Why You Invest in the Wrong Projects


Tech entrepreneurs often dream of producing a new technology that will change the world. They might hope to reinvent the mobile phone as Steve Jobs did when he launched the iPhone. Or they can imagine themselves recreating the motor car as Elon Musk did when he set up Tesla. Or they might fantasize about a whole new space industry (again, Elon Musk.) Most, though, have to settle for an impressive number of downloads for their calorie-tracking app or a new way to share videos of dancing cats.

When Elizabeth Holmes dropped out of Stanford in 2003 aged 19 and launched a company to develop a new health diagnostic tool, she was thinking bigger than most. Her device would change forever the way that people monitor their health. Instead of booking an appointment at their local clinic, drawing blood and waiting for results to come back from a laboratory, people could head to their local Walgreens, prick their finger on a “nanotainer” and receive an almost instant diagnosis of as many as 240 different conditions ranging from cholesterol to cancer using the company’s proprietary “Edison” testing technology. Health tracking—and health results—would never be the same again.

Within a year, Holmes had raised almost $7 million, valuing the company at $30 million. By 2010, with no product in sight, the company had picked up enough funding to value the company at $1 billion. Five years later, Theranos had a deal with Capital BlueCross, a Pennsylvania health insurer to perform its lab work, and had increased its valuation tenfold.

What the company still didn’t have though, was a product. Holmes had never explained how exactly her Edison algorithm analyzed drops of blood or how the nanotainer worked. Nor had its technology been peer reviewed, a step not always performed in technology but essential for the more rigorous field of medtech. Suspicions that there was less to Theranos than Holmes claimed increased after an article in The Wall Street Journal argued that the company was buying in off-the-shelf technology to perform most of its tests.

Theranos refuted the allegations but the rot had settled in. More critical articles followed. Deals collapsed as doubts about the effectiveness of the technology deepened. In 2017, Theranos settled a lawsuit levied by Partner Fund Management, one of its biggest investors, which had accused the company of securities fraud. A year later, Elizabeth Holmes herself was charged by the SEC with fraud, accused of misleading investors and exaggerating the company’s performance. In January, this year, she was found guilty on four counts.

Theranos, though, wasn’t simply a story of a con-artist defrauding gullible retail investors into handing over their hard-earned savings. Holmes received funding from media mogul Rupert Murdoch, Oracle founder Larry Ellison, venture capitalist Tim Draper, and the Walgreens pharmacy chain. Some of the country’s biggest investment and private equity funds put money into the company, convinced that its technology represented an important breakthrough.

Surely investors with that kind of pedigree should have known better. They should have questioned the claims harder and looked deeper into the technology. Why didn’t they? And if investors as seasoned as the Fortress Investment Group, which led Theranos’s last funding round, couldn’t see the problems in the company a year before it collapsed, what should retail investors think as they survey projects appealing for funds? How can they be sure that the money they put into a promising new company will come back, and can they spot the signs that we’re investing in another Theranos instead of another Tesla?

The Pros and Cons of Product Creativity

One clue to the answer may lie in crowdsourcing, a field in which new companies appeal to the public to fund innovative ideas.

More than 20 million backers have now supported the development of projects on Kickstarter. About two-thirds are first-time backers. They’ve pledged some $6.3 billion dollars for almost 550,000 projects. Most of those funds, almost $5.8 billion, have gone towards projects that met their funding goals and went into production. But those promising stats belie the large number of failures. Projects that do well can do very well, attracting a large portion of the funds that pour into the platform. In fact, most projects on Kickstarter, almost 60 percent, fail to reach their funding goals. Their campaign leaders are unable to raise the money they need to create their new comic or develop their next generation 3D printer.

But of the 40 percent of projects that do receive their funding, not all make it into successful production. A 2015 survey conducted by Professor Ethan Mollick of the Wharton School of the University of Pennsylvania on behalf of Kickstarter found that 9 percent of funded Kickstarter projects failed to deliver the rewards the campaigns had promised.

“Project backers should expect a failure rate of around 1-in-10 projects,” said Mollick, “and to receive a refund 13% of the time. Since failure can happen to anyone, creators need to consider, and plan for, the ways in which they will work with backers in the event a project fails, keeping lines of communication open and explaining how the money was spent.”

