On March 10th, Silicon Valley Bank went bankrupt. Federal regulators had to take over operations to avoid economic disaster.
Due to the Federal Reserve’s determination to curb inflation it has consistently hiked interest rates for the last 12 months, an outcome that SVB and many other banks failed to anticipate. As a result, SVB suffered enormous unrealized losses in the value of its treasury bond portfolio.
As the size of SVB’s losses became known, this startled anyone with money in the bank’s coffers. Massive social media fueled panic caused a run on the bank, and within a few hours SVB received around $42 billion in requests for withdrawals that they were unable to pay. Shortly thereafter, the Federal Reserve, Treasury, and FDIC decided to bailout the bank by guaranteeing that all deposit holders would receive one hundred cents on the dollar, seeking to ease fears of a national financial crisis.
The bailout of SVB was unprecedented, reflecting a deep-seated governmental concern about the risk of financial contagion, as well as the immense political power of the venture capital industry to engineer an implicit government guarantee of more than a hundred billion dollars in uninsured deposits. For example, Roku had close to $500 million in SVB, and billionaire Mark Cuban apparently had close to $10 million of uninsured deposits.
Startups were pressured by the venture capital industry
Up until the collapse, SVB had provided nearly $150 billion to technology startups in the form of venture debt, basically small business loans with fewer restrictions. Most of these startups were venture-backed, which means they had access to venture capital, a form of private investment.
Poor investment decisions by SVB’s senior managers were the proximate cause of unrealized losses on SVB’s bond portfolio and the resulting liquidity crisis that led to the bank’s collapse. When startups panicked and started tweeting about the situation, the problem escalated into a full-blown crisis overnight.
However, the real root cause of the crisis might be laid at the feet of the venture capital (VC) industry. Why did supposedly sophisticated VC investors allow their startups to hold billions of dollars of uninsured deposits in a single bank? Although SVB was an extremely well-capitalized bank, when it announced that it had sold its bond portfolio at a $1.8 billion loss, VC investors sent frenzied messages to the CEOs of these startups and pressed them to pull out their precious funds before they were lost.
What exactly is venture capital? And why do VC investors have so much power over startup decisions? This article gives a rundown of the industry and what changes need to happen to avoid a similar catastrophe in the future.
Venture Capital 101
Venture capitalists invest in early-to-mid stage companies in a wide range of industries: artificial intelligence, healthcare, climate technology, and pretty much any other industry you can think of. They willingly take on extreme risks, knowing that most of the companies in their investment portfolio (also known as “port-cos”) will fail or come back empty-handed. However, they do this on the belief that a handful of the port-cos will return 10x the money invested, which will more than compensate for their losses. Although venture capital accounts for only a small portion of all investments in the world, it can be incredibly lucrative.
VCs get their funding from wealthy individuals and large institutions, including pension funds and university endowments. These individuals and institutions expect the VCs to invest their money wisely and typically pay them carried interest, which amounts of around 20% of the profits generated over the five-to-ten-year life of the investment. This puts huge pressure on VCs, whose income is linked to investment returns.
This pressure trickles down to the startup CEOs, who receive guidance from and report their performance to VCs regularly. To protect their investment, VCs often place an investor on the startup’s board of directors, which is the company’s decision-making body. These investors can often overrule executive decisions or even fire the CEO. VCs also often have a lot of dry powder or unused capital, which they can provide to a port-co as a follow-on investment or withhold depending on performance. Thus, VCs have significant influence over startup decisions.
VC risk management practices caused the startup panic
Up until the end of 2021, the economy was ripe for VC investments. In fact, venture capital was at its all-time high. Investors took on greater risk, giving large checks to twice as many companies. However, as the U.S. economy slowed down with rising interest rates and declining demand, weaker startups started failing, and so VCs started putting added pressure on their port-cos.
The problem was not with the port-cos themselves, but rather with reckless VC investment and poor risk management practices. Over the years, VCs across the industry had invested in the same types of companies, many of which were weak and would not survive an economic downturn. Many of these weak companies also tended to bank with Silicon Valley Bank, with large deposits exceeding the standard deposit insurance limit of US$250,000.
Prudent financial risk management could have shielded VC investors and their startups from the risk of bank failure. Businesses have a number of options available to protect liquid assets from loss, including investing in US Treasury bills, investing in a money market fund, or investing in physical assets like gold, bitcoin, or real estate. Why were these precautions not taken?
With so much at stake, when doubts about SVB’s solvency surfaced, startups felt enormous pressure to immediately withdraw their deposits. This stampede of withdrawals would not have occurred but for the many years of weak investment and risk management practices of VC investors. It is not surprising that the gaggle of vulnerable startups panicked at the first sign of trouble.
How to avoid another collapse
How can the venture capital industry avoid this kind of fiasco in the future? Here are three recommendations:
1. Invest in quality, not the ‘squeaky wheels’
Investors should take the time to perform quality due diligence, which is essentially a background check of the company’s market, management, and product. While networking is a key part of the investing world, connections are not the same as a viable business model. By focusing on long-term growth and product-market fit, investors can avoid focusing on the “squeaky wheels” that may distract attention from better investment opportunities.
2. Diversify funding sources
To avoid losses in the next banking crisis, startups should reduce their dependence on any one bank or investor; purposeful diversification is key. This means securing funding from different sources including VCs, venture debt, and smaller lenders. It also means using several different banks instead of concentrating on one popular option. Diversifying funding sources can help avoid a “prisoner’s dilemma” scenario where someone shouting fire in a crowded bank leads startups to stampede towards the exits in a way that causes a lot of economic collateral damage.
3. Keep all stakeholders fully informed
Transparency in communication between CEOs, investors, and other stakeholders is crucial to building trust and reducing the likelihood of sudden, disruptive action. Since success in the venture capital industry often involves keeping key knowledge private and taking advantage of exclusive opportunities, communication is often vague and opaque at best. While proprietary knowledge should be protected, general economic trends should be discussed openly and the implications for investors should be researched and published often. This can help prevent situations like the collapse of SVB, where vague but urgent investor pressure led startups to make rash decisions based on fear.
In conclusion
The collapse of Silicon Valley Bank revealed the true power dynamics between VCs and startups. VCs are under immense pressure to generate returns for their investors, which trickles down to the CEOs of their portfolio companies. This pressure can lead startups to make rash and panicked decisions that lead to unintended and avoidable economic damage.
To prevent a similar collapse in the future, the venture capital industry needs to make fundamental changes in its approach to due diligence, startup funding, and communication. Only a full understanding of investment incentives and a concerted effort to turn around the industry will prevent venture capital from causing similar economic disasters in the future.
Wes Brooks is an incoming Summer Business Analyst at Cicero Group and an undergraduate studying economics, management, and strategy. He is a serial entrepreneur, works in venture capital, and enjoys singing a capella and piano improvisation.
Image: Unsplash
🔴 Interested in consulting?