Not long before Elizabeth Holmes’ blood testing start-up Theranos imploded amid revelations that its core technology didn’t work as advertised, investors had valued the company at a breathtaking $9 billion.
Before Adam Neumann’s office-sharing start-up WeWork nearly collapsed in a wave of scandals in 2019, its backers pegged the company’s valuation at a whopping $47 billion.
How did their investor bases, which included sophisticated venture capital firms, hedge funds and money managers for some of America’s most prominent families, get the stories so wrong?
“There isn’t a lot of investigation into private companies,” said Matthew Wansley, an assistant professor at Yeshiva University’s Cardozo School of Law in New York, in an interview with CNBC’s “American Greed.” “And there’s not a lot of transparency.”
Wansley, an expert on venture capital who previously worked as general counsel at a start-up, said there’s often a reverse incentive for investors to do too much digging before writing a check. Ask too many tough questions and they risk losing money on their investments or getting shut out of a current or future funding round.
The dynamic becomes even more challenging when a start-up reaches “unicorn” status, with a private market valuation of $1 billion or more, and starts attracting the attention of a wider swath of thirsty investors.
“If you’re a company that everyone wants to invest in, one of many ways that you can get leverage over investors is by saying, ‘Let’s make the due diligence requests a little more modest here,'” Wansley said.
That, in turn, can feed a founder’s worst impulses.
“If you are working at a private company and you know that fewer people are investigating you, it’s a lot easier to conceal misconduct, and conceal it for a longer period of time,” Wansley said.
Few start-ups have taken that to more of an extreme than WeWork.
While Neumann has never been charged with wrongdoing, revelations about his outrageously lavish lifestyle, which reportedly included ownership of six homes and use of a $60 million Gulfstream jet to take his family on surfing vacations, nearly sunk the company.
“His hairdresser would fly around with him,” said journalist Maureen Farrell, co-author of “The Cult of We: WeWork, Adam Neumann, and the Great Startup Delusion,” in an interview with “American Greed.” “It was just a level of extravagance that’s kind of unimaginable, even for a paper billionaire.”
The extravagance really took off in 2017 after a $4 billion investment from Japanese conglomerate SoftBank and its billionaire founder, Masayoshi Son. SoftBank would ultimately plunge some $18.5 billion into the company.
Neumann later admitted that the investments went to his head.
“The valuation was just another way where people sort of told us that we were right,” Neumann told CNBC “Squawk Box” co-anchor Andrew Ross Sorkin at the New York Times DealBook Online Summit in November.
Ultimately, Son soured on Neumann and engineered his ouster as CEO. SoftBank took majority control of WeWork in what amounted to a bailout, and remained the company’s largest shareholder at the time of its public market debut in October.
The lofty $47 billion valuation, driven largely by SoftBank’s investments, plunged to far more earthly levels. It’s currently worth less than $7 billion. WeWork, which has yet to turn a profit, recently announced it will have to restate financial results for the sponsor of the special purpose acquisition company that took it public.
Son would eventually refer to his investment as “foolish,” and SoftBank has a long way to go to make its money back on the deal. But Son has said he still believes in Neumann despite the way things turned out.
“I am part of the responsibility of his mistake,” Son told the DealBook Summit in 2020. “So, I still love him, I still respect him. I’m sure he would come back and do some great stuff.”
As for the loss on WeWork, Son was taking it in stride.
“Luckily, we have some other hits,” he said. “So, in total score, we are still positive.”
Wansley said that type of thinking is precisely the problem with the current model for financing start-ups. He calls it “asymmetric risk.”
“You’ve got 20 companies in your portfolio. Of those 20 companies, about 18 of them are going to go nowhere,” Wansley said. “If you have a portfolio where you find one Facebook, or one Uber and 19 other total failures, that’s great, because the outsized gains that you get from that one company that becomes a hit is enough to make your whole portfolio successful and offset those losses.”
An alternative, according to Wansley, is to reform securities laws to allow limited trading in the shares of start-ups and to mandate more public disclosures, thus subjecting the companies to the scrutiny of the markets.
It’s an argument he laid out in a recent academic paper titled “Taming Unicorns.”
“These reforms would create a market for robust trading in unicorn securities among accredited investors — and thereby strengthen deterrence of unicorn misconduct — while protecting retail investors and companies that wish to retain concentrated ownership,” he wrote.
Wansley acknowledged that his model would not eliminate misconduct. After all, some of the biggest corporate scandals in history have involved publicly traded companies. But he said it would at least add a new level of transparency.
And while venture capitalists might lose some of their advantage when it comes to the companies that hit it big, Wansley said his paper has received some positive feedback from VCs since it would allow them to cut their losses by selling their shares if an investment is going badly.
Still, there are few signs that the current model is about to change.
The National Venture Capital Association reports that investments soared in 2021 to a record total of nearly $330 billion, nearly twice the prior record set just a year earlier.
If high-profile debacles like WeWork and Theranos are giving anyone in the investment community pause, the numbers aren’t showing it.
See how fame and fortune go to WeWork founder Adam Neumann’s head, while investors seem to turn a blind eye and employees are left holding the bag. Watch an ALL NEW episode of “American Greed,” Wednesday, Jan. 19, at 10 p.m. ET on CNBC.