What you are describing sounds more like "moonlighting for a startup" to me, which is quite common. Not only in SV but also over here in the "silicon valley of the southeast".
Startups are a great experience, even if they fail. IMO everyone who is in the younger years of their life should participate in at least one or two. The experience is worth far more than any of the stock or options (that almost always end up worthless). I've been involved in three startup situations before, and consulted for dozens more. Much easier to do when you are young, single, no kids, no big bills, etc.
But it's not an internship. I've done that too - and it really can help a student break into a field that values experience as much (or more) than a diploma. Internship is just a way to give someone valuable field experience without having to pay market rates for them. Often at the very same company that they hope to work for as a normal hire after completing school.
Startup moonlighting would typically not include any pay at first - in exchange for partial ownership - while interning does pay (poorly) and offers no ownership.
My biggest concern if I was an interested person would be how quickly it seems like the previous people have been "fired" for making mistakes. In your example the guy ordered the wrong part from digikey, wasting 250 LEDs. Even if they were a dollar each, you're saying you fired someone for a $250 mistake that easily could be made by anybody. That's petty, and I doubt I'd want to put my time on the line knowing that if I sneeze wrong I'd likely get fired with nothing to show for it.