In the wake of a host of negative developments, Theranos Inc. is reportedly under investigation by the Department of Justice and the Securities and Exchange Commission. The SEC and DOJ inquiries are likely to focus on whether Theranos misled investors about the state of its technology and operations. Even beyond potential misrepresentation issues, we believe the SEC may also be focused on the adequacy of internal controls at privately-held companies, potentially viewing governance and control problems as contributing factors to other issues.

Theranos has also been dealing with issues raised by the FDA and the Centers for Medicare and Medicaid Services (CMS), including quality control concerns involving the company’s lab testing process. The SEC may have parallel concerns about the company’s internal controls over financial reporting. Under pressure to perform to the expectations of the company’s $9 billion valuation and to prove the viability of its signature technology, it is possible that enhancing internal controls may not have been the company’s top priority.

Private companies are still subject to SEC action for violations of the antifraud provisions, even though they are not typically subject to reporting and internal control requirements set out in the federal securities laws. We believe the SEC may expand its footprint and focus on whether internal controls are adequate at rapidly-growing private companies.

As we previously discussed, in a recent speech addressing issues relating to pre-IPO companies, SEC Chair Mary Jo White noted that the SEC was looking closely at privately-held “unicorns”, even where the investors appeared to be venture capital and private equity funds. She stated that control issues were a major risk factor that could lead to opportunities to misstate financial results: “The risk of distortion and inaccuracy is amplified because start-up companies, even quite mature ones, often have far less robust internal controls and governance procedures than most public companies.” Newly-public companies are not immune to these pressures. For example, Chair White cited a recent action filed by the SEC alleging that a company and its executive inflated results to meet projections during its first year public, which occurred in part because of insufficient internal controls.

Similarly, startup founders are dependent on each successive round of funding. With the private funding environment getting more challenging and the IPO market largely non-existent (notwithstanding the recent IPO of Acacia), private companies are beginning to face a binary outcome: obtain private financing or go out of business. When the choice comes down to survival as a company, there may be temptations to push the envelope on financial results and projections.

For investors, the allegations regarding Theranos are a good reminder that eye-popping valuations for private companies can be inherently subjective, and may be affected by inadequate internal controls.

Even where there is ultimately no enforcement action, we expect that greater focus by the SEC on privately-held companies will drain time and resources not only from those companies, but also their investors, brokers, placement agents, and other liquidity providers. In these situations we expect the SEC to focus not only on company representations during fundraising, but also on the company’s internal reporting procedures. Private funds that invest in privately-held unicorns would be wise to look carefully at related representations the company made to them as well those provided to later investors, in addition to examining the internal control processes at the company.