Smoke and Mirrors: The Risks of Valuation in Silicon Valley

Is Tesla really worth a $1 trillion? In October 2021, the electric-vehicle company – founded just 18 years earlier – hit a staggering trillion dollar valuation. When confronted with these massive numbers, it can be easy to forget that valuations are not abstract figures, but real representations of a company’s achievements. Yet, in Silicon Valley, where companies are often valued before they have any concrete success, valuations are both hard to measure, and easy to manipulate. The consequences of this ambiguity can be dire. There is no better example than Theranos, the medical device company that hit a peak valuation of $9 billion before investors discovered that the product itself did not function as well as they believed. In many ways, the example of Theranos – and its founder, Elizabeth Holmes – seems extreme. Yet, to some extent, it could have been – and is – the story of many Silicon Valley start-ups: Just a few months before the Department of Justice brought charges against Holmes, the S.E.C. filed a complaint against the CEO of Headspin, another Silicon Valley tech start-up. Even Tesla, with its $1 trillion valuation, started out as a story. Simply stated, the amount of risk – and potential fraud – involved in the valuation of these companies is huge.

This risk partly stems from the process of valuation itself. In his GoogleTalk about the subject, NYU Professor Aswath Damodaran stated that “valuation can never be just about the numbers. To me, valuation is a bridge between stories and numbers.” In Silicon Valley, this is a precarious balance. Newer companies that may not have concrete numbers must rely more on their stories to attract investors and high valuations. The risk with this approach, though, is that valuations can easily become inflated depending on the amount of “hype” a story generates.

Some could argue that this is true of all valuations, not just of tech startups. Valuations can easily be manipulated to portray a certain image of a company. Yet, with tech startups, instead of using existing data points, investors have to make predictions. A McKinsey article states that while many of the components of valuation are similar across industries, tech companies emphasize some factors more than others. In particular, tech valuations focus on the “potential size of the market… the company’s market share, as well as the level of return on capital the company might be able to earn.”

The key words here are “potential” and “might.” Whereas with a more traditional company, executives may rely on past performance and credentials to predict the future, tech employees cannot. CEOs have to show how big the market could be, how much revenue could be brought in, how many consumers might be interested. While all companies have to answer these same questions, not all companies can demonstrate a functioning product, an existing customer base, or a 10-year development plan. Instead, some companies have to rely on their story. That’s where the risk comes from. Depending on the narrative the founders tell – the “hype” they generate – startups can mislead their shareholders towards inflated predictions of market size, revenue, and market share. At some point in this game, it becomes difficult to separate the substantial from the superficial, and the true from the false. John Carreyrou – Wall Street Journal reporter and author of Bad Blood: Secrets and Lies in a Silicon Valley Startup – recently spoke about the importance of this distinction. In his talk at Stanford Business School, Carreyrou noted the difference between entrepreneurs believing in their product and “hyping so much that [they] cross over into outright lies.”

Nevertheless, this difference is not always easy to spot. Tesla is an interesting foil. While the company is vastly different from Theranos in that it presented a tangible product in a somewhat more understood industry, Tesla has a similar emergence story. The electric vehicle company had a great narrative – a dream – and a mysterious CEO to act as its face. Now, it also has a trillion dollar valuation. Professor Damodaran explained what this numbers means in a November 2021 interview with CNBC. “If you believe that Tesla is fairly valued, you’re also believing that Tesla can sell $1 trillion – that revenues will rise to a trillion [dollars],” Damodaran said. He added that there is a “plausible pathway” there – and that some believe that Tesla will hit that number. The explanation is a reminder of what a company’s valuation means. In a sense, valuation is almost supposed to be objective – a number summarizing how successful investors think a company will be. The concern is that valuations are often seen as objective, while the process of getting there – particularly when narratives are emphasized – can be so subjective.

In the case of Theranos, the company’s fraudulent conduct took years to uncover. Their product was an easy-to-use blood test device that could allegedly detect a range of diseases with minimal blood taken, in a short period of time. Employees soon discovered flaws in the device’s accuracy, and discrepancies in the results it showed in comparison to other lab tests. Moreover, many of the company’s tests were conducted not through Theranos’ device, but through existing products on the market. Ultimately, in 2014, an employee – Tyler Shultz – sent a tip to New York’s state public health lab, informing the agency of potential wrongdoing in how Theranos was testing its product’s accuracy. Shultz also spoke to the Wall Street Journal regarding his concerns about the company. As the newspaper began conducting its investigation, other employees began speaking to its reporters as well. Thus started years of investigations by a number of federal agencies, including the SEC and the Department of Justice. Ultimately, Theranos was dissolved in September 2018.
A few months before the dissolution, in March 2018, the company also settled with the SEC over civil-securities charges. In the SEC’s press release announcing the decision, Jina Choi, the director of the Commission’s regional office in San Francisco, raised a warning bell for other companies: “The Theranos story is an important lesson for Silicon Valley. Innovators who seek to revolutionize and disrupt an industry must tell investors the truth about what their technology can do today, not just what they hope it might do someday.”

Her statement captured the essence of the issue. Perhaps at some point, there was a “plausible pathway” for Theranos as well; a path in which the company’s hype was not a problem, because it turned out to be true. The issue with the timing argument, though, is that valuation is an ever-changing metric. Investors invest in the product that exists at the time of giving money. Yet, in Silicon Valley, and in early-stages of high-tech companies, the present is near-impossible to measure. Valuations are bets on the future.

This behavior and process can put investors at risk. As a result, in the past few years, government agencies have become increasingly interested in Silicon Valley valuations. In a speech she gave in March 2016, Mary Jo White, then-chairwoman of the SEC, stated that “the concern is whether the prestige associated with reaching a sky-high valuation fast drives companies to try to appear more valuable than they actually are.” Two years later, her concerns came to fruition with the Theranos dissolution. More recently, the founder of the company, Elizabeth Holmes, was recently found guilty on four of eleven federal charges – with all four counts related to defrauding investors. Albeit slightly less publicly, other companies have also faced consequences for similar actions. In August 2021, the SEC charged Manish Lachwani, the CEO of HeadSpin, with “defrauding investors out of $80 million.” In its press release about the case, the SEC alleged that “Lachwani engaged in a fraudulent scheme to propel HeadSpin’s valuation to over $1 billion.” The trend is clear.

As digitalization increases, the mathematics of valuation has become an inherently grey area. From a legal perspective, it can be hard to understand founders’ intentions and prove fraudulent conduct. As the Theranos case illustrates, this is where insiders can be vital. Employees of these companies can play a key role in protecting investors and promoting the truth. Sanford Heisler Sharp is experienced in representing whistleblowers and is committed to fighting against all of the ever-evolving types of fraud.