Bad Blood: Five Lessons for Startup Founders

by Jossey PLLC | Sep 3, 2024 | SEC

Bad Blood: Five Lessons for Startup Founders

As Elizabeth Holmes, the disgraced founder of Theranos, tries to rehabilitate her image and stay out of jail, the story of her meteoric rise and fall keeps reverberating through startup world.

Wall Street Journal reporter John Carreyrou initially broke the story of Theranos’ shady practices in 2015. He later wrote the definitive account of the entire saga in the best seller Bad Blood.

For those familiar with the Theranos story, the book doesn’t provide any new revelations, but it does explain, in sharp detail, the many, and in hindsight, obvious, mistakes Theranos made during its short time as Silicon Valley’s hottest startup.

Here are five lessons startup founders should take from the downfall of Theranos and Elizabeth Holmes as described in Bad Blood.

• Do the damn work: One obvious takeaway from Bad Blood was how far Holmes’s ambition exceeded her willingness to become proficient in her field. She majored in chemical engineering at Stanford, but famously dropped out after two semesters. When presenting to investors and later at conferences and talks with fawning attendees she spoke in airy terms about “changing the world.” This sentiment along with her arresting facial features and cultivated image worked most of the time. But on the rare occasions she pitched to technically competent audiences her charm quickly turned to hostility and the meetings abruptly ended. Of course, Theranos hired scores of technicians with impressive credentials, but Holmes never allowed them the time needed to produce the machine that would fulfill her vision (or even fully investigate whether it was technically possible.)
• Choose your team carefully: Another obvious Bad Blood takeaway is the impossible management structure at Theranos. Holmes ran the startup with her erratic boyfriend and live-in lover Sunny Balwani. The couple apparently kept their relationship secret from the board of directors. Throughout the book, Carreyrou portrays Balwani as a toxic tyrant prone to sudden outbursts who fired people near daily. The poisonous management situation resulted in constant turnover where no one from upper management to low-level technicians was safe from unwarranted tirades. This atmosphere contrasts with the ‘we’re-saving-the-world’ sentiment expressed at company parties and all-hands meetings. Perhaps it would not have mattered in the end, but the unease Balwani’s omnipresence provoked negated any chance Theranos would ever fulfill its mission.
• Never lose sight of the mission: Elizabeth Holmes’s goal was to become famous, she wanted to be the female Steve Jobs—a force of nature whose sheer will could mesmerize crowds and whose ideas could change the lives of billions. In at least one respect, she got her wish. Whilst PhDs slaved away under Sunny Balwani’s tyrannical gaze, Holmes’ star rose. Particularly, after going “live” with the Walgreens partnership, her life seemed to consist of unending talks, glowing profiles, and conferences. Holmes, with a security detail fit for a president, constantly schmoozed VIPs. Celebrity can be intoxicating but unless it’s earned, it’s worthless. A founder’s main duty is to her investors/shareholders. Holmes treated this cohort as an expendable ATM. The Theranos board, despite numerous warnings, also failed to guard shareholders’ interests.
• Don’t lie to people: Fraudsters exist in every industry. But the amount of lies that Holmes told was stunning. She lied about the technology, the reliability of the machines, the use of commercial analyzers, the patents she filed and so on. She and Balwani relied on NDAs, legal threats, and the omnipresent “trade secrets” whenever lies were exposed. The inability to level with anyone including shareholders, employees, media, business partners, regulators, and eventually medial patients was stunning. The mantra ‘fake it until you make it’ popular in Silicon Valley can’t mean blatantly lie to everyone and hope everything works out. The Theranos situation was worse than most because people’s actual lives were at stake, but a clean conscience is good policy for any founder. 
• Never run when you’re right. The last lesson applies to everyone who discovered the rampant deceit at Theranos. The media portrayed lab technicians Tyler Schultz and Erika Cheung as the heroes of the story. No doubt their courage in the face of unrelenting bullying by lawyer David Boise and his hatchet team deserves plaudits. But what is striking is how many people stood up to Holmes and Balwani. Holmes fired her CFO immediately when he warned her not to lie to potential investors. A lab manager and medical doctor provided the first proof to Carreyrou that something was awry. One scientist even committed suicide. Outside the company, as well, numerous people refused to be taken in by Holmes’s charm. A consultant hired by Walgreens repeatedly warned the company things did not add up. A regulator held his ground in the face of a four-star general who tried to fast-track Theranos machines to fields of combat. Even people at Theranos’ PR firm tried to warn their superiors. In the end, all these people came out of the affair with their integrity intact.

Will the Theranos debacle change anything? Probably not, larger investors may demand more proof before entrusting millions of dollars to charismatic, messianic founders. But then again maybe they won’t. As hype surrounding crypto reached a fever pitch, VCs lined up to back fraudsters like Sam Bankman-Fried and Do Kwon.

