What Elizabeth Holmes and Theranos Reveal About Venture Capitalism

"The conviction this month of Elizabeth Holmes, founder of the fraudulent blood-testing start-up Theranos, has been presented as something grander: the discrediting of venture capital. Gullible investors poured almost $1 billion into Theranos, only to discover that it had all the substance of a B-movie prop. Coming on top of the venture crowd’s well-known offenses — sexism (women account for a shockingly low 16 percent of venture capital investment partners), racial bias (just 3 percent of partners are Black), and elitism (among V.C.s with M.B.A.s, one-third attended either Stanford or Harvard) — the apparent revelation that venture capitalists are incompetent feels like a knockout punch.

This indictment of venture capital strikes at the heart of the way capitalism functions. A couple of decades ago, early-stage technology investing was a niche business because technology itself was a niche affair. Today, venture capital is expanding in three ways: It is spreading beyond Silicon Valley to other U.S. cities and to Asia and Europe, it is colonizing new industries, and it is reaching beyond the start-up phase, as multibillion-dollar “unicorns” prefer to remain in the hands of V.C. investors rather than going public.

While venture capital’s lack of diversity is a genuine problem, the claim of incompetence is false. Venture capitalists have not risen to prominence by dint of bungling; the Boris Johnson theory of the industry is wrong. To the contrary, venture-capital skills are an essential driver of innovation and growth.

Only a fraction of 1 percent of firms in the United States receive venture-capital backing, but this tiny minority accounts for 47 percent of the nonfinancial companies that do well enough to go public, not to mention 89 percent of research and development spending by those that make it onto the stock exchange.

The Theranos debacle fails as an indictment of venture capital for two reasons. First, nearly all the money raised by the company came not from venture capitalists but from technology outsiders. The Walton family (which made its fortune from Walmart) invested $150 million. The media baron Rupert Murdoch invested $121 million. The DeVos family (Amway) and the Cox family (radio and television stations), kicked in $100 million each. Apparently, none of these venture tourists bothered to insist on evidence that the Theranos technology worked. By contrast, when Ms. Holmes pitched Theranos to a real venture partnership, MedVenture, she was unable to answer their questions, and the meeting ended with her abrupt departure.

Second, the handful of famous technology investors who did back Theranos do not discredit venture capital as a whole.

V.C.s approach risk differently from other financiers. They fully expect the majority of their bets to be losers, an unthinkable catastrophe for a stock market investor. But they also hope that a minority will multiply their money 10 times or more, generating bonanzas far larger than mere hedge funders can earn from a single position.

So losing $1 million on a long shot early bet on Theranos is just V.C. business as usual. Ms. Holmes’s subsequent fraud was outrageous. The fact that she raised experimental capital to try out her improbable technology was not.

Nevertheless, the claim of incompetence demands a serious hearing. Other investors demonstrate skill by winning more bets than they lose, and by doing so for years. Venture capitalists do neither. Because they make losing bets so frequently, their occasional bonanzas could, theoretically, be as random as picking the winning number in roulette. And because top entrepreneurs flock to venture capitalists who have a record of winning, sustained performance does not necessarily prove skill. V.C. winners might continue to flourish because of this unearned “halo” effect.

However plausible these hypotheses, four years of researching venture capital have taught me to doubt them. Academic attempts to measure the halo effect suggest that it is modest. And the history of venture capital is replete with partnerships that bestrode the Valley and then lost their footing. In 2001, the top two investors at the storied firm of Kleiner Perkins were ranked first and third on the Forbes Midas List of the top 100 V.C. investors. Twenty years later, only one Kleiner partner was ranked, and he came 77th.

If the halo effect does not ensure persistent performance, venture firms that sustain strong returns must, presumably, have skill. But to understand what the skill is, you first have to cut through the charming but distracting stories about how venture deals get done.

I once asked Patrick Collison, co-founder of the payments company Stripe, how he had raised capital from one of the top venture capitalists, Michael Moritz of Sequoia. Mr. Collison told me that he had pedaled over to Mr. Moritz’s office on his sleek Cervelo road bike, gun metal gray with a red stripe on the fat down tube. After he saw the bike, Mr. Moritz latched on. Did Mr. Collison cycle everywhere? Was he a racer? And what was his best time on the Old La Honda climb? The grilling led Mr. Collison to suspect that being competitive at a gritty sport had told the V.C. world something about his entrepreneurial prospects.

You can roam Silicon Valley and collect countless versions of this story.

But if you probe a little further, the real mechanics of venture capital emerge. In the case of Sequoia’s Stripe investment, the key was an early-warning system that flagged Mr. Collison as a hot prospect when he was only 21. Sequoia built this system carefully. It doled out capital to young technologists and invited them to make “angel” investments in promising members of their cohort, thus getting new prospects onto its radar.

One year before his meeting with Mr. Moritz, Mr. Collison had raised $30,000 from two Sequoia-linked angels. This, much more than his cool bike, was the key to the Stripe-Sequoia partnership.

Spend time with other sophisticated V.C. shops, and their deliberate methods become clear. Accel, the partnership best known for backing Facebook, developed an approach known as “prepared mind.” You study a coming technology shift — for example, the migration of data from customer devices to the cloud. You figure out the implications: new hardware configurations, new software business models, new security vulnerabilities. Then, when you come across a start-up that is poised to surf the new wave profitably, you are primed to react quickly.

Human beings, as it happens, are wired to approach the world in the opposite fashion. We will gamble to avoid a loss, but are irrationally reluctant to reach for the upside. “Failures don’t matter,” the Kleiner Perkins leaders used to tell each other. “You can only lose one times your capital.”

Vinod Khosla, a former kingmaker at Kleiner Perkins who now runs his own venture capital outfit, once told me of his decision to bet on the meat-free burger company Impossible Foods, a start-up whose ambitions once seemed as over-the-top as that of Theranos. Patrick Brown, Impossible’s founder, had laid out a plan to eliminate the meat-industrial complex. It was an insanely messianic vision. If he fails, Mr. Khosla recalls thinking, “he’ll be mocked.”

Mr. Khosla put that worry aside, and made a bet on Impossible, reckoning that even if Mr. Brown had only a one in a hundred chance, it was a shot worth taking. Eleven years later, while the meat-industrial complex may not have been toppled, Impossible is worth $7 billion. Which is better, Mr. Khosla observed: to try and fail, or to fail to try?

Sebastian Mallaby is a senior fellow at the Council on Foreign Relations and the author of “The Power Law: Venture Capital and the Making of the New Future.”"