally, they said never.

“You never make an investment thinking that the founders won't succeed,” echoed Homebrew partner Hunter Walk. “But you have to be comfortable with a tremendous amount of the unknown.”

Greylock Partner Josh Elman broke the unknown of venture investing into three big bets: Does the startup occupy a growing investment space? Can the founder’s specific concept own a lion’s share of the market? Does the founder have what it takes to get the company there?

If the VC is confident that the answer to all three of those questions is a yes — as it likely was when investors decided to back Theranos — then the company might make sense for the portfolio.

“You have to believe that they can build something that no one else has,” Elman said simply. “As an investor, you can only pick the journey you go on — not necessarily where that journey goes.”

You can’t be everywhere at once.

Investors do a healthy amount of due diligence on a startup — but they can’t know everything. Jenny Lefcourt of Freestyle Capital cited market research as a big part of her job, but said leaps of faith must always be made. “All investments have risk and the best investors have clarity about which risks they are taking on, and why they are comfortable making them,” she added.

The most active investors sit on the board and can try and impact a startup through influence, but ultimately the management team is in charge, explained Redpoint Partner Tomasz Tunguz of Redpoint. “You can help recruit and offer ideas, but you're just opening the door and ultimately it is up to the management team and the company to close it,” he said.

To avoid being blindsided with problems, the best an investor can do is stay in relatively constant communication with their teams. Yet not being around for day-to-day operations means he has to trust that his portfolio founders aren’t participating in any shady behavior, explained Greylock’s Elman.

“You can look at as many materials and have as many conversations that you can, but if people are being fraudulent, you can’t know everything that is happening,” Elman said. “It’s like a marriage. There are cases of infidelity where you have no idea.”

Hyper-growth means sticky stones left unturned.

In the pursuit of investing in ideas that can “change the world,” finding the line between “white lies” and “real lies” can be tricky. One investor equated the regulatory issues at Theranos to those that Uber and Lyft faced against the traditional taxi industry. Investors continue to herald Uber and Lyft as great companies, even though in many cases their operations are breaking laws (as they’re currently written).

In the case of Theranos, it’s clear that the startup has crossed the line — trying to figure out where that line is crossed is the challenging part when you’re creating a new market.

“This is all super gray,” he said.

Unlike the public market which is regulated by standardized reports, metrics and third-party auditors, the early-stage private market is “built on trust” that required a heavy dose of skepticism, points out Meritech Capital General Partner Max Motschwiller. When a founder sends him over an income statement or user metrics, Motschwiller is constantly thinking about mistakes -- intentional or not -- that could have been made in those calculations.

“Given the lack of regulation, pitching [a startup] can cross the line into dishonesty or fraud,” he said. “We are all taking a leap of faith in this business, thankfully most entrepreneur’s intentions are honest.”

By the time you smell smoke, it’s too late.

There are cases where an investor might try and pull out entirely from an investment, but those are very rare. Even if it became clear that a founding team misled its investors about its technology or growth — as might be the case with Theranos — most of the investors I spoke with said those issues are viewed as sunk costs. About a third of term sheets have what’s called a redemption clause — it allows investors repurchase their shares if a startup takes a turn for the worse — but they are rarely exercised. By the time the move makes sense, there typically is no money to be paid back.

“I do not personally know of a case of this happening. The process is tedious, expensive and, I would imagine, not fruitful,” said Lefcourt.

If a startup gets to a point where it is at risk of not surviving, there is a high likelihood that the investors just haven’t been paying attention. At any given moment, Walk of Homebrew says he is aware of at least one founder who is dealing with a big problem. His job is to figure out when to let the founder work it out for himself and when to “sound the alarm.”

“I equate it to parenting,” he said. “If I have a 4-year-old, I want to teach her lessons. But if there is a piano about to fall on her, I am not going to try and tell her about gravity. I’ll push her out of the way.”

During down market times, there are even more pianos falling out of the sky. When I pointed this out, most of the VCs turned to a now cliche phrase: “Good companies can be started at anytime.” Pointing to uber-successful startups like Airbnb that were founded during the last recession, investors are quick to say that the biggest stars in their portfolio can withstand even the biggest market challenges.

If you take that logic and extend it to the hopes Silicon Valley had for Theranos just a year ago, perhaps Holmes and her blood-testing technology will surprise us all.

“Great companies will become great companies,” said Elman. “If you have something meaningful that you are doing, they will figure it out.”