By Rolfe Winkler
Last winter, Goldman Sachs Group Inc. presented Silicon Valley
investors with what seemed like a hot opportunity in Chicago.
Advertising company Outcome Health was one of the city's rising
stars, run by a charismatic founder with close ties to local
billionaire J.B. Pritzker. Revenue was soaring, profits were
impressive, investors were promised a guaranteed return, and
Goldman's involvement gave Outcome the backing of a blue-chip
firm.
Those were some of the highlights that led experienced startup
investors to put $478.5 million into Outcome last spring at a
valuation the company said was $5.5 billion. The investors placed
the Outcome bet despite multiple warning signs, a Wall Street
Journal examination shows, illustrating how even the savviest
investors can gloss over potential issues in pursuit of a big
score.
Outcome carried significant debt and had no independent board
oversight. Its chief executive and co-founder, Rishi Shah, had
publicly discussed how the company's growth strategy required
flawless execution to avoid selling something "that doesn't exist."
He and his co-founder Shradha Agarwal would also reap an unusually
large payout from that investment while maintaining control of the
company.
An Outcome spokesman said in a statement: "Throughout the
monthslong investment diligence process Outcome Health maintained
full transparency, cooperated, and proudly shared the company's
10-year record of delivering health information to patients.
Investors actively reviewed hundreds of documents, interviewed
employees and spoke directly with customers and partners about
Outcome Health's success."
Outcome, which was founded in 2006, puts flat screens and
tablets in doctor's offices and streams pharmaceutical ads to them.
Its revenue grew swiftly in the years before the May 2017 funding
round, but behind the scenes the company faced issues.
Former employees and advertisers alleged that from 2014 through
2016, some Outcome employees had charged advertisers for ad
placements on more screens than the startup had installed,
allegations which the Journal reported in October. Outcome had
offered free advertising worth tens of millions of dollars in 2017
to make up for shortfalls, people familiar with the arrangements
said. Some drug advertisers later suspended their business with the
company.
In response to an earlier Journal inquiry, a company spokesman
said Outcome had put three employees on paid leave and hired the
law firm of former U.S. attorney Dan Webb "to review allegations
about certain employees' conduct" raised internally and by the
Journal. The spokesman said Outcome "has always upheld the highest
ethical standards."
Some investors--including funds managed by Goldman, Google
parent Alphabet Inc. and Mr. Pritzker's venture firm--are now suing
Outcome and its founders for their money back, claiming they were
duped by fraudulent documents that inflated Outcome's product and
financial performance. They have also alleged the company charged
for advertising space it didn't deliver.
Outcome says the fraud allegations are baseless and its founders
did nothing wrong. Outcome didn't make either Mr. Shah or Ms.
Agarwal available for comment.
This deal will cause "a lot more soul-searching," said one
investor, whose firm has written off its investment in Outcome.
"Clearly investors didn't do enough diligence."
Venture-capital investing is inherently risky--most startups
fail and few deliver outsize returns. So investors have to weigh
potential rewards against possible risks, and be sure they
understand both.
One question investors might have asked is how Outcome rapidly
surpassed older rivals in a traditionally slow-growing industry
despite having raised minimal outside capital. That growth was
powered in part by a unique strategy to solve what Mr. Shah
described as its "chicken-egg" problem, a strategy he explained
came with a key risk.
Outcome needed cash to install screens in doctor's offices, but
without a network of screens it couldn't attract advertisers to
spend money, the company's founders said in video interviews
published online.
Some companies that try to build a business by connecting two
sides of a marketplace do so by raising investor capital to seed
their market. Outcome had bootstrapped itself, meaning it needed a
creative way to get cash to install the screens.
Ms. Agarwal in a 2012 interview at a tech event that can be
viewed online described how Outcome solved the problem, saying Mr.
Shah "negotiated upfront payments" on advertising deals "to have
money in the bank and actually go and do these installations and
deliver 200 screens, deliver 500 screens, 2,000 screens, that's how
we kept growing." In a 2016 interview also available online, Mr.
Shah described the strategy as bringing "from the future what we
need to fuel the future in the present, which is a concept we've
recycled."
The risk of that strategy, which Mr. Shah described in both the
2012 and 2016 interviews, was that Outcome needed to execute with
"military" precision. "It required you to sell an idea to both"
doctors and advertisers, he said in 2016, "and then you couldn't
mistime it, because you know, that would be fraud, right? If you
sell something that doesn't exist.