In the end, the human desire to be seen as virtuous combined with the human trait of greed will usually supplant the business need for boring, forensic due diligence. But that doesn’t mean individual startup founders can’t take the lessons of Theranos to heart, particularly if they’d prefer not to share a prison cell with her.

By Jossey PLLC

Who will own the internet?

by Jossey PLLC | Sep 2, 2024 | SEC

Who will own the internet?

Who will own the internet? The question is up for grabs according venture capitalist and author Chris Dixon in his new book Read Write Own, Building the Next Era of the Internet. The future internet could be an open-air bazaar where people skip through various apps taking their followers with them, where no one worries about being censored or being demonetized for upsetting corporate overlords, and where everyone who brings value is rewarded accordingly.

That’s not the internet today. Who owns the internet today is simple. According to Dixon, the top 1 percent of social networks account for 95 percent of the social web traffic and 86 percent of social mobile app use. The top 1 percent of search engines account for 97 percent of search traffic, and the top 1 percent of e-commerce sites account for 57 percent of e-commerce traffic. The top five biggest tech companies gain massive market cap and leave alternatives in the dust.

Thus, the internet is intermediated by five companies. In some circles this is fine, don’t like the stranglehold Google, Meta, et al have on the internet? Don’t like that you’re at the whim of specious and ever-changing terms of service? That’s just the market at work. You can always build an alternative yourself. That’s fine in theory, but network effects and sunk costs mean switching from tech behemoths is impractical at best and impossible at worst.

Corporate Networks Own the Internet Today

According to Dixon, the oligarchy isn’t actually part of the internet, certainly not as it was originally designed as an “information superhighway” exists adjacent to the stack the internet was built upon. “Corporate services like Facebook and Twitter operate networks that interoperate with the web, using components like HTTP, but they are not part of the web in any meaningful sense. They do not adhere to the web’s entrenched customs and norms. Indeed, they break the web’s many technical, economic, and cultural tenants—like openness, permissionless innovation, and democratic governance.”

This set up has deleterious effects for everyone except the corporations themselves and their shareholders. The companies cheat the internet of its original innovation, energy, and promise by making it permissioned. In business, writes Dixon, “permission becomes a pretense for tyranny.”

Examples of corporate tyranny aren’t hard to find.

Corporate networks rob the people who make them valuable; the ones who create and consume platform content by keeping all the money in “take rates” which hover around 1% except for YouTube which is an outlier at around 45%. “Publishing” has been democratized, but with strict controls about who can publish. If you happen to be controversial or start moving the needle in a direction the oligarchs don’t like you’re deplatformed. Or your story is banned if it’s about a presidential candidate’s son that may hurt the oligarchs’ preferred candidate.

We All May Own the Internet Soon

But a new era may already be here. Crypto or “blockchain networks” as Dixon refers to them can change the current power structure by making internet a bottom-up bazaar—an open-air market where creators and private enterprises sell their wares on top of a “public” infrastructure, open source and permissionless. This design structure costs money, hobbyists can tinker but building out and maintaining the infrastructure costs real money. That’s where tokens come in. As more people use a blockchain network the tokens that are inherently part of its design become valuable creating the right incentive for people to dedicate themselves to using, creating, and maintaining its functioning and security.

As Dixon writes,

Tokens have all the earmarks of a disruptive technology. They are multiplayer, like websites and posts, the disruptive computing primitives or earlier internet eras. They become more useful as more people use them—a classic network effect that primes them to be must more than mere playthings. The blockchains that underpin them are also improving at a rapid rate, driving by platform app feedback loops that generate compound growth.

The bonus of this system is everyone becomes owners, creating a virtuous cycle. As tokens gain value, everyone—coders, content creators, validators, and users—have an incentive to maintain and grow the network. Moreover, everyone is paid fairly for their contributions, and if they’re not, switching costs approach zero. Open source means a new “fork” is always available. Code ensures stability which invites ever more investment and innovation. Major changes require votes not the whims of CEOs or “Trust and Safey Councils.” Code limits human meddling. DeFi applications, for example, kept running smoothly amid the tumult caused by Sam Bankman-Fried, Do Kwon, and others unjustly associated with crypto because their frauds involved tokens.

Dixon Swings and Misses on Proof-of-Stake

But Dixon doesn’t get everything right. An obvious supporter of the Ethereum blockchain, he brushes off concerns about its vulnerability to centralization and political capture. Ethereum switched from the energy intensive but decentralized Proof-of-Work to the less secure Proof-of-Stake as its consensus mechanism in 2022.

Others, no less knowledgeable, have real concerns about the long-term viability of Proof-of-Stake. Brian Brooks, former acting Comptroller of the Currency, describes Proof-of-Stake as an “electronic means of traditional corporate governance – the shareholders with the most shares can control the system and could in theory act contrary to the interests of other users who have smaller token holdings.”

