The top lessons investors should heed from Theranos and FTX

You could say this is a big week for failed start-ups. Elizabeth Holmes of Theranos is to be sentenced this week - facing up to 20 years in prison. Sam Bankman-Fried of FTX Trading filed for bankruptcy on Friday. 

There's billions of dollars in losses to investors, hardly small change. Some of the investors in each of these companies are big names from celebrities to large corporations.

Take for example, Rupert Murdoch who lost $125million to Theranos and Walmart lost $150million, while some of the big corporate names investing in FTX included Sequoia Capital and BlackRock. If it can happen to them with all the resources available to them for analysis, it can happen to anyone. 

While hindsight is a wonderful thing, there are a number of red flags that were missed in the case of both companies. While you can't always avoid situations where there's been outright fraud and lying, these are the key things to be mindful of to prevent your own investment disaster. 

Balance sheets need to balance

Check the accounts and make sure it all adds up. 

In the case of FTX, there were a range of anomalies. The FTX token prices were also being backed by 'parent company' Alameda while Alameda used the tokens in their trading activities (aka creating their own currency to fund themselves) - sounds like a house of cards? Further to this, FTX had substantial illiquid liabilities and little buffer to deal with market problems.

Checking the balance sheets sounds simple enough, but to be fair, if someone is cooking the books, it might be a bit more difficult. This is where you need to be requesting audited financial statements. Interestingly, Holmes never provided audited statements to any investors. 

Even more frightening is the fact that Theranos didn't have a CFO. Holmes had sacked CFO Henry Mosley early in the piece when he discovered she had been faking results and questioned it. He was bound by a non-disclosure statement meaning he was unable to warn others. She never replaced him. This should have been a warning sign to investors.

Inexperienced CEO and board members

The experience of a founding CEO doesn't have to be a deal-breaker if they've surrounded themselves with people who do have relevant experience. 

In the case of Theranos, Holmes not only was inexperienced and unqualified but she didn't hire qualified and experienced senior leaders. Her board was filled with names to offer her celebrity or a degree of credibility but none of them had experience relevant to Theranos. For example, former senators and politicians sat on the board of Theranos including Henry Kissinger and George Shultz.

Many of the FTX 'inner circle' appeared to have relevant experience, previously working at credible organisations like Jane Street Capital. It had good ideas too. The problem was that the 10 senior team members were all too closely interlinked by longstanding friendships and even romantic relationships. Arguably that means poorer governance - who is going to say no to who?

Due diligence on the ideas

One of the most shocking things to come out of the Theranos case was that the company faked results. 

Theranos was required to pass certain standards set by the Federal Centers for Medicare and Medicaid Services in order to operate its blood-testing machines. Rather than use it's own technology for these tests (which didn't offer consistent results), Theranos used the standard blood testing equipment in order to pass. 

Theranos employees also faked reports from pharmaceutical companies by writing these themselves and putting pharmaceutical logos on them.

While investors took Theranos at their word, there are a few measures they could have used.

1.  Visit the facilities to see how the technology works and assess overall operations. None of the key investors did this.
2. Have qualified experts conduct due diligence on the technology. One of Pfizer's Directors recounted asking Holmes specific technical questions that she evaded and so he recommended Pfizer not partner with Theranos. I'm sure that's a decision they've continued to be pleased with.
3. Contact any external auditors and companies that the business claims to offer reports from. For example, if investors had contacted any of the pharmaceutical companies Theranos offered reports from, they would have discovered these were faked.

Finally, ASK ALL THE QUESTIONS

It's characteristic in scams, let alone big company downfalls that people don't ask enough questions. Or even ask questions at all. They rely on their trust or liking of the person selling something to them and accept the information provided. In some situations, people will be made to feel like they are in an exclusive set and are hesitant to rock the boat. Investors have often spoken of both Holmes and Bankman-Fried as being high charismatic and likeable. Both were media darlings too, with a focus on participating in puff pieces.

Ponzi schemes work in this way too, if you take the example of Bernie Madoff, or even locally, Melissa Caddick. Their investors liked them and trusted them so assumed that they were given the correct information.

Holmes focused on the highly wealthy to invest and made generous use of NDAs. A lot of her investors were treated as 'invitation-only' opportunities. Her investors were often blown away by her and hesitant to ask questions that might see them lose out. She also created a work culture where employees were punished for questioning the status quo.

Similarly, there was very little attempt to challenge the decisions at FTX. No one asked where money was coming from to make large scale purchases, even sensible ones, like shares in Robinhood (NASDAQ: HOOD). Even when the President of FTX's US exchange suddenly left, no one asked why. When a range of stakeholders were pushed on why, the most common factor came down to the fact they liked Bankman-Fried and considered him a friend.

You could effectively summarise this as don't be afraid to ask questions and get help from experts who can ask the right questions on your behalf. If a founder is putting you in the situation where the opportunity to invest will be taken from you if you ask too many questions or take the time for due diligence, there's probably a good reason for that. They don't want you to know there is no substance behind the company.

Avoiding the car crash investments

While there's no hard and fast rule to avoiding poor investments, these are a good starting point. Some of the biggest red flags are often in plain view. That said, every company does things differently so there will be nuances in whether something counts as a flag or not.

This is one occasion where it pays to be cynical and diligent. While sometimes that won't be enough, other times it could just make all the difference.