A person lost in music

In 2003, a 19-year-old Elizabeth Holmes founded Theranos, a health tech startup that claimed it had devised blood tests that required a very small amount of blood and its tests could be performed rapidly. Elizabeth’s Theranos quickly gained hype in the market. She raised USD 700 million from venture capitalists and private investors in no time, even before making any substantial profits, merely based on valuations which increased in leaps and bounds, based on the hype surrounding the technology alone. 12 years later, in 2015, medical research professors and investigative journalists raised some uncomfortable questions on Theranos’ technology. This raised the curiosity of the Securities Exchange Commission (SEC) which started investigating the company.

The company faced a string of legal and commercial challenges from medical authorities, investors, Centers for Medicare and Medicaid Services (CMS), state attorneys general, former business partners, patients, and others. By June 2016, Holmes’s personal net worth had dropped from USD 4.5 billion to virtually nothing. In July 2016, Theranos received sanctions from the CMS, including the revocation of its CLIA certificate and prohibition of Holmes and other company officials from owning or operating a laboratory for two years. The company was near bankruptcy until it received, in 2017, a USD 100 million loan from Fortress Investment Group secured by its patents. In March 2018, Holmes and former company president Ramesh Balwani were charged with massive fraud by SEC. It turned out that the entire story built around Theranos’s new technology was, after all, a story – pure fiction! In September 2018, the company ceased operations. Holmes and Balwani have been indicted in charges of wire fraud and conspiracy with trials ongoing till date.

Death of accounting

The last two decades have seen a tectonic shift in the way businesses are valued. An unlisted company’s value is calculated by extrapolating profits in the past into future years to find future cash flows and such cash flows are discounted to find their present value – Discounted Cash Flow (DCF) valuation. The value of a business has shifted from tangible to intangible assets. While tangible assets have a value and fixed useful life which restricts the valuer to limit the estimates to the installed capacity of the assets, the intangible assets have no upper limits and the same can be replicated, licensed or exploited any number of times, to any number of people or users. There’s a huge difference between the book values which are usually based on historical cost, the present value based on future cash flows and the actual value of the entity. This is where the death of accounting began. Figures in accounting, no longer reflect any version of the reality.

Intellectual property rights which are valued heavily during valuations can turn worthless overnight when alternatives are discovered or government regulations change. Most of the intangibles such as copyrights, brand values, trademarks, etc. recorded in the books of account are of similar nature which has huge values assigned to them in books of account, however, in reality, may not realise the same. There’s usually no real perceived value as these assets do not return any real cash flows on its own. Thus, the value assigned in books remains questionable.

Why is valuation a matter of concern?

Over the last decade, various startups without any assets in their books have managed to earn astronomical valuations, based on their argument that their ideas are worth millions and will fetch cashflows in future. You can try this exercise yourself – pick up a few financials of so-called ‘New age tech startups’ and compare them to the same of shell companies, and you will find a striking resemblance amongst them – no assets, no business activity, and no revenue. All they have is an idea and some geeky founders in T-shirts who fetch millions and billions in valuations. Investors relying on the valuations of these startups pump money into it, who are also mesmerised by the idea. However, these businesses keep making losses and yet their valuations curiously are higher than before. The inclusion of the value of intangible assets into valuation has made accounting subjective and thus, it no longer gives a true picture.

It’s worthy to mention here that the investors include angel investors, venture capitalists, asset management companies, fund houses and other types of investors who are not necessarily investing on their behalf, instead of borrowing money from the mainstream financial system or the public at large. Thus, all is not well, if the valuations are not reliable.

How do fraudsters exploit the ecosystem?

A bunch of teens pitching an idea to you – excited as always, the teens who believe their idea is best and want you to invest in it. While over the past decade, India and the world as well have seen such teens turning small ideas to a multi-million business venture, however, the count of such startups is fewer. Technology-driven startups are volatile – a new technology by bigger corporate, an alternative technology, a new platform, or a change in regulation can erode the entire idea and technology overnight. Zebpay and Coinmark had their all-time high valuations before Reserve Bank of India (RBI) banned trading cryptocurrencies in India and thus, overnight the startups lost their value. One day the valuations are deep and sound, the other day the valuations are worthless – there’s a very thin line of difference between the sheep and the wolves here. You can’t differentiate whether the startup was valuable earlier and doesn’t have a value now, or did it never have a valuation at all and merely a show well put up. Thus, there is a breeding ground for the fraudsters to exploit.

There’s forensic auditor to find out what happened and how a healthy living startup collapsed to death in a short time, however, there’s very little to achieve here as the line between genuine failure and fraud is hard to decipher. Besides, fraudulent founders don’t need to siphon money, they just need to pay themselves a hefty salary from the funds received from investors.

New methods of valuations

Many new methods are of valuation in vogue now which use complicated formula and multiple benchmarks to calculate the value of a startup. In theory, valuation is the total of future benefits expected from the enterprise and thus, the profits are at the centre of the entire discussion. However, the new-age startups barely make profits, there are only revenue and heavy revenue expenditure which makes it impossible to value based on profits. Such startups are valued based on other benchmarks such as revenue. Thus, to drive the valuation higher, you need to drive the revenue higher. Now, revenue is usually difficult to increase, however, if one forgets about earning – it usually becomes a cakewalk. That’s exactly what happens – deep discounts, selling below cost and foregoing all profits, extravagant marketing expenditures, etc. just to ensure that the revenue goes higher. Almost all benchmarks suffer a similar shortfall. The founders burn the investors’ money and in no time, the startup is left with no money in pockets and still the same original idea!


Valuations are estimates of the future benefits, by nature they have a probability attached to it. When the methods and benchmarks of valuations become creative, the valuations become unreliable, especially with the intangibles. Thus, investors must learn from the past cases and ensure due diligence and background checks of the startups and their founders before investing, instead of inclining decisions on valuations alone. Besides, valuations based on multiple benchmarks and through multiple methods must all be considered before considering a valuation, as different methods can highlight the prospects from different perspectives. However, in the end, equity investing is a risky affair. In a bid to earn higher profits, one must be open to higher risks.