The Theranos Fraud: A $1 Billion Lesson in Due Diligence

November 28, 2022

The Theranos scandal stands as one of the most spectacular corporate frauds in modern history. Elizabeth Holmes, once hailed as the "world's youngest self-made female billionaire" and the "next Steve Jobs," built a $9 billion company on a foundation of lies. When the house of cards finally collapsed, investors lost nearly $1 billion, patients received potentially life-threatening incorrect test results, and Holmes was sentenced to over 11 years in prison.

What makes this case particularly striking is not just the scale of the fraud, but the caliber of investors who were duped. This wasn't a case of unsophisticated investors falling for a penny stock scam. The victims included some of the most prominent names in business and politics: media mogul Rupert Murdoch (who lost $120 million), former Treasury Secretary George Shultz, the Walton family (America's richest family), and Oracle founder Larry Ellison. Even Harvard Medical School's former dean was sufficiently impressed to invite Holmes to join the school's Board of Fellows.

The Theranos case demonstrates two critical lessons for investors: first, that properly conducted due diligence would have exposed this fraud long before it reached its peak valuation, and second, that even the most sophisticated investors can be victims of fraud when they abandon fundamental investment principles.

The Red Flags That Proper Due Diligence Would Have Caught

1. Lack of Peer-Reviewed Scientific Validation: The most glaring red flag was the complete absence of peer-reviewed scientific publications validating Theranos' claimed breakthrough technology. Any legitimate revolutionary medical device would have generated multiple research papers in prestigious medical journals. The medical and scientific communities would have been buzzing with excitement about such a breakthrough.

Due Diligence Action: Investors should have demanded to see peer-reviewed studies published in journals like Nature, Science, or The New England Journal of Medicine. The absence of such publications for a supposedly revolutionary medical technology should have been an immediate deal-breaker.
2. Refusal to Provide Technical Details or Allow Independent Testing: Holmes consistently refused to provide technical details about how the Edison machines worked, claiming trade secrets. She also refused to allow independent laboratories to validate the technology. This level of secrecy is highly unusual for a medical device company seeking investment.

Due Diligence Action: Investors should have insisted on independent technical validation by qualified third-party laboratories. They should have demanded detailed technical specifications and required the company to demonstrate the technology in controlled conditions with independent observers.
3. Impossibly Broad Claims Without Incremental Development: Theranos claimed its technology could perform "over 240 tests" from a single drop of blood, covering everything from basic cholesterol screening to complex genetic analysis. This is scientifically implausible without years of incremental development and validation for each test type.

Due Diligence Action: Investors should have demanded to see the development pathway for each claimed test, including validation data, accuracy metrics, and FDA approval status. They should have consulted with independent medical technology experts who could assess the plausibility of such broad claims.
4. Fabricated Financial Projections and Customer Relationships: The evidence revealed that Holmes made wildly false claims about Theranos' financial prospects, claiming the company would generate over $100 million in revenue in 2014 and $1 billion in 2015, when she knew the actual revenues would be negligible. She also fabricated relationships with pharmaceutical companies and the Department of Defense.

Due Diligence Action: Investors should have:

Demanded independently audited financial statements

Requested direct confirmation from claimed partners and customers

Required detailed revenue recognition policies and customer contracts

Insisted on meeting with key customers and partners independently
5. Questionable Management Credentials and Board Composition: Holmes had dropped out of Stanford after just two semesters of chemical engineering and had no relevant experience in medical device development, laboratory management, or healthcare regulation. The board was packed with political figures and business leaders but notably lacked medical device experts, laboratory professionals, or regulatory specialists.

Due Diligence Action: Investors should have:

Thoroughly vetted the management team's relevant experience and track record

Demanded a board composition that included genuine subject matter experts

Required management to demonstrate deep technical knowledge through detailed technical presentations

Conducted background checks on key personnel
6. Regulatory Red Flags and Quality Control Issues: By 2015, FDA investigations had raised serious concerns about Theranos' testing accuracy, and the company was forced to retract two years of blood test results. The company was also operating its laboratory without proper regulatory oversight for years.

Due Diligence Action: Investors should have:

Reviewed all FDA correspondence and regulatory filings

Demanded evidence of proper laboratory certification and quality control procedures

Required independent audits of laboratory practices and quality assurance

Insisted on seeing detailed accuracy and reliability data for all tests

The Sophisticated Investor Trap

The Theranos case reveals how even sophisticated investors can fall victim to fraud when they abandon fundamental due diligence principles. Several factors contributed to this:

Star Power and Social Proof: The presence of prestigious investors and board members created a false sense of legitimacy. Each new high-profile investor provided social proof that attracted the next one, creating a self-reinforcing cycle of credibility.

Fear of Missing Out (FOMO): The promise of revolutionary technology that could "change the world" created urgency that discouraged thorough analysis. Investors feared that asking too many questions might cause them to lose their allocation in what appeared to be a transformative opportunity.

Deference to Claimed Expertise: Holmes' Stanford pedigree and confident presentation style created an aura of technical expertise that many investors didn't feel qualified to challenge. This deference to apparent authority prevented them from asking the hard technical questions that would have exposed the fraud.

Confirmation Bias: Once investors had made an initial commitment, they became psychologically invested in the company's success and were less likely to objectively evaluate negative information.

The Due Diligence Framework That Could Have Prevented This Disaster

Technical Validation (The Most Critical Step)

Require independent technical validation by qualified experts

Demand peer-reviewed scientific publications

Insist on controlled demonstrations under independent observation

Require detailed technical specifications and performance data

Financial Verification

Demand independently audited financial statements

Require direct confirmation of all claimed partnerships and customer relationships

Insist on detailed revenue recognition policies and customer contracts

Verify all financial projections with independent market analysis

Management and Governance Assessment

Thoroughly vet management team's relevant experience and track record

Require board composition that includes genuine subject matter experts

Conduct comprehensive background checks on key personnel

Test management's technical knowledge through detailed presentations

Regulatory and Compliance Review

Review all regulatory correspondence and filings

Verify proper licensing and certification of all operations

Require independent audits of quality control procedures

Confirm compliance with all relevant industry regulations

Independent Expert Consultation

Engage independent medical device experts to assess technical claims

Consult with regulatory specialists familiar with FDA requirements

Seek input from practicing clinicians who would be end users

Commission independent market research to validate business model assumptions

Lessons for Today's Investors

The Theranos fraud offers several enduring lessons for modern investors:

Extraordinary claims require extraordinary evidence. Revolutionary breakthrough technologies should generate substantial independent validation and peer-reviewed research.

Secrecy is not a valid excuse for avoiding due diligence. Legitimate companies can provide technical validation while protecting true trade secrets.

Star power is not a substitute for fundamental analysis. The presence of prestigious investors or board members should never replace independent due diligence.

Management credibility is crucial. Investors must thoroughly vet management teams and ensure they have the relevant expertise to execute their claimed breakthroughs.

Independent expert validation is essential. Complex technical claims require assessment by qualified independent experts, not just the investor's own judgment.

The Theranos case serves as a stark reminder that even the most sophisticated investors can be victims of fraud when they abandon fundamental investment principles. However, it also demonstrates that proper due diligence, conducted with appropriate skepticism and independent validation, can identify even the most sophisticated frauds before they reach their peak.

The cost of thorough due diligence pales in comparison to the potential losses from fraud. In the case of Theranos, a few hundred thousand dollars spent on proper technical validation could have saved investors nearly $1 billion in losses. The lesson is clear: when it comes to revolutionary breakthrough technologies, trust but verify—and verify thoroughly.