The collapse of Silicon Valley Bank will have enormous repercussions for startups and VCs in ways seen and unseen. As for the unseen, SVB had deep relationships among the various players in the venture ecosystem. Founders and investors established banking relationships with SVB in part because of the opportunities SVB provided to network within the space. It will be difficult for other lenders who don’t have these deep relationships to replace SVB in this capacity and fill this valuable role.
But SVB’s downfall will impact startups in tangible ways as well. SVB was the largest provider of venture debt, a niche category of lower cost financing that was tailored for early stage, venture backed companies. Venture debt provides an attractive means for startups to extend runway with less dilution, at lower interest rates than with standard commercial loans (typically, 50 basis points above prime) and looser credit protection mechanisms. Less dilution rather than no dilution (as is the case with most loans) because venture debt almost always involves an equity kicker in the form of warrants. Venture debt is predicated on venture investors providing equity in subsequent rounds to take out the earlier venture loans. Interest rate and loan size tend to vary based on the scale of the company, the amount of equity previously raised and the use of proceeds. Venture lenders typically agree to lend between 25% to 35% of the amount raised in the most recent equity round.
Interestingly, it’s possible that SVB borrowers breached their loan covenants as a result of their run on the bank that precipitated its collapse. Most venture debt loan agreements mandate that the lender be the borrower’s principal depository and disbursement bank, and require the borrower to conduct all of its primary banking business with the lender, including primary deposits. SVB’s loan agreements typically included this banking relationship covenant, which would have been breached by the withdrawing depositors absent a waiver from SVB. In any event, with SVB’s collapse, venture debt will now be more expensive and scarce.
The anticipated contraction in the venture debt market will also likely result in lower valuations. In a recent research brief, the good folks at CB Insights picked up on two telling statements contained in SVB’s mid-quarter update for first quarter 2023. The first of these quotes is that “[c]lients [of SVB] continue to opt for debt over raising equity at pressured valuations.” As to “pressured valuations”, CB Insights offers data illustrating a tangible disconnect between public and private tech company valuations. According to CB Insights, the combined market cap of the companies that went public in the 50 largest tech IPOs since 2020 is down 59% as compared with their combined market cap at the time of their respective IPOs. On the other hand, Series C and Series D valuations were actually up 20% and 30%, respectively, as compared with 2020. CB Insights’ theory on the disconnect is plausible: many venture backed companies would have faced down rounds, but avoided a lower valuation by opting for venture debt. Further, CB Insights also believes the fittest companies were the ones securing equity funding at lofty valuations, while the weaker ones were being funded with venture debt to avoid down rounds, further feeding the disconnect between public and private company valuations. With venture debt now harder to come by, however, it stands to reason that more companies will need to seek equity funding and that, with VCs far more discerning than they were a year ago, such rounds will necessarily be at lower valuations, meaning more down rounds.
The headwinds in the venture debt market may also impact headcount. Another telling quote in SVB’s mid-quarter update for first quarter 2023 was that “[c]lient cash burn remains ~2x higher than pre-2021 levels.” CB Insights’ analysis bears this out, finding that 86% of unicorns increased headcount since Q1’22, and that 37% of unicorns have grown headcount by more than 50%. Hence, it seems that companies have been able to avoid tough headcount decisions either by closing equity rounds at valuations that thus far have remained persistently high (in the case of the stronger companies) or by securing venture debt (in the case of weaker companies). Consequently, with the coming challenges in venture debt, coupled with the already contracting venture equity market, it stands to reason that, in addition to lower valuations, we’ll also likely be seeing increasing layoffs. Looks like a bumpy road ahead for startups.