The federal judge in the upcoming criminal trial of Theranos founder Elizabeth Holmes ruled that the Justice Department could introduce evidence of Holmes’ lavish lifestyle, to demonstrate her alleged motive to commit fraud: money. Holmes stayed in upscale hotels, wore expensive clothes, and liked to hang out with the rich and famous. In that way, she was hardly different from other high-flying CEOs who, the court noted, are known to live a different lifestyle than most people.
Theranos imploded even before it went public. But plenty of other start-ups are reaching the public markets at an astounding pace, presumably with more legitimate business operations than those described in the indictment of Holmes.
In 2020, there were no fewer than 450 initial public offerings in the United States—double the previous year—despite the pandemic that had all of us hunkered down. So far this year, there have been 450 IPOs, even though we have not hit the halfway mark in 2021.
The rush to go public is driven by the desire to gain access to ready available capital in the public markets—not to mention the prestige of operating a public company and the extraordinary explosion of wealth awaiting founders of companies that are successful in their public offerings.
Ask the executives of any pre-public enterprise what they are working toward: They either want to get acquired by an established company or do an IPO. Every non-public company is aiming toward one of those exit strategies, or venture capitalists will not invest.
Once upon a time, a new business was successful if it made a product people wanted to buy and earned a profit. Now going public or getting acquired is the very definition of whether a start-up is successful.
Going Public: The Dark Side
But there is a dark side to companies going public. Many are not ready for the obligations and expense of complying with a dizzying array of regulations. And the government has feasted on newly public entities by launching investigations of actual or perceived ethical shortcomings.
For example, Luckin Coffee went public on Nasdaq on May 17, 2019. Within seven months, a short-seller alleged that it had inflated its sales numbers. The SEC started an investigation, and Luckin, a Chinese company, settled by paying a $180 million civil penalty.
In addition to the unlucky Luckin, nCino, a fintech company that went public last year, announced that it is the subject of a federal antitrust investigation; so has Clover Health, which just went public in 2021.
And there are others on the government’s investigative radar. The new administration will almost certainly ratchet up the scrutiny of newly public enterprises, particularly those that have gone public through SPAC mergers.
Why Newly Public Companies Attract Scrutiny
There are many reasons why newly public companies are an attractive target for regulators, short sellers, and plaintiffs’ lawyers. For one thing, being public carries obligations of disclosure and transparency that just do not apply to privately run companies.
And chief executives and financial officers have to attest that the information in the public filings is true. That makes them personally liable along with the company for statements that are not true.
Many newly public companies lack the infrastructure that mature companies have developed. They have small legal and finance departments. Some newly public companies may not even have an in-house general counsel, and few have the kind of evolved compliance programs that the government now expects, which include training programs, audits, well-developed policies, and risk assessments.
These components can be expensive. Even worse, they are often considered cost centers rather than profit generators, so they have no internal constituency.
There is also a cultural aspect. Sometimes the very qualities that made a company successful in the first place—risk-taking, boldness, innovation—lead to the kind of corner-cutting that is grist for the second-guessing that attends any government investigation. Entrepreneurs thrive because they won’t take no for an answer. They are results-driven.
But the essence of a healthy corporate compliance program is not about results but about good process, which to many start-up CEOs looks and sounds like so much red tape—until the feds arrive.
Importance of Getting Advice on Compliance
Most public companies are likely to experience an SEC or DOJ investigation at one time or another in their lifecycle. But the costs of an early investigation can be devastating to a newly public company.
They are expensive, distracting, bad for business, and are accompanied by a loss of control that is an anathema to an entrepreneur. Understanding how to implement a real program of corporate compliance, and soliciting sophisticated advice about avoiding the potholes that have tripped up so many companies that have gone public and a few, like Theranos, that did not even make it that far.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Matthew J. Jacobs is managing partner of Vinson & Elkins’ San Francisco office and co-chair of the firm’s Government Investigations & White-Collar Criminal Defense practice. A former federal prosecutor in the Northern District of California, he is experienced in internal and government investigations and white-collar matters including complex commercial litigation.