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How to Lose $4.5 Billion Overnight

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Forbes made quite a stir last week, by reporting that it had cut the estimated net worth of Theranos founder Elizabeth Holmes from $4.5 billion to…zero. Since Forbes is widely regarded as the authority on the size of private fortunes, this was a dramatic move. How could so much wealth disappear so fast?

One reason is that wealth represents a guess about the value of future earnings. When Theranos’ blood-testing technology was found not to fulfill its early promise -- some suggested it was fraudulent to begin with -- people realized that the company wouldn’t have nearly as much earnings power as expected. That sharply cut the value of the company. Since so much of Holmes’ wealth was tied up in her own company’s stock, that meant she got much poorer.

But a lot of Holmes’ wealth -- like that of many other billionaires -- wasn’t the same kind of wealth that you or I or most people have. I wouldn’t quite say that it’s imaginary, but it’s qualitatively different.

Most people have their wealth in the form of bank deposits, pensions, investment accounts and houses. Except for houses (which I’ll talk about later), these things are both liquid and diversified.

Liquidity essentially means the ease with which you can use an asset to pay for other things, without it losing its value. A bank account is liquid. You can quickly withdraw money from it to pay for milk or broccoli or parking tickets. A stock portfolio is fairly liquid too -- it isn’t too time-consuming or expensive to sell some of your stocks to pay for an emergency or a big purchase. A pension fund can be liquidated with effort, but you can still get the money if you really need it. 

Entrepreneurs’ fortunes often aren’t like that. For the founder of a closely held company like Uber, Snapchat or Theranos to use their holdings to pay for something substantial, they would need to sell it to a private party -- a laborious and protracted process. Also, an announcement that the founder is selling their stake in their own company, before it even does an initial public offering or gets acquired, could be disastrous PR, and might result in a large markdown for the company’s value.

Generally, the higher the percentage of an asset that you own, the less liquid it is. Imagine owning all the gold in the world. The price probably would be very high, because someone out there who really, really needs a few ounces of gold would have to pay a huge premium. Suppose there are a billion ounces of gold in the world -- all of it stashed in your living room -- and the price is $10,000 an ounce. On paper, you’re worth $10 trillion. But if you tried to sell all your gold for cash, the price would drop and drop. By the time you finished selling all your gold, you’d have much less than $10 trillion in the bank. Private company founders’ fortunes are a little like that.

Also, very illiquid assets often have paper valuations that reflect models, or wishful thinking, rather than the price that could actually be gotten in a sale. For example, mutual-fund company Fidelity Investments marked down the value of its holdings in a number of so-called unicorns (closely held startup companies valued at more than $1 billion), and then marked some of them up again a month later. Those valuation changes didn’t involve any actual market transactions -- they were just people sitting at desks revising their guesses of how much the investments were worth. Or recall the 2008 financial crisis, when big banks found that they couldn’t sell their mortgage-related assets for anything close to what their fancy models predicted. When a liquid market doesn’t exist for your assets, part of your wealth might be a fantasy.
QuickTake Unicorns

Sometimes, in fact, illiquidity means that you can’t sell your assets at all. Even after Theranos’ value was marked down, the company is still estimated to be worth about $800 million. But the funding that it received from venture capitalists and other outside investors came with special provisions that mean Holmes gets paid off last in the event of a liquidity event. So although Holmes’ 50 percent stake in the company was worth a lot on paper in good times, when the company had an estimated value of $9 billion, in bad times it dropped to zero much more quickly than the company’s actual value. Some investors now counsel founders against accepting these sorts of liquidity limitations in their funding rounds.

Diversification is the second reason wealth isn’t always what it seems. A bank account is only subject to a very small set of risks -- inflation, or a sovereign default. A diversified stock portfolio -- for example, an index fund or collection of index funds -- only goes down when the whole market goes down, and thus isn’t very dependent on any single company’s performance. But when all of your wealth is tied up in a single company’s stock, your net worth lives and dies with that company.

Illiquidity and under-diversification mean that founders’ true wealth is probably less than the numbers on paper. Yes, the market compensates people for illiquidity with somewhat higher returns in the future -- that’s why many people hold illiquid assets in the first place -- but that doesn’t mean that all of the eye-popping numbers you see on the Forbes billionaire list are equivalent to your own bank account. And in an efficient market, there’s no compensation for under-diversification, which is another reason founders’ wealth isn’t quite as high as it appears.

There’s a lesson here for normal people. The one highly illiquid asset that many middle-class people pour a huge percent of their wealth into is their house. Houses are time-consuming and expensive to sell, and if you borrow against your house you’ll have to pay interest on the loan. So houses are illiquid. This implies that many middle-class homeowners are very under-diversified because they have so much of their personal wealth tied up in residential real estate.

In other words, your house is a little bit like Elizabeth Holmes’ stock in her own company. On paper it might be worth a lot, and much of that does reflect real value. But if your local housing market crashes, your net worth is in big trouble. I think more people should consider that before making the decision to buy instead of rent.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net