In other words, if you find a project on Kickstarter that you like, you have a more than 50/50 chance that the project won’t be funded. And even if it is funded, there’s about one-in-ten chance that it still won’t deliver.

In a paper entitled “Red flags and rave reviews: Explaining too-good-to-be-true crowdfunding campaigns,” Stella K. Seyb of the Price College of Business at the University of Oklahoma pinpoints the difference between successful crowdfunding campaigns and those that fail to produce despite meeting their funding goals.

Seyb focuses her study on medical technology campaigns, the kind of product that turned Theranos into a $10 billion business before sending its founder to court. Start-ups developing medical technology are increasingly turning to crowdfunding to facilitate their product development and launch, argues Seyb. The industry is highly competitive and relies on intensive innovation fueled by high R&D expenditure to turn an idea into a product.

It’s the level of innovation, says Seyb, that determines both a company’s ability to raise funds and its chances of success. Product creativity, “the extent to which a product represents a meaningful, value-creating advancement as compared to existing market offerings in the product category,” tends to attract donors. But the addition of new innovations also increases the product’s complexity and raises the chances that the company will fail.

“Because product creativity is associated with a range of beneficial outcomes, such as positive affect and increased perceptions of quality, it tends to have a positive effect on campaign funding,” says Seyb. “But in the context of medical devices, creativity can prove a double-edged sword, both making it more likely that crowdfunders will buy into the idea and increasing the risk the organizer will fail to deliver the product on time or with the promised functionality.”

In fact, the attractiveness of a particularly innovative product can create a kind of feedback loop. The increased perception of novelty and usefulness draws in more investors. Those investors are more motivated to ignore evidence suggesting that the product might not work, and increase the rate of positive comments. Just as early investments in Theranos by Rupert Murdoch and Larry Ellison acted as endorsements that brought in more investments, so enthusiastic early crowdfunders can create social proof and attract more dollars.

But Seyb also notes that devices with high technological novelty often innovate on the edge of what’s technically possible. If rival products aren’t offering a feature, such as a wide range of instant diagnoses based on a few drops of blood, there’s likely to be a good reason for that missing functionality.

In other words, the more innovative a crowdfunded product appears, the more attractive it is to investors—and the greater the chances that the funding campaign will succeed but the product will fail.

So what can both funders and creators do to increase their chances of success?

Look Past the Breathrough

Seyb advises funders not to be blinded by usefulness. “When a product appears particularly useful,” she warns, “take that as a sign to be extra diligent regarding technological feasibility.”

When evaluating that feasibility, funders should also focus on the most radical innovations because they’re the areas most likely to fail. Look for evidence that confirms your doubts, as well as proof of success, and reward projects with contingency plans that the creators  can implement if things go wrong.

Entrepreneurs looking for crowdsourced funds for their innovative projects should ensure that their plans are flexible and that the research and development is transparent. Funders should be able to see if there are any problems and understand what you’re doing to overcome them.

Most importantly, creators can also use the risk inherent in crowdfunding innovative projects to their advantage. Funders know that every project they fund from a new company making its first product carries a certain amount of risk. They know that there’s always a chance that the project won’t be funded (in which case they might not be charged depending on the platform) or that the product won’t be produced (in which case it’s unlikely that they’ll get their money back.) So creators can stand out from their competitors by increasing that trust. Just as venture capital investors pay more attention to the management team than they do to the idea, so crowdfunders can emphasize their expertise and their entrepreneurial experience.

Evidence that the people behind a crowdfunding campaign have built and delivered similar products in the past should help funders to feel that they’re more likely to receive the product they’re funding, even if it’s highly innovative.

And as for the platforms themselves, Seyb recommends that they emphasize not just the percentage of projects that are funded successfully but the percentage that fulfill successfully too. Kickstarter’s statistics don’t currently include fulfilment data.

Entrepreneurs want to build innovative ideas that can change the world, and those are also the very ideas that investors most want to fund. Transparency and trust should help to ensure that the funds they supply go to the right projects and build companies that are more like Tesla than Theranos.

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