Cytonics Response to SVB Bank Debacle
3/13/2023
by Joey Bose, President and CEO, Cytonics Corp.
By now, you are likely aware of Silicon Valley Bank's ("SVB") missteps in securing customer deposits, forcing regulators to scramble and thrusting Small Tech startup companies into a state of financial purgatory as their treasury funds were frozen. Thankfully, Cytonics has zero exposure to SVB, and will not be directly affected regardless of SVB’s fate.?On Sunday evening, the Federal Reserve announced that all customer deposits will be available as of this (Monday) morning. What happens to the rest of SVB's assets while in the FDIC's receivership remains a mystery, but they will almost certainly be liquidated to make their customers whole.
While the dust settles, the financial services sector and the startup community must give serious thought to the confluence of factors that led to this disaster, and implement policies that will prevent a repeat performance.
Since its founding in 1983, SVB has firmly entrenched itself in the startup ecosystem as the bank for burgeoning, venture-backed tech companies and their financiers. This specialty lending institution has played a significant role in providing Small Tech with commercial and investment banking services, as well as underwriting loans to both these companies and their venture capitalist backers. One of their offerings was an unsecured loan to startups called "venture debt", which provided non-dilutive capital to rapidly expanding companies. Just like their commercial banking counterparts (e.g., Bank of America), SVB’s lending and investing activities were funded by customer deposits. None of this is particularly alarming; most large financial institutions offer multiple financial services and engage in the capital markets to make money. But depository institutions (which offer interest bearing savings, checking, and money market accounts) have a strict fiduciary responsibility to guarantee the solvency of customer (i.e., depositors’) funds.
This is where SVB failed to meet its legal and ethical obligations. Almost $200B worth of startup and venture capital treasury funds were housed in SVB depository accounts. The bank invested a significant portion of these funds in 10-year Treasury bonds which were paying over 5% annual interest prior to the SVB collapse. This sounds like a great return for a passive, risk free investment, but not during times of uncertain interest rate hikes. The core financial concept that decimated the value of SVB's balance sheet is that the market price of bonds are inversely correlated to prevailing interest rates in the open market. This is because bond buyers demand a commensurate interest rate (i.e., return on investment, a fixed payment determined at the time of bond issuance) for a bond issued yesterday as for one issued today. If the interest rates on bonds issued today rise, then the price of a bond issued yesterday must fall to mathematically produce a competitive interest rate (i.e., fixed interest income determined at time of issuance divided by the current market price of the bond) in the open market. For example, a 10x increase in interest rates decreases the market price of a previously issued bond by 90%.
Why is this relevant? The Federal Reserve hiked interest rates eight times since March 2022, adding an additional 450 basis points (Federal Funds rate rose from ~0.25% to 4.75%) on to what will (hopefully) be a cap on the central bank's aggressively hawkish approach to curbing inflation. During this time, SVB drastically grew its portfolio of securities and increased its exposure to Treasuries and mortgage backed securities, both of which are highly sensitive to interest rates. As the Federal Funds rate continued to rise, the book value (i.e., unrealized market value) of these fixed income assets fell precipitously, triggering investor panic and causing SVB's stock to lose 60% of its value since last Tuesday. This caused more scrutiny into SVB's balance sheet by investors and depositors alike, and concerned Founders began emptying their accounts in fear that SVB would not be able to meet their near-term financing obligations. Word in Silicon Valley spreads fast. A classic "run on the bank" was the result.
Silicon Valley Bank's overly aggressive approach to investing customer deposits is not the only cause of their collapse. The bank's risk seeking nature is illustrated by their venture debt financial product offered to startup tech companies. Venture debt is an unsecured loan that gives the lender "upside" potential through the issuance of stock warrants (the right, but not the obligation, to purchase a certain number of shares at an agreed upon price within a predetermined time frame) in the borrowing company. This is not your typical commercial bank loan, which needs to be secured by some real asset that can be seized if the borrower defaults. SVB's investment strategy was reliant on the appreciation of stock warrants to make up for (and supersede) all the defaults that would likely occur. This was great for SVB's top line, but not so great for Founders who deposited their cash under the implicit assumption that those funds would always be available - a clear breach of SVB's fiduciary duty to keep customer deposits liquid and accessible.
The collapse of SVB is a tragic event in the startup world, but it is not a death knell and the sector will continue to be funded by the bold and propelled by those who dare to innovate. In fact, many positives will likely emerge as increased scrutiny by regulators will “tighten up” the private capital markets, VCs will have to be more judicious about capital allocation, and Founders will have to be more cautious with investor funds. Cytonics is not directly exposed to SVB and has emerged completely unscathed, but we will heed this warning and continue to take the security of our investors' hard earned money seriously. We bank with PNC, and do not store funds in regional banks nor invest in securities. Rest assured, (y)our money is safe. And it will stay that way.
Sincerely,
Joey Bose
President and CEO
This letter may contain forward-looking statements and information relating to, among other things, the company, its business plan and strategy, and its industry. These statements reflectmanagement’s current views with respect to future events based information currently available and are subject to risks and uncertainties that could cause the company’s actual resultsto differ materially. Investors are cautioned not to place undue reliance on these forward-looking statements as they contain hypothetical illustrations of mathematical principles, aremeant for illustrative purposes, and they do not represent guarantees of future results, levels of activity, performance, or achievements, all of which cannot be made. Moreover, no person nor anyother person or entity assumes responsibility for the accuracy and completeness of forward-looking statements, and is under no duty to update any such statements to conform them.