Silicon Valley's Thin Grey Line: When Does Hype Turn To Fraud?

Society celebrates the successful, anointing genius status to those who reach the top rung. At the same time, society can (and will) turn on a dime, instantly heaping derision on those same captains of industry if they fall from grace.?We see this playing out right now with once high-flying Theranos founder Elizabeth Holmes. She was the next big thing. Until she wasn’t. The jury just convicted her for fraud, of course. But did Holmes essentially do what Silicon Valley has long rewarded entrepreneurs to do - “fake it until they make it?”

Holmes sold an aspirational, audacious dream, and she sold it extremely effectively. Her fundamental defense at trial was that she believed that “tech” tale that she preached and that made investors swoon.?And here's the thing. Founders frequently believe their own stories, even when their pitches don’t hold up to scrutiny (which they frequently do). That’s the Silicon Valley rule, not the exception.?Pitch decks are filled with financials that always rise logarithmically up and to the right. Always. And entrepreneurs, by definition, are believers who think they can pull off what they preach. Always. If not today or tomorrow, somewhere down the line they'll just figure it out. So the fundamental question at Holmes' trial was whether there was actual proof of fraud. The jury concluded that the answer was "yes" (and they likely are right). But how many other juries would reach the same conclusion with many other Silicon Valley entrepreneurs?

Consider two other Silicon Valley business titans — both of whom have been lionized, but one who now also faces the deafening roar of hate.?The first is Reed Hastings, founder and CEO of streaming juggernaut Netflix. The second is Adam Neumann, founder and former CEO of once-darling WeWork.?Hastings is widely hailed as being one of the foremost business visionaries of our time. After all, he built a seemingly invincible company that now boasts over 214 million subscribers worldwide and a market capitalization of $263 billion (as of this morning). Neumann, on the other hand, is now widely castigated as being a con artist who bilked billions. At one point, WeWork planned to go public at a near $47 billion valuation, but it then cratered 80%. All thanks to Neumann, so the story goes. Neumann, the grifter - the quintessential cautionary tale.

But like most things in life, these stories aren’t so simple.?No one can dispute Neumann’s core brilliance of re-imagining commercial real estate, transforming them into inspiring, open and cool cathedrals to entrepreneurialism.?So what did Neumann do wrong??Like any self-respecting Silicon Valley-inspired entrepreneur, he pushed a sexier central story of tech-dom that drove significantly loftier financial multiples. Sophisticated investors like SoftBank ate it all up – that is, until certain more sober financial analysts began to dig deeper and poke holes in Neumann’s tech story. That’s when the dominoes began to fall. And now this former hero is a monster.

Now let’s take the legend of Reed Hastings.?He alone saw the streaming opportunity and grabbed it (at least, so the story goes).?But upon digging deeper, significant holes can be poked in Netflix’s story as well.?First, Hastings certainly wasn't any lone ship in the night when it came to streaming. Many others had jumped onto that boat streaming into our lives (while some like Blockbuster simply missed it). But, even more, while certainly not equating those with WeWork’s or Theranos’s, a credible bearish “House of Cards” case can be made with respect to Netflix as well. Yes, Netflix is frequently profitable in an accounting GAAP sense. But the gap in its story is that cashflow positivity remains elusive; the company was cashflow negative once again in Q3 2021. And its debt load of billions has generally risen over time to pay for ballooning content budgets that reached $17 billion last year (the company reported long-term debt of about $15 billion as of Q3). Those content budgets, of course, will only continue to rise. Up and to the right.

Hastings justifies these realities by convincing investors that Netflix’s Herculean historical growth can continue endlessly. But Netflix U.S. and Canadian subscriber growth is essentially non-existent at this point. The company reported only 70,000 new subscribers in Q3, and it actually lost U.S. and Canadian subscribers in Q2 2021. That means it still has fewer paid subscribers in those regions than it had about one year ago. Netflix also faces massive challenges overseas by the likes of Amazon and Disney (which amassed over half of Netflix’s global subscriber count in less than two years). Netflix’s basic business model is also knee-capped, because it essentially sells only one product – content. Its gargantuan competitors, on the other hand, can use their streaming services primarily to market other core products. Apple TV+ is one big commercial for iPhones and Macs. Amazon Prime Video lures us in to subscribe to free shipping so that we keep shopping.

Does this mean that Hastings is pulling a fast one on us or guilty of Holmes-like behavior? Of course not! He likely authentically believes that his business recipe can work endlessly. But even if he doesn’t, you can’t fault him for being a great Silicon Valley-styled salesperson who knows how to “sell the dream” to a world of few doubters.

That's the Silicon Valley way, after all.