Books #7: Bad Blood, Secrets and Lies in a Silicon Valley Startup

Bad Blood depicted the story of Theranos from its inception to its bankruptcy over the span of 15 years. At the heart of the story was Elizabeth Holmes, the blue eye blonde who dropped out of Stanford to start her healthtech company aimed on revolutionizing blood tests. Alas, it was all a big fairy tale as Theranos never had any breakthrough technology nor the culture to bring anything together. It was a slow motion corporate train wreck and a cautionary tale with many lessons for investors to learn from.

For those who aren't familiar, Theranos was another Silicon Valley startup trying to change the world. But it's not like the typical tech or internet startup with a new business model. Healthcare is not software or e-commerce. It directly affects people's lives and is tightly regulated. Elizabeth Holmes believed she was destined to change how blood tests were performed after she experienced SARS in Asia. She saw firsthand how people suffered during the early months of 2003 when SARS broke out. There weren't enough nurses to draw blood, nor blood analyzers that could process results faster enough. Nurses and doctors themselves succumbed to the deadly disease. Hell broke loose and a lot of people died. She happened to be an intern in the middle of all this, in Singapore! That's when she thought the world needed a blood analyzer that could give results with one drop of blood.

She truly believed the world needed better blood tests to save lives and she was the messiah.

But vision has to be grounded in reality. She, her partner, or rather partner-in-crime and her board did not have the experience nor the technical background to understand it would not be possible without years of R&D. For most of us going through routine health checks, the dreadful blood test required 3-4 vials of blood drawn from our forearm's veins. Just simply going by blood volume, to reduce vials to drops of blood required for the tests meant a 100x improvement, very roughly speaking. It's a moonshot, using Google's lingo. Yet, this is healthcare, not software. It would take years, or even decades to achieve these results.

It might still be possible if one had the amount of resources to throw at the problem. Silicon Valley had the money, the talent and the drive and grit to do all that. But Theranos was a different story. It was led by a 19 year old university dropout and a super villain. For reasons unclear, Holmes fell in love with this Sunny Balwani who would wreak havoc in her company, randomly firing people and threatening ex-employees with lawsuits. The culture became toxic, good people left. Bad people thrived. Evil deeds were condoned. It was just crazy.

Sunny and Holmes

As the author of the book put it though, ultimately it was Holmes. She had the last say in almost everything. She endorsed the tyrant and all his despicable actions. So, when a villain is protected by a queen (or a king), then it's game over. Reading the book provided the revelation how warped our society had become. It took so much for this incredible story to come out because powerful people with money and connections played with justice. Imagine all the other stories where the villains are still controlling peoples' lives. As individuals, we have to be able to recognize these situations fast and move on. Well, unless we have the means to bring them down, like having lawyers with bigger guns or strong connections to powerful media like the Wall Street Journal.

As investors, there were also important lessons. The first one relates to stories with all the rainbows and unicorns that had dulled our senses. In recent years, we heard so many rainbow stories and saw so many unicorns and wondered why hasn't one landed in our own portfolios. As such, we suffered from the fear of missing out (FOMO) and forgot to be vigilant. Last count, we have over 452 unicorns according to techcrunch.com. 

The Unicorn Leaderboard now lists 452 companies, which have collectively raised $345 billion and represent a cumulative valuation of $1.6 trillion. Go back to February 2018 and there were just 279 companies, with $206 billion raised and valued at $1 trillion. In just 15 months 170+ companies reached unicorn status, raised $140 billion more and added $600 billion in company valuations.

Rainbows and Unicorns back in 2017

Unicorns were supposed to be so rare that we don't get to see one in decades inside fairy tale stories. Yet today, it's everywhere, in our real world. How many have real gamechanging technology? How many doesn't really have anything, like Theranos? How do we tell which unicorns are real unicorns? Despite having luminaries such as George Shultz and Henry Kissinger on its board, Theranos was a fraud. If the board didn't know, how could investors have an edge?

