Asking the right questions: Lessons from U.S. vs Elizabeth Holmes

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Asking questions is the simplest thing to do, but the hardest thing to do well.

Last week, a jury in San Jose, California found Elizabeth Holmes guilty of conspiracy and wire fraud following her breath-taking scheme to accept investors’ capital based on a business that proved to be smoke and mirrors. Though there will likely be an appeal, the outcome in the Holmes trial shows how quickly a promising start-up can go “Down the Tubes.”

Holmes is the latest in a long line of charismatic founders and executives who overhyped their companies and successfully misled even the most sophisticated investors—leading to a string of financial collapses and accompanying headlines over the last handful of years. How do these frauds and misrepresentations grow so large? It all starts with a failure to ask the right questions and get the real answers.

With the benefit of hindsight, the red flags are clear to see: failures in oversight, distracted management teams, questionable business decisions, misrepresentations of business activities, lack of understanding of a core product, technology, or service, and even outright fraud. The challenge is turning hindsight into foresight.

There is no one easy fix for how to do so, as each investment is unique, with risks particular to the sector, jurisdiction, and history of the business. The type of diligence needed on a regional electrical utility, medical device manufacturer, fintech startup, online betting platform or cannabis distributor—just to name a few—varies vastly. The task is further complicated when evaluating disrupters whose businesses are upending traditional financial and operational models. There is surely no checklist or playbook to turn to. At its most basic, every deal at some level comes down to trust. So how is trust developed?

The Anatomy of a Fraud

In the case of Elizabeth Holmes, the evidence brought forth during the trial revealed Holmes knew the company’s minilab technology was flawed but still knowingly obfuscated or simply lied about it to investors. While boasting the potential for billion-dollar revenues and allegedly significant military contracts, Holmes knew that the business would only produce negligible or modest returns at best. The bottom line: she knew the business was failing yet represented that Theranos was profitable and would continue to grow in its returns. How was a prospective investor to know?

The Art of Due Diligence

Due Diligence is a good place to start and can prove very fruitful in uncovering red flags. A Google search might lead to an anonymous posting by a former employee on a company review site that alleges a company is misrepresenting its financials. Pulling past lawsuits from a county court might reveal a series of disputes between a founder and former business partner that call into question his or her track record. A corporate record might reveal an association with a director that is not disclosed on the company’s website.

Sometimes, details found in the public record are enough when examined by an experienced investigator. The anonymous posting by a former employee may not seem like much more than a disgruntled complaint, but when looked at next to a recent exodus of long-time employees from the company, it could point to systemic, company-wide issues. But much like it happened in the case of Theranos: public records do not always tell the whole story. Sometimes they reveal only hints of the story. Sometimes they may miss the real story altogether.

Often, the only chance to uncover the real story before a fraud comes to light is by asking the right questions of the right people. And that is no easy thing to do.

To know what questions are the right questions, investigators need to think deeply and creatively about the types of risks that may be hidden inside the business, the linchpins of the investment thesis investors are depending on. Necessary to this process are resources with deep experience investigating a diverse range of frauds, working with regulatory and enforcement bodies, and building and rehabilitating compliance programs in similar companies and industries.

And to have success finding and connecting with the right people, investigators need a broad range of skills -- the ability to identify former employees and customers and business partners and adversaries who would be in a position to know when things were going badly, the relationship mapping techniques built from tracing complex corporate structures and social networks, and the rapport-building experience that comes from decades of cultivating relationships with sources, conducting investigative interviews, and eliciting information.

The right team, and the right combination of industry, regulatory, and fraud experience, lays the groundwork needed to find the objective observers, the would-be whistleblowers, and to ask the questions that connect the seemingly disparate data points that can tell the story of a fraud.

At the end of the process, after asking all the questions and receiving all the answers, no news may be good news. Middle of the road news may be manageable. Bad news may require the investor to walk away. But one thing is clear: the only wrong answer is not asking the questions in the first place.

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