If you’ve been living under a rock, Silicon Valley Bank, the 16th largest bank in the US and the number one bank for venture-backed startups and venture capital firms failed last week.
I began preparing to write this essay when there was the possibility of a much scarier situation for all of us. As it stands, total disaster was averted, but all of us who plan to raise capital still have much to prepare for, and I’d like you all to be… well, prepared.
I’ll get to the impacts on fundraising and recommendations, but first…
To understand the disaster, you first need to understand how a bank works. Let’s start with an overly simple guide to banking:
A bank’s business relies on taking deposits from customers and lending that money out to generate interest.
A bank does not keep 100% of the deposits ready to be withdrawn, otherwise it would have no way of making money. In fact, laws require banks to maintain a portion in cash or highly liquid assets (loans that could be converted to cash in a short period of time). Banks constantly manage the ratio of longer term loans (ones that produce more interest but can’t be converted into cash easily) and cash / cash equivalents (aka their Liquidity Ratio) to ensure depositors have access to funds. This Liquidity Ratio balancing act is where they maximize profits…
Like any business, there are many risks involved in the business of banking. There are two relevant ones to cover before talking about SVB.
Risk #1 - the value of longer term investments go down
As a bank models out what cash they’ll have on hand for depositors, they predict the value of longer term investments. At maturity, those investments will turn into a certain amount of cash and allow them to loan even more money. If the expected value of an investment goes down, their liquidity ratios can take an unexpected hit. These liquidity ratios need to be maintained to protect against risk #2…
Risk #2 - higher than expected depositors withdraw their funds
Banks know that on any given day, customers will deposit and withdraw funds. For the most part, they expect a large majority of deposits to remain in the bank and inflows to exceed outflows. If more withdrawals happen than expected and outflows overly exceed inflows, liquidity ratios can also take a hit. Even scarier, a larger than expected outflow of funds can trigger fear in the safety of other depositors’ funds and lead to other depositors defensively withdrawing their funds. This is what is called a good ol’ fashioned “run on the bank”. I say ol’ fashioned because this hadn’t really happened since the 1930’s when 9000 banks failed during the stock market crash of the Great Depression and depositors scrambled to get whatever money they could.
I called out those 2 specific risks because those are the two main body blows that KO’d SVB. That combined with a horrific management of communications spelled doom for the bank.
The quick summary: SVB invested in low yield and relatively low-risk mortgage-backed securities. When interest rates rose, the value of those securities dropped and drove SVB to make actually prudent efforts to raise more capital. SVB announced those moves right after another smaller regional bank failed, which spooked the market and caused the stock price to plummet ~60% in one day which in turn caused customers to withdraw their money all at once. This was the bank run. $42B of capital exited SVB in one day. Game over. (Editor’s note: there are other conspiracy theories of investors shorting the stock and then triggering the fear and bank run…but not worth jumping into that in this essay).
And this was HUGE in the world of tech startups. Silicon Valley Bank was an essential player in the ecosystem. They held $175B of deposits from ~2500 venture capital firms and almost half of all tech startups in the US.
From my small startup Adamant to Roku, a public company with almost $500M trapped at SVB, thousands of companies for a time thought that only $250k of their capital (the FDIC insurance limit for deposits) might be accessible. This is an extinction level disruption when a company can’t access its money to run payroll. So thousands of companies that employ tens of thousands more employees were on the verge of going under.
And while disaster was averted when the gov’t came in to do the right thing* by guaranteeing depositors their money, there are still massive impacts on our ecosystem…
*I don’t want to get into a political debate but I want to add two footnotes to dispute the idea that SVB or the tech industry is getting a “bailout”. First, although SVB had a liquidity crunch as in they would have a hard time giving depositors their money immediately, they were solvent. In other words, their assets covered their deposits. They just needed time to convert their less liquid assets into cash. Second, I heard David Sacks say something in a debate that is helpful to hear if you (or more likely someone you’re debating on twitter) thinks SVB should have been left to completely fail and its startup depositors stuck dealing with the frozen assets. If you go to a doctor that is found guilty of malpractice, should you be liable for what the doctor did? The answer is no. Startups should not be punished for a bank’s mismanagement.
How much is that shirt you’re wearing worth?
What about the house you live in?
The startup you’re raising capital for?
The answer to all 3 is the same. Things are worth what someone is willing to pay for it. When an asset produces revenue or measurable utility, valuing something might seem easier. But even then, when valuing the entire worth of any asset, you are baking in some future value. And anytime you consider the future, well, it’s uncertain. The future is unwritten. In other words… there’s risk.
So how much the market is willing to pay for something (IF AT ALL) is deeply impacted by their risk appetite. This is especially true with investing in early- stage companies whose future revenues are highly unpredictable.
Startup investing is incredibly driven by excitement in future opportunities, openness to take on risk, and CONFIDENCE in the system. Confidence in America is quite resilient which has served the startup market well over the last 15 years, but it can only withstand so much…
At the beginning of 2022, we were in raging good times but Russia’s invasion of Ukraine in February initiated a pullback and correction in the market that many had been predicting for the previous 7-8 years (no joke… I remember being in meetings at Greycroft where we talked about warning our companies about tough times in 2015).
Following that there was uncertainty and some pullback but there were still plenty of VCs actively investing. There was still optimism and excitement. Then came the first crypto crash, triggered by the collapse of Luna in May 2022. 5 months later, FTX failed. And now after a 4-month reprieve, we have the collapse of SVB.
In each of those periods between unexpected shocks to the system, I saw the industry begin to rally and pick itself up. The startup fundraising market wanted to return and let capital flow freely to back innovation and growth. It’s sad because I talked to many investors who had just gotten back off the sidelines and were excited to get deals done. Now I fear that this 4th shock in a year to an institution so core to the startup market will have lasting impacts. While the startups that held capital with SVB were spared, the overall confidence and risk tolerance of the market were not.
If you’ve made it this far, here are my expectations.
VC investing will not go to zero. Too much capital is waiting to be deployed for that to happen. But the dollars will be bottled up for a while and only let to slowly drip out over at least a 6-month period while confidence rebuilds in a shaky economy. The intrepid investors who had been leading the charge in January and February of this year (see our list of investors doing deals in 2023) will still be leading the charge but their bar to invest is going to be MUCH higher.
Can you blame them?
If we can no longer blithely throw our money into a bank assuming zero chance of losing deposits, how do you think check-writers will underwrite a pre-revenue startup?
This means access to capital is going to be difficult. If you have X months of runway before you need to raise, do what you can to double your runway. If you have the ability to raise capital, raise more than you think you need. If you think you could have raised on a few proof points, a certain amount of traction, a reasonable level of relationship, do more.
The fundraising environment we’re entering into is my skydiving analogy on steroids. You’re no longer just trying to get an investor to go skydiving with you. Your challenge now is to get an investor to jump out of a plane with you who is scared of heights while flying over an active battlefield. In other words, the level of comfort you’re going to have to instill in them before they take the leap has gone up tremendously.
What I want you to do: