The dodgy business practices venture-debt banks don’t want us talking about.
UPDATED: This post was scheduled to be published at 4 pm PST Sunday, March 12th. Shortly after that, US regulators made an announcement that has been added below — it doesn’t change the fact that what's described here helped cause the crisis, and must be addressed.
Just about everyone in the tech world, and the “real” world is aware of the high-level details of the SVB melt-down that is unfolding as I write this. A massive run started on SVB on Thursday, and by Friday it was under the control of the US Federal Deposit Insurance Corporation (FDIC).
Why another post on SVB? This post is not about the overall situation but is written to shine a light on a key business practice of SVB and its competitors that isn’t being discussed (almost at all) by the punditry. Even if SVB is saved (let’s hope) — we as an industry need to discuss the business practices described below. They directly contributed to this crisis, and regulators are asleep at the wheel. They apply to several other banks that do the same thing, and that is scary.
Catch-up quick: If you don’t know the backdrop, you can catch up quickly with excellent coverage at these links by the Wall Street Journal, or this excellent blog post by David Kellog. The short version is that SVB failed on Friday, and it’s the 2nd largest bank failure in US history. That’s bad for the US banking sector, but for tech, it could be a disaster if a solution isn’t found rapidly. “Silicon Valley” Bank is aptly named: it is a cornerstone institution in Silicon Valley and the entire tech ecosystem we use that phrase colloquially to describe. The failure of SVB won’t just shake Silicon Valley but will reverberate through all tech investing (in both public and private companies, venture capital, and private equity, both in the USA and globally). That will happen no matter what. What is unknown yet is how bad it’s going to be.
BREAKING NEWS UPDATE: Read here that as of ~4:30 pm PST US Federal regulators have announced they will back-stop SVB deposits. That’s great, but this story is about a) how we got here; b) and why VC’s told their portfolios to pull their cash on Thursday. The business practices here must be addressed.
The splashy headlines miss the point: this collapse is not about Roku potentially losing $450M of cash or Circle potentially losing billions. Those companies are big and ugly enough to ride this out and get whatever they can recoup in 2024 if they have to. This crisis is about the many many small tech companies… tomorrow’s Google’s and Facebook’s… that may all get snuffed out in the weeks ahead if this thing isn’t contained, or if it spreads to SVB’s peers. Many thousands of families will suddenly lose income, and be cast out into an ugly job market for tech.
The “dodgy” business practices that aren’t being discussed: cutting to the chase, the topic I want to shine a light on is how SVB and its competitors have won a lot of business over the last 20 years. It has directly contributed to this crisis, and it means that this crisis could be widespread. And hundreds of companies could go belly-up.
It also means that the other banks who use this tactic need to be looked at very closely, and with urgency.
It goes like this:
if you are a start-up and you raise equity capital, SVB and its direct competitors will lend you money on the back of that equity round almost sight unseen.
The fine print? You must deposit all your cash with SVB and do all your banking through them.
What does this mean?
It means that definitionally hundreds if not thousands of SVB’s customers are: a) super risky loans, because they are loans to startups that are burning a lot of cash and are truly not credit-worthy; b) those startups have most, if not all, their cash with SVB; c) those startups are now up sh*t creek without a paddle.
Who am I to have an opinion or write about this? This isn’t an opinion post. This is based on my experience raising capital, negotiating with SVB on multiple occasions, getting offers for loans from SVB, and taking loans from SVB’s direct competitors.
An example — simple math: let’s take “ACME Corp”., a software company with $10M a year in revenue, and $17M a year in costs (a very typical scenario). They are “burning” $580k of cash per month. ACME raises $10M in equity from a venture capital firm or a private equity firm. Let’s call them “VCPE”. ACME will most usually become aware of offers from SVB and similar banks (e.g. PacWest and the Square1 Bank they bought, First Republic, etc). SVB will offer ACME $2–4M in debt almost sight unseen. VCPE is happy, because ACME now has even more “runway”, and it reduces VCPE’s risk (boy did this turn out to be untrue!).
