Will Fallout from SVB Lead to a Rethinking of Tech Investment?

The immediate disruptions from Silicon Valley Bank’s (SVB) abrupt demise have largely been backstopped with account holders being made whole through regulatory action; though there was some initial concern about tech startups losing access to funds needed to keep their lights on.

There may be lasting discussions, however, about ways financial institutions service and invest in the types of cash-hungry startups that patronized SVB.

Questionable approaches to investment in bonds and fear among backers of SVB led to a bank run that cratered its liquidity last week, which brought on its closure. The Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) stepped in to ensure account holders would be made whole, keeping the numerous tech companies that used SVB able to maintain business operations and functions such as payroll.

A plethora of questions are being asked about how SVB was managed. Some news outlets sought to blame diversity and a focus on "woke" initiatives for the bank’s implosion. Daily Mail and Fox News decried diversity and environmental efforts SVB engaged in leading up to its collapse. An opinion piece by a Wall Street Journal columnist pointed out that the board included one minority, two veterans, and just under half of its directors were women, then questioned if "diversity demands" distracted the board -- even though SVB’s board was far from the most diverse among banks.

SVB had a long-running reputation for offering banking to customers -- startups in particular -- other institutions might wave off, says Chris DeMayo, partner with Withum and practice leader for its technology and emerging growth services. This included capital for many tech startups and app developers who needed a bank to keep their businesses running.

Having tech startups as customers has not been named as the catalyst for the bank’s collapse, but DeMayo says the overall situation may be a bit of a wakeup call for how such innovators are funded.

He spoke with InformationWeek about what SVB’s shuttering could mean for access to capital and financing terms for tech startups in the future and contingency plans they may need.

What has the collapse of SVB done to the innovation landscape?

There’s a couple of pretty meaningful macro things that I think are going to come out of this. Prior to this particular bank failure, when have we ever seen a bank fail and had a moment in time where there was a legitimate concern that customers would lose their deposits. Nobody in recent history can really talk about that. Even in the 2008 banking crisis that concern wasn’t realized. This was the first time that an entire community, the tech community, was faced with real peril for a 48- to 72-hour-period.

CEOs, CFOs, the C-suite in general was forced to make decisions that out of nowhere put them in a position where they were in crisis, similar to the feeling of the pandemic.

One of the fallouts will be that the mid-tier banking system is going to have headwinds because even though in the end the customers were made whole, I think there’s a lot of companies looking at this and saying, “I don’t want to have to deal with this again.”

The mid-tier banking system is going to feel some pain in that process as a result.

Chris DeMayo, partner with Withum

The fact that the Fed and FDIC protected depositors saved the mid-tier banks because I think there would have been more runs on the bank, on banks. I think other banks would have fallen if we saw companies were really having an economic loss as a result of this.

The other macro issue we’ve got is the fall of SVB is going to be a problem for the tech community. A lot of people outside the tech community don’t realize that for 40 years, SVB has been banking the unbankable. These are cash-burning startups that are extraordinarily high-risk and there are many banks that don’t like to play in this space. SVB was the core player of that space. With them no longer in the picture, who fills the void?

How do they bank companies that are early-stage startups that are high-risk, venture-backed, burn a lot of cash? If we can’t find suitable replacements for that, banks that will step in and fill that kind of void, startups are going to be required to burn less cash. They’re going to have to raise money and make sure they’re managing the working capital more carefully because it’s easy to place your deposits in a bank -- it’s hard to get capital lines of credit when you’re not cashflow positive.

Startups are going to have to be more careful in how they spend their money. There’s going to be a much more delicate dance between startups and venture capital funds. Because of rising interest rates, we were already seeing tension building between venture capital funds and startups that are trying to raise money over valuations because of cost of capital. Having a void in the banking industry is not going to help that tension.

Does HSBC acquiring the UK branch of SVB -- for less than a pair of socks -- indicate that HSBC have a deep interest in the market SVB was in? If other banks pick up other pieces of SVB, does that mean they’re interested in “banking the unbankable?”

I think you will see institutions come in and take some of these assets, but SVB was all-in on this sector. I don’t think you’re going to see a bank or banks all collectively go all-in on this sector. There are some banks that are there right now. PacWest is all-in on this sector and was the prototypical No. 1 competitor to SVB. They might be strengthened by the failure of SVB because people are going to start to go toward a PacWest potentially.

