BOOM OR BUST

Theranos exposes the perverse incentives at work in Silicon Valley

Theranos, the health technology company once valued at $9 billion, is making its investors’ blood run cold.

The business founded by Elizabeth Holmes 13 years ago promised to use finger-pricking technology to make blood testing faster and more accessible. Yet while Holmes has landed covers on Forbes, Fortune, and Inc., her company has yet to produce a working product. In January, an investigation by the US Centers for Medicare and Medicaid Services found that the company’s finger stick was unreliable and included deficiencies that posed a threat to patient safety. The Center is currently scrutinizing the company for a host of failures to comply with regulations. Meanwhile, the Department of Justice has opened a criminal investigation against Theranos as well, and the Securities and Exchange Commission is investigating the accuracy of the company’s disclosures to investors as it raised $700 million. The company’s apparent practice of cutting corners undermines confidence in everything it does, from the accuracy of its devices to how it is protecting the medical records it collects.

While the rise and fall of Theranos has been dramatic, it is far from a rare case. In fact, it illustrates the perverse incentives faced by every startup in Silicon Valley. As bad as these incentives are for investors, they might be even worse for consumers.

Many people in Silicon Valley aren’t interested in drawing lessons from Theranos. Instead, they’re trying to distance themselves from the backlash. This perspective was supported by a recent op-ed in the New York Times, in which columnist Randall Stross argues that the overvaluation of Theranos had nothing to do with systemic problems in startup investment. Sophisticated venture-capital firms that invest in life sciences passed on Theranos’s pitches, he says. It was the media and trend-seeking investors who were fooled.

But this account overlooks an obvious issue. Something is wrong with an investment model in which tech companies can raise hundreds of millions of dollars out of thin air, and lose it just as quickly.

Investors in Silicon Valley are, by and large, not in the game because they hope to help entrepreneurs build businesses. They’re playing roulette, and hoping to win big. But it takes time to build a sustainably profitable business, and Valley investors want rapid, stunning growth. In the search for the next “unicorn”—a privately-held $1 billion startup—investors prioritize exponential returns over lasting results.

As the Theranos controversy shows, the pressure to grow quickly leads companies to take shortcuts and engage in sloppy practices—and sometimes outright fraud. Take Zynga, the gaming company responsible for Farmville, which has earned the moniker “Scamville” for its allegedly deceptive advertising. The co-founder of Zynga, Mark Pincus, famously said, “I knew I needed revenues…. Like I needed revenues now. So I funded the company myself but I did every horrible thing in the book … just to get revenues right away.” While Pincus, incredibly, made this statement in public, he expressed the private sentiment of countless entrepreneurs faced with the ticking of the VC clock. (Disclosure: our law firm, Edelson PC, has brought class-action lawsuits against Zynga and some of the other companies mentioned below, but not for the conduct discussed in this article.)

This is bad for investors, including venture investors who care just about growth. (Fraudulent companies are, at best, an unreliable source of revenue.) But the reckless pursuit of growth often comes at consumers’ expense as well. That’s because the way that companies grow rapidly is to expand their user bases by hook or by crook, in a process called “growth hacking.”

One of the most common examples of this involves “spam-viting,” or hijacking a consumer’s contact list to blast them with text messages or emails, knowingly in violation of various federal and state statutes. Companies spam-vite because it works. Sending millions of text messages or e-mails to consumers, dressed up as if they came from those consumers’ friends, is a viable, illegal way to grow a business quickly. LinkedIn, for example, settled a lawsuit for $13 million over its practice of repeatedly sending “add connections” emails to a new user’s entire email contact list. And TextMe, a text-based social network, generated its growth by sending a large volume of text messages to new user’s phone contacts, although it eventually won its legal battle with the Federal Communications Commission.

The pressure to growth-hack begets pressure to disregard the law, at least temporarily. A similar pressure explains why, for example, so many minor league baseball players were using steroids during the height of the doping era in baseball. Everyone was doing it, and there was just no way to get to the majors unless you cheated, too.

Now we’ve created a system in which startups are tempted not to serve their users but to treat them carelessly. We’ve almost grown accustomed to losing our privacy for the sake of LinkedIn or Facebook. But as accusations against Theranos show, medical tech companies responding to investors’ incentives could lead us to lose something far worse.

We welcome your comments at ideas@qz.com.

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