Venture capitalists invest in many promising start-ups hoping to cash in on the next billion dollar company, these grand visions however may be blinding investors to red flags for fraud
Industry analysts are projecting that 2017 will be a banner year for start-ups. But while venture capitalists are poised to unleash a tidal wave of cash into promising new businesses, dreaming of hitching their wagon to the next unicorn, it remains to be seen whether professional investors will have learned any of the hard lessons of the past decade.
Two of 2016’s biggest VC horror stories involved blood-testing firm Theranos, Inc. and the environmentally conscious food company Hampton Creek Foods. Both companies were led by wunderkinds promising to revolutionize their respective industries. In the end, however, these companies were consumed by allegations of fraud, fabricated product claims, cooked-books, lawsuits and criminal investigations.
At Theranos, CEO Elizabeth Holmes, just a 19-year-old Stanford dropout when she founded the company in 2004, enticed investors into the Palo Alto-based biotech firm with the promise of revolutionary ‘pin-prick’ blood analysis technology. The company raised more than $632 million and built a company valued at $9 billion with Henry Kissinger and General James Mattis on the Board of Directors. But the company’s valuation evaporated (along with its investors’ capital) over the past year when it was discovered that Theranos’ technology was a myth and it was using data from traditional labs using standard amounts of drawn blood. How was Holmes able to escape serious scrutiny for years? One general partner at a venture capital firm noted that ‘late stage investors’ had been swayed by the assumption that due-diligence had already been conducted and were drawn to Holmes celebrity-like status.
Meanwhile, over the past five years Hampton Creek Foods founder and CEO Josh Tetrick has raised over a hundred million dollars from a Who’s Who of Silicon Valley for his vegan food company known primarily for its eggless Just Mayo. Unfortunately for respected investors like Khosla Ventures and Horizons Ventures, Hampton Creek’s environmental claims were largely untrue and its science unremarkable. The company also boosted its revenues by using followers known as “Creekers” to secretly buy large quantities of its own product from retailers. One investor brought into management quit just nine days into the job stating that after he reviewed the company’s books that shareholders “might have a case for fraud.” Tetrick is currently the target of SEC and Justice Department investigations into securities fraud.
Sadly, tales of “visionary” chief executives bedazzling name-brand investors with change-the-world technologies before going down like The Hindenburg amongst allegations of fraud are not new. One such VC play that still haunts investors was Pay By Touch, a classic story from the 2000s that bears revisiting.
When the head of human resources attempted to investigate reports of sexual harassment, the CEO fired her and hired his mother as head of personnel.
In the early and mid-2000s, Pay By Touch was heralded in Silicon Valley as the next big thing for its biometric payment system where a person’s fingerprints could be used as a bankcard, offering consumers the ultimate protection through genetic encryption. The company claimed its technology was on the verge of completely changing the retail point of purchase experience.
Pay By Touch’s CEO was John P. Rogers, a good-looking, charismatic salesman, who was able to convince investment industry heavy-hitters like Ron Burkle, William Newsom and Gordon Getty to put more than $340 million into the company. As one investor later told the San Francisco Chronicle: that Rogers “speaks in-hyperbole isn’t a strong enough word. He has very grand visions, and he speaks them with enough authority that people can discount them significantly and still think, ‘There must be something there.'”
But Rogers’ blue chip converts – who often invest in multiple startups to make sure they do not miss a passing unicorn – did not know what was smoldering in Rogers’ past: a series of failed businesses, a record of arrests, allegations of domestic violence and a serious cocaine habit.
The first warning sign might have been Rogers’ self-declarations of being a “visionary” innovator, a veritable ATM spitting out golden ideas, but with little tangible to actually show for it. Yet with a enticing business proposition and a growing number of blue chip endorsements, Rogers appeared to avoid a proper vetting as the newest member of the old boys network.
One investor later told the Chronicle that “only minimal background checks were performed” and claimed that the Rogers fairly common name and opaque biography presented to venture capital groups prevented even cursory research from identifying the laundry list of warning signs smoldering in Rogers’ past.
Rogers successfully concealed that fact that he been the subject of lawsuits in the mid-1990s over a failed scheme to build a chain of Midwest chiropractic clinics around a group of ambulance-chasing attorneys who would funnel accident victims into treatment. Perhaps more significantly, Rogers also had a string of arrests and restraining orders in Minnesota from former girlfriends that alleged he had stalked and physically attacked them. No one, it seemed, bothered to look deep enough into Rogers’ background to unearth these incidents.
“One of the most interesting things about the Rogers case is that he didn’t have one or two questionable episodes in his past, but rather had a string of incidents,” said David Cogan, Managing Director of Sapient Investigations, Inc. “Still he seemed to glide between the raindrops due to his high-level connections.”
Once Rogers relocated to San Francisco he quickly remade his image and launched a company in 2003 called Solidus Networks, Inc., that adopted a compelling new product, a biometric authentication application known as Pay By Touch. One of his key earlier moves was teaming up with tech start-up guru Brian Miller, who he made an Executive Vice President. Miller’s hire surely helped imbue the company with a patina of credibility and opened up access to moneyed investors like Gus Spanos and Arthur Petrie.
Flush with $50 million in investment cash, it did not take long for Rogers’ bad management practices to be on display: lavish spending, aggressive hiring (the company eventually had 750 employees) and acquiring competitors before they demonstrated a valid threat. All of this occurred before the company ever generated any significant revenue flow. In 2007, most notably, the company spent $137 million against revenues of $600,000 according to the San Francisco Chronicle.
But at the root of the executive malfeasance and incompetence was the man who started it all, CEO and President John P. Rogers, who controlled the company through his majority stake in preferred stock.
According to insiders, the collapse and bankruptcy of Pay By Touch was preceded by the disintegration of Rogers himself, who began missing work for days at a time and when he did show up looked disheveled and out of it. He allegedly offered cocaine to a board member. A former employee alleged Rogers told her to submit bogus expense reports to be reimbursed for drug buys. When the company’s VP of Human Resources attempted to investigate reports of Rogers sexual harassing female employees, Rogers fired her and hired his mother to do the job. One board member became so concerned about Rogers that he arranged for an ‘intervention’ in a Las Vegas hotel room in an effort to get him into rehab, according to media reports. The effort apparently failed and the board member did not alert investors to Rogers’ problems.
By 2008, the jig was up. Pay By Touch, the subject of securities fraud lawsuits, was forced into bankruptcy and ultimately had its assets liquidated. Following the company’s collapse it was revealed that a Federal Deposit Insurance Corporation investigation into Pay By Touch had been concealed from investors. In 2009, investors, including at least five NFL quarterbacks, sued UBS Securities, Rogers and his Board of Directors alleging they continued selling shares in the company even after it was apparent to insiders that Pay By Touch was a sinking ship.
Rogers was never charged criminally in the Pay By Touch debacle. And by last account, offered in a blistering critique in Gawker in late 2008 entitled ‘The Dotcom Douche of Beverly Hills,’ Rogers continued to live the high-life, ensconced in a luxury apartment and driving a $90K Mercedes Benz G-class SUV.
While the recent collapse of Theranos and the bizarre derailment of Hampton Creek has left investors wondering how they could not have seen this coming-some investors were pouring money into the companies right up until they were aflame-the real question remains the same as it was in the aftermath of Pay By Touch’s epic tanking: who was looking for the warning signs when it would have mattered for investors?
Apparently, no one. That’s worth remembering as 2017 gets underway.