Pyramids, Ponzis and beyond; beware the things we don’t think about that can do us in.
Elizabeth Holmes, founder and former CEO of Theranos.
January 27, 2020 14 min read
Opinions expressed by Entrepreneur contributors are their own.
It began with a private note from a dear woman friend who was more than 70 years old and recovering from the most recent of several hospital stints. I checked in on her, as I often do. When she responded, she gave me shocking news I would have never suspected. She had invested $300,000 in a program to create authority websites through a friend and his family who we have both known and worked with at various levels since roughly 2014.
“It’s awful,” she said. “Rapid growth, lack of communication. I invested $300,000, and it could all go down the drain.”
She suggested I write an article, not about the individual or company (plenty is being written by the traditional press). She wanted me to give insights on ways for people to protect their investments, especially when investing with someone they know and trust. This is that article, along with my thoughts on how to protect yourself as an entrepreneur from ever becoming guilty of getting into a situation like this yourself.
In the days since my friend’s email, the Securities and Exchange Commission (SEC) issued a complaint to the aforementioned company on December 27, 2019. All assets in this particular company are now frozen. The doors are locked, its 100 employees were dismissed without warning or severance in the final days of the year, and its assets are now in receivership. So, what went wrong?
The company had assisted investors (some 500, to the tune of at least $75 million, according to the SEC) in buying or creating revenue-creating websites the company would build, maintain and host. The company would advertise and grow the Google authority and revenue of the sites at its own cost, and outside of a $1,000-a-month service fee to the investor, pledged to return either 50 percent of the revenue or, if revenue was insufficient to meet the return, guarantee the investor an annual return of 13-20 percent of initial investment, paid monthly.
On the face of it, who wouldn’t invest in a program like this? Even if you needed to borrow the money to invest — through an SBA loan, for example — exchanging your 8 percent interest cost for the loan for a guaranteed return of 13-20 percent is “such easy math, it’s just stupid,” the founder proclaimed at multiple events from the stage.
I will openly acknowledge my belief, for a variety of reasons, that this founder began his company with no ill intent. I believe he had every intention of building a company that would exceed expectations and help hundreds of friends and thousands of followers, all unsung entrepreneurs who’d worked tirelessly, just as he had, to succeed. It was especially sweet that like him, many of the friends and investors he brought in had grown their experiences in the face of prior defeats. Plumbers. Pizza shops. The founder’s own family had been affected by the failure of a video store left with no further options when the world of home videos moved online. His wife had served as an elected official. The company assured all who attended his conferences that it was in solid financial condition and free of debt (which it was).
Most compelling of all was the atmosphere of genuine value-add and friendship that permeated every event. At a mile a minute, he would outline strategies and stories around the building of online authority sites on Google, strategies for career progress and specific ideas for business success. The stories were true, and he gave his ideas and experience freely. I even covered a few in my entrepreneurial columns, although an instinct held me back from covering the program itself. Instead, I shared my impressions of the marketing ideas received from events. In fact, I spoke myself at two of them. The gatherings weren’t the rallies of a get-rich-quick program, but focused on value for all who attended (although the tables at the back for closing deals were ever-present and active). The founder gave to philanthropy freely and openly as one of his highest entrepreneurial goals.
Who Was Victimized and Why?
First, let’s take a look at the extended list and nature of the victims in this and other similar situations. It’s much worse than you’d think:
- The 500 investors who paid the estimated $75 million into the program. The outcome of the receivership is unknown. The SEC estimates $9 million in revenue has been created, but even with extreme delays in the launch of some of the sites and the beginnings of payouts, the company paid investors some $30 million in returns. You see the problem.
- The 100 employees who are now unemployed.
