The Fallout For Startups In The Wake of SVB, Explained

Before the last few weeks, most startups banked across the same handful of institutions, with Silicon Valley Bank being the clear leader. When SVB failed, it was the latest secular headwind to challenge the tech industry, making us all acutely aware of how much counterparty risk exists in our ecosystem.

At TheGP right now, a lot of founders are asking us questions that are both operational and existential. First and foremost, they want to know the best practices for cash forecasting and management in the wake of SVB. They’re also asking us what will happen now that SVB is no longer the financial services leader in the venture ecosystem. At this point, we’re left to ask—will SVB's failure fundamentally change the way startups manage cash? 

Banks are key partners in a startup’s journey, but they’re not without risk

Banks use a business model built on two essential social contracts. On the one hand, they offer customers a secure place to store their money. On the other hand, they utilize these funds to provide credit to individuals and businesses. While these two functions are inextricably linked, they’re also fundamentally at odds. The proverbial “borrow short to lend long” paradox. 

Banks have several guard rails in place that enable them to maintain these functions, which help to protect depositors and the banking system as a whole. Recent events have highlighted the acute vulnerabilities of these guard rails in real-time. The downfall of SVB started when their first line of defense—asset/liability risk management—failed. This also exposed additional flaws in other lines of defense, such as FDIC deposit insurance and the two-tier system of systemically large banks and their smaller, regionally-focused competitors. These weak spots are concerning and potentially dangerous because it’s now abundantly clear just how fast a bank can fail (swiftly, with industrial-level strength) now that digital banking and social media are part of the equation. 

Before last week’s failures, most depositors felt bank deposits were not something you should think about as “risky.” In the years since the 2008 financial crisis, depositors have been conditioned to believe that banks were much safer than they used to be. This worldview was informed by a collective alignment that regulation was more stringent, that risk-taking was reduced (or outright eliminated), and that thresholds for determining when a bank was headed in the wrong direction (i.e. solvency testing and capital requirements) were much higher. 

As a result, most of us believe that bank accounts—like many other modern products— should just work. The fear that bubbled up over the last few weeks came in part from a collective realization that our assumptions were possibly wrong, and the fate of deposits held above the FDIC threshold was very much in the hands of regulators making a subjective call on the degree of systemic risk posed by a failing bank. The dirty little secret in banking is that all banks can fail—from the smallest to largest, from the worst managed to the best. Every bank has a tipping point because they can’t make every depositor whole in short order. The only real uncertainty is how your bank will be treated if it happens.

Should founders manage their cash differently now?

With this in mind, perhaps the collapse of SVB is a wake-up call that startups need to actively manage their deposit risk. If that’s the case, then there are likely significant ripple effects looming on the medium to long-term horizon. Historically, banks have relied on their depositors’ inertia and the difficulties associated with changing bank partners to maintain customer loyalty. Yet, there is a burgeoning class of technology-enabled tools that mitigate the pain of a more active approach to managing risks and frictions (i.e. Mercury, Brex, Modern Treasury, Stripe Treasury).

Depositors have the power to forcibly restructure a bank’s balance sheet by pulling funds and redistributing them across other financial institutions and products. When this happens, excess deposits will move in one of three directions: 

1. Uninsured deposits at systemically important “Too Big To Fail” banks

2. Insured deposits held at other banks on your behalf

3. Short-term cash equivalent securities held in custody on your behalf

In any case, these movements are effectively a reduction in the deposit base at the original bank and will require liquid cash to facilitate (in the form of asset sales or borrowing against asset collateral). Regardless of how the bank accesses liquidity, declining deposits are a barrier for individuals and businesses who want credit in the form of loans.

If there were to be a significant shift from banks to public institutions, with a focus on purchasing government bonds as well as state and local municipal debt, it could have a chilling effect on aggregate credit creation across the economy. While this may be a welcome development in the Fed's fight against inflation, it would represent a significant supply-side effect on monetary conditions. To date, the Fed has mainly relied on quantitatively tightening its balance sheet and adjusting the cost of money to curb inflation, but these measures haven’t been very effective. The potential supply-side shock for liquidity could impact the entire economy (not just the technology industry), and if large enough, it may even precipitate a recession.

Will banks lend less even if their depositors stay put?

Depositors aren't the only stakeholders in the bank. There are executives, managers, bondholders, and shareholders who also have to determine what the Fed has explicitly and implicitly communicated with its actions, and they need to respond accordingly. For these stakeholders, it should be very apparent that the management of risk is more important than ever because the Fed is willing to flush them out when they fail. This means the duty to manage the asset/liability mix of the bank is paramount, as an enterprise bailout is still only available to the biggest and most systemically important banks. 

While the cumulative effects of this realization may not be felt as quickly as depositor migration, bank balance sheets and business models will undergo significant restructuring in the meantime. These changes both foreshadow secular headwinds and may hinder the long-term potential for growth-stage businesses, as well as the broader economy. As a result, concentration, segmentation, overlap in strategic advisory, deposit variations, and sensitivity to interest rate changes are likely to become critical factors in establishing and maintaining relationships between banks and their customers.

Some of these business model concerns are relevant to venture and growth-stage businesses, and they’ll likely be mediated by fintech companies that address these challenges by abstracting the interactions for both their customers and bank partners. However, it will almost certainly require fintech companies to work with many more bank partners much sooner than we all thought.  

No matter the degree or form of liquidity reduction we see across the economy, we can say with certainty that the technology industry has lost a growth-minded bank with the expertise to lend to startups directly. As the venture capital asset class matured, venture debt grew in popularity as an alternative financing option. Bank facilities are now a key tool in long-term capital planning for many firms at both a corporate and product level due to their attractive all-in cost of capital (rate and dilution). SVB was not the only provider of these loans, but they were a dominant force in the market. We expect many large banks will likely maintain their venture debt franchises, but the qualifications necessary to access their services will remain out of reach for many venture-backed borrowers. 

Since its earliest days, SVB provided loans to startups with an attractive cost of capital but also flexible covenants. Beyond being a low-cost provider, the loss of SVB removes significant institutional knowledge from the venture debt industry. Venture debt is a highly networked product, and by the end of 2022, SVB had issued $6.7 billion in venture debt. Because the borrower lacks enterprise value that can be discerned through hard assets or a history of operating profits, these loans were evaluated by existing investors’ quality and their commitment to startups. Building this type of institutional knowledge takes decades.

In conclusion

With SVB’s failure, the tech industry has lost the network effect of its customers. Its deep knowledge base was the foundation of its business, which it used to garner repeat introductions to startups it could give credit. For startups, the failure of SVB and its impact across the banking industry represents a step backward for the venture asset class. This will mimic the structural shift from banks to direct lenders we witnessed after the 2008 financial crisis when banks wound down their leveraged lending operations for mid-sized businesses owned by private equity sponsors. Attractive bank financing options will be rare, ultimately meaning less money for everyone.