Nic Carter, nobody’s crypto fool, describes Proof-of-Stake this way:

[A] cornerstone of the anti-Bitcoin energy argument [is] the notion that you can have something for nothing with Proof of Stake. No energy consumption, yet still a functioning decentralized consensus. . . . [T]his is fantastical. ‘Proof of Stake’ is just a fancy phrase meaning “those who have the most wealth wield political control.” That sounds a lot like our current system, which Bitcoin is specifically designed to solve. Bitcoin explicitly rejects politics, and doesn’t grant any special privileges based on coins held.

Perhaps Dixon may prove correct and new-Ethereum will prove as secure as its “classic” predecessor. But Ethereum made the switch over specious energy concerns that have plagued the West. We are not running out of energy and wouldn’t even approach it for centuries. Further Bitcoin’s energy use is miniscule and potentially quite valuable for human flourishing.

Overall, however, Dixon has written an interesting valuable book for how the internet may change in the coming decade. If he’s right, it will be a massive improvement from the current iteration and may spur ways of communicating and creating not yet imagined.

By Jossey PLLC

Reg CF Issuers, File Your Annual Reports!

by Jossey PLLC | Sep 2, 2024 | SEC

Reg CF Issuers, File Your Annual Reports!

For Regulation Crowdfunding (Reg CF) issuers, Spring means more than tax time. Uncle Sam, through the Securities and Exchange Commission (SEC), requires an annual report, Form C-AR. Companies must submit these reports 120 days after the fiscal year (usually December 31) until they become eligible to stop.

And while an SEC Enforcement Division letter may not seem as scary as the IRS kind, ignoring these reports, which update investors on company progress and financials, comes with dire consequences.

First, the SEC could deem Reg CF securities as unregistered. This can mean personal liability for founders and other officers. Indeed, it could put the entire company at risk. The Commission is particularly protective of Reg CF-eligible retail investors. In its 2015 release the regulator stated it may prosecute delinquent filers, even if they had remedied. “We note that even if an issuer has regained eligibility [by filing past reports], the Commission could still bring an enforcement action under the federal securities laws based on the issuer’s failure to make the required filings.”

Reg CF Issuers must file Annual Reports to avoid SEC trouble

But even without this extreme action, founders ignoring Form C-ARs face potential legal headaches. First, the company will be ineligible to do another Reg CF raise until the company files past-due reports dating back two years. Second, companies must be current on these reports to exclude Reg CF investors from the 12(g) record-holder count. Exceeding this shareholder number requires companies to formally register with the SEC—an expensive and time-consuming process almost no recent Reg CF issuer is ready for. Third, issuers must disclose past failure to comply with reporting requirements on any future Reg CF offering statement and annual report, risking reputational harm.

More broadly for the industry, low filing rates give ammunition to those hostile to retail investor access to the private capital markets, particularly state-level regulators.

Reg CF issuer compliance with Annual Reports is abysmal

Despite these myriad negative repercussions, issuer compliance with Form C-AR is abysmal. In a recent Crowdfund Insider article, Howard Marks, founder and CEO of the StartEngine portal compiled the following data:

• Based on my team’s calculations, an estimated 1,548 Form Cs were filed in 2022, signifying the start of new Reg CF offerings.
• From that group, we further estimate that 810 companies that filed Form C-U – this typically indicates a successfully completed Reg CF funding round.
• We estimate that of the approximate 1,548 Form C filings, only 361 filed Form C-AR’s; and of the 810 successful rounds, as few as 253 completed the filing on time.

This results in compliance rates of 23% and 31% respectively. As stated, noncompliant founders and officers risk professional and personal harm.

Companies may stop annual reporting after as few as one C-AR, depending on number of shareholders and total assets, although it must notify the SEC with Form C-TR: Termination of Reporting. Other companies must report until some event occurs like registering the securities, repurchasing them, or ending operations.

By Jossey PLLC, contact for further information [email protected]

SEC discovery tactics questionable in Ripple case

by Jossey PLLC | Aug 7, 2021 | SEC

SEC discovery tactics questionable in Ripple case 

The Securities and Exchange Commission (SEC) has gotten away with questionable investigation and litigation methods for years. The Commission’s Enforcement Division tactics are so well known they have earned a particular kind of lore among securities lawyers, described by one as “like living in hell without dying.” But in the SEC’s epic battle against cryptocurrency company Ripple and two of its executives, the agency’s go-to tactics are finally being challenged.

In April, U.S Magistrate Judge Sarah Netburn ordered the SEC to produce documents, including certain internal and external communications, along with a log of privileged documents, that could reveal potentially sensitive or embarrassing information about SEC crypto legal uncertainty in the midst of dozens of prosecutions. Of the high-profile nonfraud crypto cases—Kik, Telegram, LBRY, and the current case involving Ripple—the Ripple litigation is the first time a court has forced the SEC’s own actions to the fore.