- The secondary victims. These include the contractors, consultants and advocates who worked with the company and spoke out honestly on behalf of the founder and thus became unwitting accomplices by lending their reputations to his, and in many cases going unpaid for their service. They have less protection than investors. (Another important note: In some cases, there is a precedence of prosecution and even jail for individuals who’ve given testimonial of programs they used and believed to be worthwhile if they are compensated for the participants their endorsements obtain and the program is later found to have been a fraud. This can be true even if they had no knowledge of the workings that were later shown to be fraudulent. Be careful, always, of who and what you endorse.)
- The spouses and families of the employees and even of the founder himself. At what point does the spouse of a founder in trouble become aware of the situation and become culpable as well? These are difficult questions.
- Many friends and affiliates who weren’t directly involved. These are people who didn’t lose money, but by inviting the founder onto stages and advocating for him as an individual are feeling bamboozled.
How Do We Avoid Being Victims in These Scenarios?
Here are my thoughts, and I’m sure readers will provide others:
- Beware an unregistered investment. In this case, the company’s attorney opined the investment was not a security. The SEC disagrees. An investment that involves the purchase of a registered security can be more complex to enact. It may not protect you from risk and may require that you be an accredited investor to participate, but the oversight and reporting it enforces can provide a greater level of protection from fraud.
- Whether you are required to participate as an accredited investor or not, the guidelines of accredited investing can help you. In the U.S., this is generally an individual with net worth of $1 million (outside of their primary residence) and an income of at least $200,000 a year. The stipulations ensure that investors who participate can afford to do so and would have the means to recover if the investment vehicle fails. In this case, the investment was unregistered and the majority of participants, as far as we can tell, were non-accredited investors.
- Beware making an investment of more than 10 percent of your worth. This criterion alone would prevent the investment, for example, of 100 percent of a family’s retirement into a vehicle that creates undue risk and provides you with insufficient regulatory protection.
- Beware any investment that guarantees a return above prevalent norms. According to experts, this would be a guarantee of returns above 7-8 percent.
- Check thoroughly into the legality of any investment. Lest I sound smug about this, I will disclose that I once invested in a project that promised a minimum return of 13-14 percent in rent income for investment in a condo being refurbished to an optimal state and rented to vacationing guests. I later discovered the promise of “kickback” revenue in a deal like this is illegal. Even worse, the banks funding the mortgages for this project included the notorious “jiffy memo” process from a major bank whose internal memo for how to hasten a loan resulted in massively bad outcomes during the real estate crash. In the outcome of this project, we discovered too late that our loan application, which had been submitted via Q&A on the phone, had inflated our income by $100,000 a year and had recorded our 401(k) fund as liquid cash. Why didn’t we notice? Because the documents were overnighted to us with a turnaround of just several hours to get to a notary, sign all 30-40 pages and overnight back as a requirement of the program. Thankfully, a mass joinder lawsuit by the 261 investors who’d come in through the same bank and process led to an eventual resolution. But how we even got into the deal leads to the next point….
- Never enter a program that requires haste. Don’t agree to a deal that eliminates the chance to sleep on a decision or perform proper due diligence.
- Beware direct-selling programs in which the compensation model promises extremely high-income possibilities for building a downline of participants. Many of the companies that traditionally followed this model are making changes, both in response to the current market and to avoid the risk of legal analysis determining that an illegal pyramid structure exists. Still, when the model for selling or receiving legal or internet service or weight loss or nutrition products follows a recruiting model and requires monthly purchases, beware. (And a word to the wise: While it’s vital to check authenticity and expiration dates, many of the products you may want from a direct-selling company are available for less on eBay or Amazon from participants needing to liquidate the excess inventory sitting in the garage.)
- Beware the allure of investing with friends. Affiliation can be a deadly factor in many of the deals that go bad. If you know the goodness and heart and even the families of a founder, and if many of your friends are investing, you run a higher risk of mistakes.
How Do You Stay Out of Trouble as an Entrepreneur?
