Smart Investors & Founder Fantasy

Investing in deep-tech ventures is challenging because it is often not about the tech; it is about the storytelling. Founders typically understand the underlying science far better than the investor. It can be argued that the more charismatic and persuasive the founder, the harder it is to distinguish fiction from fantasy.

Past success does not protect investors against deception; instead, a track record of successes may elicit confidence that may make investors overlook the flaws. Protecting capital requires looking past narratives and enforcing independent validation of product data and scientific feasibility.

The cost of unvetted science

I've been intrigued by scientific fraud ever since the Theranos scandal. It not only gave a bad name to the scientific community, but made biology startups suspect to many. More importantly, the capital allocated to fraud is capital denied to viable innovations. And in sectors like healthcare, these failures directly impact human lives.

Consider these two examples outside of venture capital:

Paolo Macchiarini: The celebrity surgeon claimed he could replace damaged tracheas with synthetic windpipes seeded with a patient's stem cells. He was exposed in 2016, but the damage is irreversible; reportedly, seven of his patients died.

Alzheimer's Research Fabrication: In 2022, Science published that a 2006 Nature paper on Alzheimer's disease allegedly contained fabricated image data ¹. For over a decade, the paper had directed millions of dollars of research funding down a dead end. The human cost of derailed progress and missed opportunities is immeasurable.

Prioritizing narrative over science

While these cases are notable, the Theranos scandal remains dominant in public consciousness, with a new documentary about Elizabeth Holmes coming out in a couple of days. So here is a quick rundown.

Founded in 2003, Theranos operated in stealth until 2013, claiming its proprietary hardware, called "Edison," could run hundreds of diagnostic tests from a single drop of finger-prick blood.

But the core technology was fundamentally flawed.

Venous blood plasma drawn via needle is homogeneous. Capillary blood from a finger prick is a mixture of blood from arterioles, venules, and capillaries, mixed fluids of the cells themselves and intercellular spaces. Furthermore, squeezing the finger ruptures red blood cells, spilling intracellular components into the sample. Standard lab instruments account for this; the Edison device could not.

Ultimately, evidence showed the Edison did not work as claimed.

Court proceedings and investigations revealed that to maintain the illusion, Theranos took these tiny samples and diluted them to run them on commercial laboratory machines. This pushed target molecule concentrations below detectable thresholds and caused false negatives. At times, the company drew venous blood and ran samples on commercial equipment to pass quality checks.

The company avoided regulatory scrutiny by remaining private, leveraging regulatory loopholes around lab-developed tests, and enforcing strict internal non-disclosure agreements. Whistleblowers Tyler Shultz and Erika Cheung, alongside Wall Street Journal reporter John Carreyrou, exposed the deceit. The article was published in 2015, and in 2022, Elizabeth Holmes was sentenced to eleven years, and Ramesh Balwani to thirteen years in federal prison.

The psychology of rationalization

Theranos raised over $700 million, but the money did not come from specialized healthcare investors. Industry reports indicate that many specialized life-science VCs passed on the deal because Holmes refused to publish peer-reviewed data or allow independent technical audits. Instead, Theranos raised capital from family offices, corporate leaders, and statesmen who lacked domain expertise.

These investors fell into traps.

Venture capital research suggests investors prioritize the management team over the business or technology, citing the founder as the primary factor ². Effectively, the money flows based on gut feeling. This reliance on instinct is compounded by the bias blind spot: most people believe they are far less biased than average ³. This illusion of objectivity acts as an amplifier for every other cognitive bias.

Holmes appeared to exploit this dynamic by emulating Steve Jobs' black turtlenecks, lowering her voice, and maintaining an intense stare. Naturally, investors wanted to believe they were part of a healthcare revolution, and rationalized corporate secrecy and a lack of peer review as protection of trade secrets.

Twisting the facts to fit the narrative is called motivated reasoning, and studies suggest that highly intelligent individuals are more likely to misinterpret data when it contradicts their pre-existing beliefs ⁴. Basically, intelligence provides better cognitive tools for self-deception.

Defending against deception

There is an old saying that paper accepts everything; a pitch can be detached from reality. Protecting capital requires concrete safeguards.

1. We should assume we are as susceptible to bias as anyone else, and that past successes do not act as shields against deception. This is easier said than done.
2. Corporate secrecy should be treated as a risk factor. Proprietary claims must be scientifically backed, and refusing to share raw data or methodology under a non-disclosure agreement should be treated as a red flag.
3. When evaluating complexity, apply Occam's razor. This principle states that the simplest explanation is usually the correct one. If a convoluted explanation justifies why a technical flaw isn't a problem, a simpler explanation is likely true: the tech probably doesn't work as advertised.
4. Mandate third-party audits of product data and scientific feasibility by experts, who do not have any personal gain, to establish if the technology is likely to work or not.

Founder charisma can attract capital, but it cannot alter the laws of physics and biology. Funding fiction yields broken portfolios and reputations.