After the Theranos failure, here’s how you look for clues to spot overhyped startups

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Shafin Diamond Tejani is an investor, entrepreneur and founder and CEO of Vancouver-based Victory Square Technologies, which supports technology startups through sustainable growth.

Infamous blood-testing startup Theranos failed spectacularly last fall, but only after investors poured US$1.4-billion into what proved a hoax. In this case, founder Elizabeth Holmes, whose trial is next summer, has been accused of crossing the line separating hyperbole from felony. But many entrepreneurs have long practised this “fake it until you make it” approach. In the age of digital disruption, this ethos is, if anything, more prevalent than ever.

The central question is: How can you avoid investing in or even working at companies promising far more than they can deliver? What are the critical warning signs that tech’s next big disruptor isn’t all it’s cracked up to be?

As an investor in early stage technologies, with a focus on emerging areas such as blockchain and cannabis, I ask myself these questions all the time. Over the years, I’ve developed a few guidelines for avoiding fabulists and frauds.

Beware the PowerPoint entrepreneur (and stay in your lane)

Startups attract funding by presenting pitch decks – or slide presentations of their business idea – to investors. Invariably, these are full of impressive-looking charts with lines that shoot upward like hockey sticks. In the industry, there’s even a name for founders with too-good-to-be-true decks: PowerPoint entrepreneurs.

Take their presentations with a grain – or truckload – of salt. It’s all too easy to embellish or manufacture numbers, graphs and even partnerships with other companies. Granted, most investors understand not to take a startup’s facts and figures at face value. But how do you do your due diligence when a company’s product hasn’t been built, if it holds the advantage of asymmetric information?

Theranos’s investors would have suspected something if they knew more about basic biochemistry. After all, the company continually claimed its machines were performing feats that educated observers saw were physically impossible. I’ve learned it’s much easier to make smart decisions when you stay in your lane, where you have subject matter expertise yourself.

Bet on people (and watch out for “OPM”)

Companies at their earliest stages might not have viable products, customers or revenue. Working in spaces such as augmented and virtual reality and artificial intelligence, I see this situation all the time.

In these cases, you’re betting on the quality of the founders. Do they have depth of experience in their field? A track record of success? They’ll inevitably provide glowing references. But you’ll likely get more honest answers from people not on their reference sheet. LinkedIn makes it easy to reach out to past employers and co-workers for an unvarnished evaluation.

Coachability is paramount, as well. The reality is that most entrepreneurs, however strong their idea, will need to absorb brand-new skill sets and learn to work with a range of partners to be successful. Those convinced that they’re the “smartest person in the room” at this stage are liabilities not worth betting on.

Finally, there’s one classic sign that founders aren’t for real: They’re investing lots of OPM (Other People’s Money) in their business and little or none of their own. This is an immediate indication of how much they believe in their idea. By the same token, if they’ve gotten their friends and family to invest, it means they’re accountable to people close to them and will work that much harder to bring their vision to life.

Avoid startups that make customers (and profit) an afterthought

Far too many early-stage companies are, frankly, creating solutions to problems no one has. They’re building products in a vacuum, without ever engaging with customers to suss out product-market fit – or even whether demand exists at all.

A startup is far easier to validate once it has built a prototype that’s been improved upon with feedback from living, breathing customers. Better still is if the founders have scrapped and bootstrapped their way to an actual revenue stream.

Of course, heeding all of this advice is easier said than done. As Oaktree Capital’s Howard Marks wisely points out, “the biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.” We like to think of investing as a rational behaviour, but early stage investors are just as often driven by emotions and herd instincts.

Theranos attracted hundreds of millions from high-profile investors such as Larry Ellison, Rupert Murdoch and Tim Draper. Its all-star board included former secretaries of state George Shultz and Henry Kissinger, and former secretaries of defence Jim Mattis and William Perry. Yet those investors never asked to see audited financial statements. They trusted the respected names around the company when they should have been verifying the data behind it.