I don’t think HSBC stepping into the SVB shoes is necessarily a clear indicator that they want to go all-in the way SVB did, but there are certainly players that want to be in this space. JPMorgan Chase wants to be in this space. How deep do they want to be in this space is the question. It’s the same question with HSBC. Them stepping in and picking up these assets is an indicator they want to be in this space, and they want to entrench in but we don’t know if that means they want to be entirely into it.

After the initial shock and fear of the situation, the absolute worst does not seem to have happened -- yet. How calamitous could this have been without regulators stepping in?

I think this could have been an absolutely catastrophic financial situation if [regulators] didn’t step in. Not only if they didn’t step in, they needed to step in before the markets opened at 9:30 on Monday. If they waited until after the markets opened, you would have seen massive, massive volatility in the market.

You got to keep in mind, there’s thousands and thousands of companies that were banking that SVB that either literally couldn’t function or had to shut down and furlough employees because they just didn’t have access to capital. This wasn’t just a necessary thing for a soft landing; if they didn’t do this, I think this could have spun out of control.

Ways it could have spun out of control: untold numbers of employees getting laid off and companies literally not functioning. These are high-tech startups but they’re also servicing the preponderance of our country. Look at Roku; Roku had to disclose publicly that they had half a billion dollars that was tied up in SVB. If they suffer that economic loss, it’s a huge deal. The reverberations go on and on and on.

If you demonstrate in the banking industry that the average, main street company could actually suffer an economic loss because of a failure of a bank, that changes the entire dichotomy of the banking system. You will substantially weaken the mid- and lower-tier banks because the Average Joe is, “I’m afraid to keep my money there because they’re so small."

The fact that the Fed, FDIC, and the government stepped in to stop [bank runs] from happening, I think that’s a massive plus for the economy. If they didn’t, the horses would have been out of the barn, and you probably would have had irreversible damage.

Back to how this could change the tech scene -- has there ever been a movement to change how much money startups burn? Is there any kind of roadmap for how the tech scene might reorient itself?

This is part of a bigger conversation. Interest rates were so low for so long that money was so cheap that it was easy for venture capital firms to invest in startups, and it was easy for valuations to continue to rise. As we’ve corrected the inflationary environment by raising rates, it changed the cost of capital, and it’s made it harder to raise money.

SVB was one of the victims of that. If you dig into why SVB failed, it was largely an interest rate issue. The problem with SVB was their customers are customers that raise a ton of money, they’ve got a lot of cash on the balance sheet but a much, much smaller cohort of them need bank debt. SVB doesn’t have the ability to necessarily easily loan money out to their customers because not all of them need it because they raised a ton of money. So, they’ve got all this cash and they need to do something in order to make money off of the cash because they’ve got to pay interest to their customers.

They go out to the broader market and buy things like bonds. The problem is they are buying long-term bonds. As long as you hold that bond to maturity, you will make your percentage. If you buy a 1% bond with a five-year maturity and all of the sudden the rates go to like 6%, the value of that bond goes down because nobody wants a 1% bond when they can get a 6%. SVB got stuck because their financials started to look really bad. They had all these unrealized, noncash losses. Then the depositors started to take money out of the bank because they were afraid the bank’s financials were unstable. Because that happened, they had to sell some of these bonds and realize a loss because they sold them early. Then there was a run on the bank.

SVB would have been fine if the run on the bank didn’t happen. The fear response was ultimately what killed SVB because they couldn’t create capital fast enough for the withdrawals that were happening.

In the general, macro tech economic environment, I think that companies are going to have to operate in a way -- because the banking industry is changing around them and venture capital is more expensive, valuations are harder to agree on and VC firms are more careful about capital deployment -- startups will still burn cash but they are going to need to be much more strategic about how fast the pace of their burn is and where they’re going to be when they start to run out money and they have to raise the next round. I think they’re also going to have to be in a position where at any point in time, if they need to, they can operate at break even.

We now know the banking environment may be difficult. We now know they may have issues with raising money from venture capital at valuations that are palatable. We’ve all lived through crises in the last five years that tell us that we cannot assume the world is going to be the same tomorrow as it was today. Startups are going to need to operate with contingency plans. I think you’re going to see boards pressuring their startups to have that model in their back pockets if they need it.

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