In the early 1980s, there was a sunny region in California, with beaches to its west and redwoods to its east, which was just starting to create a unique identity for itself. Technology companies were flowering around this area due to its background in science, willingness to share knowledge, lacking of shame of failure, and the proximity of stellar academic institutions. This area would nurture incredibly innovative ideas and people, and would later be commonly known as Silicon Valley. However during this time, technology companies were in need of capital to get them off the ground. These companies didn’t have much access to equity investors, or debt lenders, such as traditional banks, which didn’t understand the complexities of this specific type of early stage lending. They viewed these companies as inherently high risk and not worth much thought. Although some people recognized that there was a problem and that it could be solved. Those people were two Wells Fargo bankers, Roger Smith and Bill Biggerstaff, and a Stanford professor, Robert Medearis. These three men lived and breathed the area and saw that it would create a huge impact on the future economy, and along with the easing of regulations, they created Silicon Valley Bank.
Silicon Valley Bank opened its first office in 1983 as a state bank and a Federal Reserve member. It started operating right away by registering with the U.S. Securities and Exchange Commission, to raise money from the public, with an uncommon 100 founders on their S-1 form. This is an example of two of the bank’s great advantages: networking and marketing. Through their prior dealings in the Valley, they gained extensive access to some of the best talent it had to offer. Not only would these technology entrepreneurs invest in this bank, they would make deposits and refer peers to it. Roger Smith said, “we promoted and sold our founders group…I never went anywhere in the world that I would not share our founders group, that somebody didn’t know or know of somebody”. This natural ability to rub shoulders with the vanguards of fledgling innovation was a central part of their strategy, which continues to the present. They also were aware that 100 founders would generate a commotion and attract onlookers due to the uniqueness of the number and quality of people involved. Soon more and more clients came through their doors and they were profitable almost right away. This appeared to validate their business model, however they had to deal with the reason other banks weren’t lending to these companies in the first place: they were too risky.
On the surface companies born yesterday; with a software idea, negative cash flow, and all so much as a calculator in terms of collateral assets; are high risks. While this might be the conventional image of a new technology company, Silicon Valley Bank would argue that there is much more variety within the technology sector. As its annual report states:
Our technology clients tend to be in the industries of: hardware (such as semiconductors, communications, data storage, and electronics); software and internet (such as infrastructure software, applications, software services, digital content and advertising technology), and energy and resource innovation…Our life science & healthcare clients primarily tend to be in the industries of biotechnology, medical devices, healthcare information technology and healthcare services.
From this description it becomes clear that technology companies aren’t all the same and have different niches. Data storage firms face different risks as opposed to energy companies that face different risks to medical device startups. Silicon Valley Bank was one of the first institutions to really understand the diversification within the new technology industry, and the need to mirror that diversification in their clientele.
There was still risk associated with the fact that these were small and emerging startups, and thus where Silicon Valley Bank truly had to innovate was in their due diligence process to mitigate these risks. One key-determining factor was a startup’s accounts receivables with a more established company. As Smith remarked, “you’re a new company, but you have a receivable from HP. That’s a pretty good piece of paper…so we’re not magicians, and that’s what a lot of people worried about us because they thought we were taking too high a risk, where in fact we were not”. This proxy of the credit worthiness of the startup allowed Silicon Valley Bank to manage un-securitized loans and effectively filter out companies that didn’t show promise. Another uniqueness of their process was the utilization of the Silicon Valley expert community. In order to determine the validity of a company’s idea, analysts would make inquiries with experienced entrepreneurs or researchers in academia in that particular company’s niche. This cross-referencing allowed Silicon Valley Bank to capitalize on the immense knowledge that surrounded them that enhanced their decision-making. A third key attribute was that people working for the firm worked incredibly hard. “The work ethic of that bank…was a 50% level higher than any other bank” commented by Medearis. The analysis of a firm’s credit worthiness would be given more attention from Silicon Valley Bank. The productivity of Silicon Valley Bank’s workers can be shown by the fact that in 2014 for every employee the bank had it generated about $130,000 of net income (SVB Financial Group) compared to Citibank’s about $30,000 of net income per employee (Citigroup Inc.).
Early stage technology companies are a major focus of Silicon Valley Bank but it must be noted that they only represent 6% of their loan portfolio, and the other 94% are non-early stage borrowers. It’s not enough to just fund startups, but to fund growing startups. The repayment of Silicon Valley Bank’s loans is predicated on the fact that these startups will keep operating and, by extension, growing. This also means that often times a startup, that was nurtured by Silicon Valley Bank, will feel comfortable banking with them as they grow. Thus the bank eventually finds itself with bigger clients over time. The non-early stage borrower magnitude indicates a mechanism for Silicon Valley Bank to diversify from early stage startups. This was part of its “three-legged stool” of technology, commercial, and real estate banking. Commercial banking would diversify away from early stage lending, while servicing the different needs of clients who’ve grown into established firms. A unique feature of doing business with technology firms is that they tend to keep high deposits. Silicon Valley Bank has about $34 billion in deposits with a loans-to-deposit ratio of 42%, which is significantly below the average of about 75% of other banks.