In my business, we got offers from SVB when no serious lending entity would take us on. To a Founder the loans are attractive. Almost no due diligence… fast closing… often the 1st couple of years' interest is accrued and doesn’t have to be paid monthly.
Why do SVB and its competitors do this? Well… beyond the obvious things like the high
interest they charge on those loans, and the profit-sharing warrants they get for issuing them, they require ACME to put all of its cash and banking business with SVB.
In that way, SVB gets a very profitable (but super risky) loan, but they also get $14M deposited with them and all the banking fees that ACME accrues. In my business, bank fees and transaction costs were almost $1M a year.
What does this mean in the real world? It means that SVB has hundreds, if not thousands, of loans to companies that are a) super risky; b) made to loss-making companies; c) to companies that are quite small; d) companies that can’t get other cash easily; and e) those companies have most of their cash-on-hand with SVB and now can’t access it; f) much of SVB’s customer roster is not at all interesting to more conservative mega- banks;
The Great Recession analogy: This is like retail banks giving credit cards and mortgages to people back in 2004–2007 that should never have been issued, creating systemic risk that screwed Wall Street and Main Street. A big difference though was that the retail outfits that sold those mortgages and credit cards to consumers then sold those assets on the back end to other bigger institutions. SVB kept these loans on their books, and then managed that money incompetently. Risk management was clearly not part of SVB’s business on the sales side or on the money-management side.
The White Walkers are coming over the wall: the fact that SVB has so many clients, and their competitors do the same shady stuff makes the SVB meltdown terrifying. There could be a run on SVB’s competitors tomorrow morning in the US when the banks open. VC’s are telling their portfolio to yank funds from those banks too.
If the deposits at SVB aren’t made available very quickly to deposit holders, then hundreds of small tech businesses will fold in the weeks and months ahead, and tens of thousands of people will lose their jobs. There was already a cold wind blowing through the halls of tech finance (with the Nasdaq down 33.1% in 2022 alone, the FTX collapse, the crypto meltdown etc). This is going to be a blast of ice. The White Walkers will be coming over the wall.
Speed is essential: Quickly is the keyword above. To small cash-burning companies getting cash out in 12 months is the same as getting cash out never. They’ll be dead.
The White House Should Pay Attention: Biden’s administration has been taking action to protect and grow the US tech sector as a buffer against China’s progress. Protecting the financial health of Silicon Valley is strategically important to the USA. Tech ascendency emerges from the multitude of start-up minnows, some of which grow into world-changing Whales. Dead minnows today means no Whales tomorrow.
What's the solution? That’s above my pay grade. I have several friends who have all their cash at SVB and are in a full-blown panic. I have others who are more sanguine. I have mates who are actively fundraising… and I worry for them. If a big bank doesn’t step in and announce that all deposits will be honoured and made available ASAP, then maybe the FDIC can lift the insurance cap from $250k to $5M. that would at least ensure that all the small companies that are least able to absorb the impacts of this bank collapse can live to fight another day.
The future: even if this crisis is contained and solved quickly (let’s hope so), regulators need to take a very close look at the business practice of the entire venture-debt industry, and in particular those banks that are super concentrated in the sorts of risky loans described here, and the attached requirements that made SVB’s customers put all their cash with them.
Please comment below, and please reshare this if you want more people to understand this element of the story. There is a big cautionary tale here for any CEO thinking of taking venture debt.
A deal that is too good to be true almost always is.
— — — — — — — — — — — — — — — — — — — — — — — — — — -
About me: I’m a software engineer by training and a software leader by profession. I’ve led two California-based SaaS companies as CEO, and am now back in my home country Australia. I’m passionate about product & believe product management is the highest leverage activity a CEO can participate in. I’m here on Medium writing mostly long-form posts on topics I’ve got experience in, mainly #Fundraising #SaaS, #Product, #Startups, #Offshoring. Thanks for reading!