The implications are huge—for crypto companies and perhaps for all facing securities investigations.

SEC discovery tactics questionable from the start 

This drama started on December 22, 2020, when then-SEC Chairman Jay Clayton, on his last day, greenlit the lawsuit against Ripple and two of its executives, accusing the firm of selling unregistered securities in the form of its cryptocurrency, XRP, which Ripple began selling in 2013.

The company and its individual defendants claim the SEC failed to provide constitutionally required fair notice about XRP’s status in form of due process. After years of crypto prosecutions, this is a potential problem the SEC is only now having to confront.

As Commissioner Hester Peirce stated:

Given the power and reach of the Commission, due process is of paramount importance. The rules should be clear, so that individuals know in advance the actions that constitute violations. In enforcing the rules, the SEC should be even-handed and sensible. An unwavering commitment to due process is particularly important in light of the continued growth in the volume and complexity of the securities rulebook.

Following due process principles is rarely costless, comfortable, or convenient for a regulator, but doing so speaks volumes of the agency’s integrity and helps to bolster the agency’s standing in the markets, the courts, and the minds of the American people. In short, an agency that adheres to basic principles of due process will be more effective at carrying out its mission.

Defendant lawyers turn tables on SEC 

Defendant lawyers, naturally, requested internal and external communications between staff and commissioners regarding XRP and non-security cryptocurrencies Bitcoin and Ether. In a change from other crypto cases, Judge Netburn ordered the SEC to produce documents including certain internal and external communications along with a log of privileged documents. The Commission is not handling it well.

The SEC refused, telling the judge brazenly that she didn’t understand how the SEC worked and that any information defendants sought could be obtained on their website: 

The Court further indicated a lack of familiarity with how the SEC operates and required the parties to meet and confer about “whether” the SEC should produce or enter onto a privilege log memos or other official documents “expressing the agency’s interpretation or views” as to XRP, Bitcoin and ether. Id. at 53:2-13 (emphasis added). As detailed below, the SEC expresses its interpretations and views in a number of ways, all of which are public. These agency interpretations and views are subject to the Order, but internal emails and memos expressing SEC staff interpretations and views are not.

(Incidentally, when convenient, the SEC discards even statements available on its website, like a former director’s pronouncement that Ether was not a security).

Magistrate Judge unhappy with SEC discovery tactics  

The judge, not accepting the SEC’s recalcitrance, again ordered the SEC to produce certain internal and external documents along with a log of documents it was withholding based on privilege claims.

Has that transpired? Nope. According to defendant lawyers, two months since the initial order, SEC lawyers have not produced a single internal document or external-response document, but told the judge the ordered discovery was “irrelevant and needless.”

SEC lawyers are also refusing to produce other discoverable documents, like communications from the Office of Investor Education and Advocacy or from its financial technology email inbox, [email protected]. Defendant lawyers have now requested a third hearing, and that motion is pending, but the judge may decide three strikes is enough.

The SEC’s questionable tactics don’t stop there. While accusing Ripple lawyers of “gamesmanship,” “harassing” the SEC, and seeking invasive materials, prosecutors sought eight years of personal bank statements and attorney-client-privileged legal advice from defendants.

New SEC Chair on board with SEC discovery tactics 

New SEC Chair Gary Gensler hasn’t commented on the legal team’s conduct or its adherence to SEC rules. The SEC’s Canon of Ethics warns: “The power to investigate carries with it the power to defame and destroy.” Its stated values include integrity (“We inspire public confidence and trust by adhering to the highest ethical standards”), accountability (“We embrace our responsibilities and hold ourselves accountable to the American public”), and fairness (“We treat investors, market participants, and others fairly and in accordance with the law”).

But Gensler has had plenty to say about crypto enforcement intentions. In congressional testimony, he signaled a looming new wave of crypto prosecutions, lamenting that the SEC has only managed 75 thus far. The SEC also touts its performance in this regard during the past pandemic year—namely, only a meager decline in prosecutions but still a record uptick in penalties. That includes $1.2 billion it disgorged from Telegram, which forced the company to shutter its blockchain project.

The SEC’s actions do not serve the public interest. Instead of protecting consumers, regulators trample constitutional rights, foist millions in legal fees on companies trying to offer innovative consumer products and, ultimately, disadvantage the U.S. economy vis á vis global competitors. 

Hopefully, Judge Netburn in the Ripple case will start holding the SEC accountable to its own ideals and mission, which has veered so far from what is fair and decent.

By Jossey PLLC via www.thecrowdfundinglawyers.com 

For more perspectives on the ongoing SEC v. Ripple case, listen to this podcast of a panel of the Federalist Society featuring CEI Senior fellow John Berlau.