Now, perhaps most importantly, how do you — as an entrepeneur yourself — avoid getting into a situation that becomes illegal? I strongly hold that very few do so knowingly or with premeditated intent. Here are a few of my thoughts:
- Avoid the assumption that a concept you’ve proven in even multiple implementations will perform the same way at mass scale. In this situation, the strategies that made the first income websites successful can cause breakage or even disaster at scale. For example, when Google sees massive increases of traffic around scenarios, it will typically shut the situation down, fearing fraud, or even change the algorithms altogether to make a former approach no longer effective. This is just one example. International tariffs, supply and demand of preferred resources or even the number of Google-indexed publications that exist to carry the mass quantity of value-add and educational materials required to make a system successful can cause a system to fail. The number of participants the market can support in a given category or the total potential market of people who require a certain kind of vitamin or supplementation can influence the way a business model performs at scale.
- Avoid the temptations and risks that accompany fast growth. Communication with employees and customers suffers. The sharpest employees aren’t able to train new hires fast enough or well enough to handle the surge. The inevitable need to run today’s operation on the revenue you secured 30-90 days ago leaves a widening delta that, in a mass-scale situation, hastens the need to either take on debt or sell faster. Lest anyone believe this is a phenomenon that only affects authority websites, I can assure you it is not. Solar companies or online-advertising sites for recruitment or education are other examples of situations I’ve witnessed where salespeople are incentivized to sell faster than the organization can obtain supplies or perform the integration. While not illegal and not pyramids, these scenarios lead to bubbles that collapse, leaving unpaid investors and unserved customers in their wake.
- Learn self-awareness of the traits that make entrepreneurs particularly vulnerable. Inevitably, the best entrepreneurs are people who succeed against all obstacles. They consider nothing impossible and are exceptionally skilled at thinking big and at thinking outside of the box. When the challenges arise, they aren’t defeated. They typically think harder, dig deeper and look for ways to resolve a short-term problem by finding creative solutions. For example, the first major technology company I worked for would joke openly about the channel-stuffing party at the end of the quarter. Under pressure of meeting Wall Street’s expectations for sales and revenue, the teams would put heat on their channels and find every creative opportunity to get additional sales on the books. At a certain level, this is legal, but under pressure, the lines can be crossed — knowingly or unknowingly. These scenarios call for checks and balances and an unyielding focus on compliance to keep founders, investors and customers safe.
- Watch out for the ease that comes with affiliation. The human tendency to trust first the people you know best leads to laxness on all sides. It is one of the most pernicious challenges of multilevel marketing and affiliate selling is that people tend to market most heavily to the people they know personally and best; “friends, family and fools,” as the saying goes. Be doubly vigilant in your marketing and also in your investments and purchasing when dealing with the people you know.
- When a line is crossed, now what? In hindsight, many of the worst of the situations we encounter involve a person who faced a short-term issue — perhaps co-mingled funds thinking it was deserved and would be quickly rectified, or used current sales or loans to provide payouts to prior investors while attempting to speed up production or find alternative lines of revenue to make up the gaps. For example, did Theranos CEO Elizabeth Holmes make a purposeful decision to issue falsified results of her company’s blood tests? Probably not. At the outset, she was most likely thinking of the endeavor as an emergency measure to maintain investor confidence until the company could figure out what was up. Most of us know the conclusion of that story. Under vigilant compliance, the company might have been able to correct its fallacious assumptions and make the solution a valid one, albeit more slowly, or could have pivoted the technology to an alternative use. But without these checks and balances, the bubble burst in a way that proved to be horrific for all parties involved.
In all, an investment that goes sour (unless it paves the way for a brilliant pivot) is seldom a good thing. Fraudulent behavior, whether by you or by someone you’ve dealt with, is a disaster that can result in penalties and even prison. It destroys careers and reputations, as well as imposing extremely high and sometimes unrecoverable costs. Whether bad business is the result of fraudulent behavior or an honest mistake, it’s an experience every entrepreneur should strive to avoid.