"It's like jumping through one train to the other train and
making it out and it's hard right? We're not the only ones to do
it, there are other chicken-and-egg businesses. But to build a
chicken-and-egg business that's capital intensive without any
capital is actually pretty hard. I'm not sure it's been done."
Ray Rotolo, who previously ran a media agency that bought
advertising space from companies like Outcome, said he hadn't seen
an example of another company in the industry charging for screens
that it hadn't yet installed, but that there would be nothing wrong
with such a policy provided clients ultimately get what they pay
for.
In a statement, an Outcome spokesman said: "Mr. Shah's comments
were about starting a company with a two-sided market and the
importance of delivering for both sets of customers, as explained
in the interview." He added that the founders always stressed "the
importance of execution with integrity."
Outcome projected a bright future when it was fundraising about
a year ago--its first time raising money from institutional
investors.
The investor presentation reviewed by the Journal claimed that
drug ads streamed on Outcome's screens delivered twice the return
on investment of television commercials or print ads. Outcome
estimated its 2016 revenue doubled to $131 million thanks to big
customers such as GlaxoSmithKline PLC, and its 2014 and 2015
financial statements were audited by a prominent firm, Deloitte,
according to people familiar with Outcome's disclosures. The
presentation showed Outcome had wide profit margins and a deep
bench of newly hired executives. Deloitte declined to comment.
Outcome also had a hometown hero in Mr. Shah, a 32-year-old
Chicago-area native who had won entrepreneur awards for his
fast-growing startup. Mr. Shah boasted a powerful ally in Mr.
Pritzker, now a candidate for Illinois governor and part of
Chicago's prominent business dynasty.
Mr. Pritzker, 53, had known Mr. Shah previously, in part through
the business-leadership group Young Presidents' Organization,
according to people familiar with the group. Mr. Shah serves on the
board that oversees 1871, a Chicago tech incubator founded by Mr.
Pritzker, and the Pritzker Group added Mr. Shah to its team of
senior advisers in 2015. Mr. Shah is no longer involved with the
Pritzker Group, but is still on the board of 1871.
Goldman Sachs Investment Partners, a unit of the investment
bank's asset-management division, signed on to lead the Outcome
investment after teaming up with the Pritzker Group on a prior
deal.
As lead investor, Goldman Sachs directed the due-diligence
process to spot potential risks, according to people familiar with
the fundraising process. Goldman, which invested $100 million of
its clients' money in Outcome, recruited other investors, these
people said.
Outcome came with risks that were evident before investors
signed on. The company owed $325 million after taking out a loan to
buy a rival in 2016, which raised the risk for investors since
creditors would be paid back first in a sale or bankruptcy.
Outcome also didn't have an independent board to provide
oversight and accountability from an outside perspective. The board
consisted solely of Mr. Shah and Ms. Agarwal before the investment,
according to a person familiar with the matter, and only Goldman
would join afterward.
Outcome informed investors before the funding of an October 2016
whistleblower claim by a salesman accusing the company of
"committing ongoing fraud" by misleading customers about the size
of its network, according to court documents. Outcome told the
investors the claims were meritless, according to the
documents.
Whatever the signs, investors say they couldn't have foreseen
that Outcome would--as they allege in their lawsuit--alter numbers
in case studies to make its ads seem more effective. An Outcome
spokesman declined to comment on the allegation that it altered
case studies, citing ongoing litigation.
People close to the deal said investors liked the large and
growing profits that Outcome stated, and were willing to bet on the
company because Outcome sweetened the deal with a unique structure
whereby it guaranteed investors a 20% annual return. In most
startup equity deals, investors simply buy shares at a set price
and hope they will rise in value.
With guaranteed upside, investors agreed to earmark $225
million--nearly half of the equity investment--to pay the founders
a dividend, according to the lawsuit.
Two venture investors say they passed on the Outcome deal
because of the dividend, the company's debt burden, and a worry
that the return guarantee wouldn't pay off as expected. One of the
investors was also wary of the founder-controlled board.
Write to Rolfe Winkler at rolfe.winkler@wsj.com
(END) Dow Jones Newswires
January 25, 2018 07:14 ET (12:14 GMT)
Copyright (c) 2018 Dow Jones & Company, Inc.
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