What Indian startups must learn from fallen unicorn Theranos

Holmes, once hailed as the “next Steve Jobs,” dropped out of Stanford to start Theranos in 2003 when she was just 19 years old. His revolutionary ‘Edison test’ for diagnosing disease promised to detect cancer and diabetes without the use of needles, and with only a small amount of the patient’s blood at a fraction of the usual cost and time taken by traditional technology. By 2010 , having received several rounds of funding, Theranos had achieved the status of a unicorn, valued at over a billion dollars.

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How much of its unicorn status was the result of investor gullibility, and what role did a marquee board play in creating this unicorn?

Most investors in Theranos were likely driven by loss aversion and fear of missing out on one of the “rising stars” among Silicon Valley startups, especially in the context of the interest shown and investment of high-profile investors. The latter included media mogul Rupert Murdoch, who had led a Series A funding round as early as 2005, as well as others such as Oracle founder Larry Ellison and American retail and pharmacy chain Walgreens.

Such investments by supposedly tough businessmen and executives can be explained by resorting to the concept of “representativeness heuristics,” a mental shortcut that involves estimating the probability of an event by comparing it to an existing prototype that already exists in the mind. The prototype is then considered the most relevant or representative of a particular event or object. Holmes’ status as an Ivy League Stanford college dropout, having spent two semesters in chemical engineering, likely led investors to overestimate the likelihood that the Holmes-backed Theranos would become the “next great unicorn.”

Such representativeness heuristics may have been responsible for “base rate bias,” in which investors ignored the fact that Theranos technology had never been submitted for peer review in medical journals. ‘Gullible’ investors appear to have paid little attention to a statistical base rate, namely the new technique success rate, which for some drugs can be as low as 1%. Instead, they displayed the typical human tendency to look for causal base rates and patterns. In such a world, successful startups would be ’caused’ by restless young minds dropping out of universities to create unicorns, as in this case.

Added to this heuristic can be an overconfidence bias, causing fund managers and investors to become careless, due to false and misleading assessments of their own skills, intellect or talent. What else can explain the fact that the company not only became a unicorn, but reached a peak valuation of $10 billion in 2015, despite Holmes’s clear inability to explain

Theranos technology? In fact, even as he explained this supposed innovation as “the chemistry is done so that a chemical reaction occurs and generates a signal from the chemical interaction with the sample, which is translated into a result, which is then reviewed by certified personnel from the laboratory”, failed to arouse sufficient suspicion among investors.

Theranos’ board was made up of several household names, including former US Secretaries of State George Shultz and Henry Kissinger, former US Secretary of Defense William Perry, and former CEO of Wells Fargo & Co, Richard Kovacevich, as well as former US Navy admirals and other senior defense personnel. Holmes’s need to assemble such a board is not surprising, given that the company planned to sell its blood-testing devices to the military.

Yet why do such illustrious people fail their vigilance, refuse to speak up when faced with damning evidence of failure, and continue to back a nefarious company with questionable technology? One of his whistleblowers, Tyler Shultz, was a Theranos board member, a grandson of George Shultz. Tyler had been convinced of wrongdoing at the company within months of starting work at Theranos. However, when he raised questions about shoddy quality controls and rigged research at Theranos, he faced resistance within his own family. His grandfather chose to ally with Holmes and Balwani, causing a family rift. Similarly, one of the other investors, Tim Draper, remained an outspoken supporter of Theranos until 2018.

Individual investors and boards made up of well-known and reputable individuals, such as Theranos, can fail to prevent such fraud due to a variety of biases, heuristics, and societal pressures affecting their judgment. The hyperbolic discounting cognitive bias, for example, leads to the threat of reputation loss being seen as a mere probability in the distance, in contrast to the actual chances of instant gratification or rewards through greater board re-election. valuation gains, contract renewals, etc. In the broader field of healthcare, the famous Tylenol case demonstrates how the human preference for immediate gratification, coupled with insufficient consideration for possible future negative consequences, can lead to disastrous consequences.

Board members, investors, auditors, and other governance stakeholders of start-ups, and indeed large companies as well, need to understand the limitations of the traditional approach to corporate governance, based simply on solving the so-called principal-agent problem. Corporate India will need to invest in understanding behavioral corporate governance, as Theranos-type breaches, far from being the exception, can become the rule even as we toast ‘India Home’.

Tulsi Jayakumar is Professor of Economics and Executive Director of the Center for Family Business and Entrepreneurship at SPJIMR Bhavan.

These are the personal opinions of the author.

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