Holding on to such high deposits would lead to decreased profitability, so to overcome this distinctive fact of technology lending, Silicon Valley Bank would utilize that last leg of the stool: real estate. It would take some of those deposits and invest in real estate, however due to the cyclical nature of the real estate market, in the early 1990s Silicon Valley Bank reported its first and one of few losses. Ironically the perceived risky lending to technology companies wasn’t the root of the loss; instead it was traditional real estate lending. A few years later they found a way around this issue of high deposits. Former CEO, Ken Wilcox explains:
The first thing my team did was decide what we were going to do with the massive unused deposits because we didn’t want to lend them the real estate developers…So we got this brilliant idea…And that is instead of letting people put these [deposits] on our balance sheet, we would open a broker-dealer. And we have two operations. We have our commercial bank and we have our broker-dealer and we would tell people, ‘Put some money on our balance sheet so you can pay your bills with your checking account. Take the rest of it and put it in the broker-dealer where we’ll buy money market instruments for you, you know, things like CDs and commercial paper and stuff like that, and everybody is better off because you’ll get a higher rate of return in the broker-dealer and it will be safer. It’s always safer to lend money to General Motors than it is to give it to us and let us lend it to technology companies’.
This approach limited the bank’s exposure to the cyclical risk of real estate, and instead allowed them to transform those excess deposits into safer investments. For example, 57% of total assets are fixed income securities with most of them, at 43%, being U.S. Treasuries, but there are still some remnants of real estate in the form of fixed rate agency-issued collateralized residential mortgage obligations.
While Silicon Valley Bank found a way to manage the high deposits of their commercial banking companies, there was still the question of how the fledgling startups would mature into more established firms that would repay loans and move into their commercial banking business. The answer was venture capital firms. These investors fund startups with equity investments, hoping that the returns of a few will outsize the losses of many. For example, a startup could be looking to take out a loan with Silicon Valley Bank, and since the bank also knows that the startup is finalizing a venture capital deal it will favor positively in the loan decision. Darian M. Ibrahim, in his paper titled “Debt as Venture Capital”, notes:
Simply put, the basic puzzle of venture debt is explained by one thing: venture capital. Venture debt rarely exists without venture capital, but once a start-up attracts venture capital, venture debt is soon to follow because VCs make an implicit promise to repay venture loans out of their present and future equity investments…venture debt is the business of ‘funding to subsequent rounds of equity,’ translating to a different exit strategy than VCs’…lenders began to recognize that the real credit in these deals was not the start-up per se; rather it was the likelihood that there would be a follow-on round of financing or a reasonably-near exit. VC investments thus substitute for the absence of cash flows, a key discovery first made by Mann in his study of software lending. Mann found that the reliance on venture capital for the repayment of venture debt created a ‘symbiotic’ relationship between software lenders and software VCs.
Venture capital has an intrinsic role in providing funds to startups to pay back loans to Silicon Valley Bank. Thus it’s in the bank’s interest to nurture the venture capital market as well, shown by doing business with over 600 venture capital firms, launching their own venture capital subsidiary, and venture capital analytics service. Interestingly, if the bank is doing business with a borrowing startup and a venture capital firm that would like to invest in that startup, the money doesn’t really leave the bank’s coffers. For instance when the bank makes a loan, its assets increase as well as its liabilities by depositing that loan in the account of the startup. That startup gets funds from the venture firm, which is just the bank moving deposits from the venture firm’s account to the startup’s account. The startup then uses the investment funds to pay back the original loan to the bank, but the bank is just moving money from the startup’s deposit account on its liability side to its cash on its asset side. During that whole time the bank still had relatively the same amount of deposits but was just exchanging them between accounts on its liability side, and thus still had the same ability use those deposits to invest or lend.
Silicon Valley Bank is very unique bank, but it is important to compare it to other banks. Its leverage ratio is 10%, which is higher than most, and it adequately hedges it against risk according to the Basel III rule of at least 4%. Its return of equity is 10.46% compared to its peers’ average 8.89%, showing that it is earning more than average on equity investments. Also with positive equity of about $4 billion it appears solvent, and with a liquidity ratio of about 230 compared to the average of 100, it appears highly liquid as well. This indicates that it has enough cash to meet its short-term obligations, while having enough equity in the case of a drying up liquidity sources. These measures are especially important when considering a future of risk of investment capital drying up. The bank appears to be relatively sound, and is supported by its positively trending share price. It will have to lookout for increased regulations into its space. For example, it will have to get rid of $246 million of private equity investments due to the Volcker Rule, pertaining to proprietary trading of covered funds. In the process of relinquishing those investments by the required time, the bank runs the risk of selling them below their value and incurring a loss. The bank also has plans for continuing to expand outside Silicon Valley and the U.S., into markets like Europe and China. This expansion will pose other risks, but give them additional geographic diversification. While there are some risks that Silicon Valley Bank has to mitigate, it’s nothing compared to the greatest risk it faced back in the early 1980s when a couple of people got together and took a risk on an idea that was uncommon, just like any startup.
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