The news moving markets this quarter was, again, the continued rise in interest rates, but also a minor earthquake in the financial sector: the collapse of Silicon Valley Bank (SVB), Signature Bank, Silvergate Bank, and Credit Suisse. In the aftermath of these events, we believe the most compelling question is: who will fill the void that Silicon Valley Bank leaves behind?
Who was Silicon Valley Bank?
Silicon Valley Bank was founded in the 1980s with the mission of addressing the specific needs of startup companies. At the time, the banking industry did not have a good understanding of startups and how to service companies that had promising futures but no revenue. SVB offered comprehensive banking services to founders with an understanding of the failure risks inherent in the world of startups. SVB managed this risk through their unique business model: offering loans in exchange for equity in the companies. Initially, founders seeking a loan from SVB had to pledge up to 50% of their equity as collateral. Over time, this rate fell to roughly 7% which reflected both a low failure rate and founders’ incentive to pay off the loans to maintain control of their companies.
With this business model and a willingness to step in where other banks would not, SVB became the go-to bank for founders by offering products that were purpose-built for the industry. SVB provided a one stop solution so that founders could focus on developing their new technology instead of managing working capital. It was common for a venture capital firm’s term sheet to require that startups open a bank account at Silicon Valley Bank. Initially, SVB’s strategy was to simply manage bank deposits, but they eventually expanded their offerings to include services that would allow SVB to support these companies as they matured beyond their startup phase. When a new company received fresh funding from a VC, the startup would typically have many other needs. SVB opened its rolodex to connect these customers to its network of venture capital, legal and accounting expertise. They provided founders with credit cards and access to mortgages. SVB sponsored technology conferences and funded networking dinners and happy hours where entrepreneurs could connect with peers. SVB built an M&A arm to broker a deal if the startup needed to be sold. If a startup failed, SVB would assist in the orderly wind up of the business. SVB played the long game and became enmeshed in the VC community. Their absence will leave a gaping hole in the heart of Silicon Valley.
Who will step in?
With SVB’s demise, the question remains, who will provide these much-needed resources to startups that don’t fit the traditional banking model? SVB is credited by many founders and VCs as being more willing to lend to startups than larger banks. Even as startups flocked to the larger banks during the recent crisis, the larger banks have no need (and are now disincentivized) to take the same risks. Wells Fargo and JP Morgan have always had specialist teams of bankers in Silicon Valley and can fill some of the gaps, but their services will not match those of a bank that spent 40 years honing a specialty business model. Without SVB, early-stage companies will be met with higher borrowing rates and more hurdles securing venture debt. It is notable that even SVB prioritized supporting companies that received funding from the top-tier VC firms such as Kleiner Perkins, Sequoia, and NEA to reduce risk. With SVB gone, only the blue blood startups will have access to resources.
Who do you trust?
The entire banking industry (and the value of the U.S. Dollar itself) is built upon trust. We trust that our financial institutions will have our money when we want it. In exchange for making our deposits, the bank takes our money, loans it elsewhere and pays us a portion of that interest spread. The entire system is predicated on all depositors not asking for their money back at the same time. At the beginning of March, news that SVB needed to quickly raise capital by selling some of its investments at a loss sent the stock into a freefall. VCs and founders rushed to their phones to encourage their portfolio companies to get their money out of the bank as quickly as possible, the very definition of a bank run. Because social media fueled the panic and withdrawals could be made via smartphone apps, this was likely one of the quickest bank runs in history.
An interesting correlation is that as these banks collapsed, the crypto economy rose. The value of Bitcoin was up 70% through Q1, and the value of Coinbase (COIN) rose nearly 80%. This would seem to imply that cryptocurrency investors view crypto as a safer alternative to the banking system. However, if over the past few years, a significant portion of the U.S. banking system had been offloaded to cryptocurrency and there had been a similar failure within the crypto ecosystem, who would have bailed out the system? Who do you trust?
There are long-term implications for public markets and our investments. SVB’s collapse, combined with an already slowing macroeconomy, will likely slow deal flow among VCs and in some ways stifle the “innovation economy.” The real effects of the demise of SVB may not be felt for many years. For public equities, venture capital is the “farm team” for the universe of public equities. Venture capital supports the innovation economy by providing funding to promising startups which will hopefully grow large enough to become public companies. According to an updated 2021 research paper, venture capital-backed companies account for 41% of total U.S. market capitalization and half of all public companies founded within the last 50 years. Our largest tech companies, and arguably the crown jewels of our economy (Apple, Alphabet/Google, Amazon, Microsoft, etc.) were all birthed from VC investment. Without the farm system, the U.S. loses its innovation engine: prior to the 1970s (when the VC industry was spawned), the U.S. did not create top public companies at a higher rate than other developed countries. But since the development of the VC ecosystem, the U.S. now produces twice as many top public companies as other developed nations.
Even prior to the recent banking crisis, there were clear negative trends within the industry:
Slowing deal flow.
Source: Venture Monitor
Fewer IPO exits.
Source: Venture Monitor
These would appear to be natural cyclical drop-offs in activity after periods of inflated (bubble?) levels of activity. However, the loss of a key cog in the system leaves questions, and a void. The events will likely put a damper on innovation and, at a minimum, squeeze long-term growth from the economy. We continue to align our client portfolios to this new reality.