So here's the last lesson from the book - nothing beats boring due diligence. We cannot trust the board in private companies. We cannot trust fellow investors to do their homework. In private equity investing, we like to look at what's call the cap table - who else has invested. We like to think these other smart investors would have done their homework. We like to think the board would have done their job. The Theranos story tells us otherwise. 

Nothing beats boring due diligence. We have dig through the dataroom ourselves. We have to go further still, tumbling down the rabbit hole. Talk to past employees, find the financial models that value stock options for rank and file employees, scrutinize management and be very careful of companies that keep talking about trade secrets and proprietary technologies. 

It's hard work. Blood and sweat. Still, there's not guarantee we can live happily ever after. Welcome to wonderland and happy unicorn hunting!

Charts #26: If all of us exercised...

Did this crazy calculation some time back.

If everyone did nothing but exercise, we can produce 9% of the world's energy!

People, Management and Networking - Part 1

Investing is fascinating because it touches so many facets of life. We need to know finance, we need to understand business models. But that is not enough, we have to look out for trends and what are the new innovations in life and in society. Finally, we also need to look at people and culture.

People, or rather relationships, play complex roles in both business and life. We can read a book and learn a few lessons, but most of them are just being understood at a very surface level. When the same lesson is shared via someone's life story, it gets reinforced. Often, if the same lesson is shared by a mentor, a guru or someone we highly respect, then we tend to absorb and follow the instructions given or are in the much better state to avoid the mistakes altogether.

That's the power of relationships and understanding people.

In analyzing companies, we need to look at the people running them ie the management. The same relationship rules apply and we need to understand some of these dynamics at play. Who is in charge? Is it a dictator or does he has a team? Who are the top lieutenants and what are their backgrounds? How do these senior executive present themselves? Do they even bother to meet investors? Is the company culture healthy or toxic? These are people questions that shrewd investors have to ask.

Having said that, Warren Buffett made the famous saying about people and business model:

"When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."

This is obviously very true. While people is important, what's more important is the business model and the business moat. Nucor comes to mind. Nucor is in the steelmaking business. It is a very bad business because there is a lot of competition and steel is a commodity. Nucor's management is known for brilliance and has relentlessly improved the company's competitiveness and created good shareholder return.

As shown above, it's share price has compounded nicely from $12.45 to $54.85 over 20 years. Part of it was helped by the commodity super cycle during 2005-2009 when China drove up most of the world's demand for steel, copper and other hard commodities. Without which, Nucor's performance would have undoubtedly suffered. So, while Nucor's performance is great, it's only in the same ballpark as the S&P500 which grew from 1,100 to 3,050 over the same time frame.

In a nutshell, analysis of the business model always takes priority. Once we figured out it's a good business, it's more than 50% of the work done. A good business generates strong cashflow and strong returns for investors. Then we think about people and management. As discussed in previous posts, the first thing about management is integrity. If management cannot be trusted, then we cannot do any more analysis right?

So assuming management is trustworthy, we can then look at the team dynamics, the board composition, succession planning, track record and all the other stuff. For young companies, it might also be worthwhile to look at who's in their circles. Who are their mentors? Are they looking up to the right people and getting the right advice? What do the past teammates say about them? Who else are in their networks? These are all part of the analysis.

By analyzing networks, we can gleam insights into companies.

The internet age has not reduced the power of networks. We can have 1,000 friends on Facebook, some celebrities have millions of followers and some posts can have 10,000 likes but we still go back to people we trust. We still rely on the word of mouth. Networking continues to be an important part of investing and life.

So while we analyze the companies' networks, we also need to build our own network. Who are the fellow investors that we are talking to? How many investing networks do we have? By having the right people in our network, we stand to gain so much more. This is a very tedious process. Networks are hard to build. It takes years to build the trust and friendship. It is also important never to break that trust.

Human relationships are probably one of the most complex and least understood fields in life. In the next post, we shall try to breakdown networking into its most basic building blocks and understand how that can help us become better investors and also better people.