How the startup funding bubble burst

Aunindyo Chakravarty
Senior Economic Analyst

IN February 2007, Metropolitan Savings Bank went belly up. It was the first bank to fail in the US in 952 days — the longest stretch in American history between bank failures. The second longest stretch was recorded between October 2020 and March this year, when much-bigger Silicon Valley Bank (SVB) failed.

Metropolitan Savings was among the three banks that failed that year. Then came the deluge — between 2008 and 2010, 465 banks failed in the US, victims of what came to be known as the Global Financial Crisis. This is what has set pundit tongues wagging. Is SVB’s failure, followed by the collapse of much-bigger Credit Suisse, an early sign of a coming financial Armageddon? The answer to that question, in the words of Nobel-winning economist Paul Krugman, is that “nobody knows”. But SVB’s failure has given us a glimpse into the underbelly of startup financing. And it ain’t pretty.

But before we look at why the SVB failed, we need a short detour into why tech startups have been getting so much funding. This is partly because software promises to ‘eat the world’. Apps have replaced traditional service companies, and artificial intelligence (AI) is threatening to replace even those services that were believed to require human creativity. The bigger reason, however, is that tech is the only industry where valuations can be justified without commensurate earnings.

The FAANG companies — Facebook (now Meta), Amazon, Apple, Netflix and Google — together make up 10 per cent of the total market capitalisation (value of all shares) of the US bourses. Add Microsoft and Tesla to that and the share rises to 26 per cent.

But Big Tech doesn’t necessarily make big money. Amazon’s net profit margin in the last four quarters has ranged between - 3.3 per cent and 2.3 per cent. The top three most profitable tech companies — Apple, Google and Meta — together earned $200 billion in the last four quarters; the top three oil companies — Saudi Aramco, ExxonMobil and Shell — earned twice that much. Yet, the combined market capitalisation of these three tech companies is 50 per cent more than that of the three oil companies.

This enables every new app maker the right to demand higher valuations than traditional businesses can. A few friends, usually with a background in coding, come up with an app that claims to solve some ‘burning problem’ of consumers. They plan a big marketing campaign to reach customers and then ‘acquire’ them by giving away freebies. But this needs money. So, they convince an early-stage ‘angel’ investor to put up some funds in exchange for a share in the company.

This becomes the first benchmark for the startup’s valuation, even before it begins real operations. The startup burns the cash and manages to garner a customer base and some revenues. Soon, the money runs out; more is needed. This time, the founders look for bigger investors, usually venture capitalists (VCs). More funds are raised, at a higher valuation, and more stake is sold.

Again, the startup burns more cash and expands. It builds a brand, but still doesn’t make any profit. This time, the VCs find even bigger investors — private equity (PE) funds that come in with serious cash, and take majority stake in the startup. This time, the valuations multiply; some startups even become ‘unicorns’. As the startup begins to spend aggressively, the ‘burn rate’ shoots up, with no real earnings in sight. In normal businesses, investors would give up at this stage and exit with whatever they can get. In the world of tech startups, the opposite happens. The investors bring in even more money to keep the valuations up. The ultimate aim is to get listed on the stock market at fabulous valuations and pass their shares to ordinary retail investors. The PE funds gain, the founders gain; retail investors are left holding the baby.

The uncharitable will call this a very sophisticated Ponzi scheme. And the SVB example only strengthens that feeling. The SVB, founded 40 years ago, specialised in providing credit to the tech sector. At the time of its failure, it boasted of having nearly half of the US’s VC-backed startups as its clients. For most of its career, the SVB had been creeping at a petty pace, till Covid happened. As governments and central banks tried to pump-prime their economies, most of the money flowed through the hands of the institutions of finance capital. And, in 2020 and 2021, a lot of money went into funding tech startups.

Startups that banked with SVB parked their cash in their accounts, causing SVB’s deposits to shoot up from some $50 billion to over $200 billion, within the space of just three years. The SVB lent a big chunk of the money to VCs, who in turn, channelled it back into startups. The startups brought that money back to SVB, which, once again, gave it as loans to VCs. This was a self-expanding cycle of the same money showing up as additional assets and liabilities.

But from early 2022, central banks began to raise interest rates. Startups could no longer access easy cash to burn. A funding winter set in, and tech companies had to start dipping into their savings. The SVB’s deposits began to dwindle. What came as a double whammy was that SVB had invested big in government bonds. But as interest rates rose, bond prices crashed. If SVB had held them till maturity, nothing would have happened. But, the bursting of the startup funding bubble forced it to sell a large portion of its bonds at a loss. It also announced a plan to sell shares to raise funds. When the news broke, it caused panic among depositors and led to a run on the bank. Depositors tried to take out over $40 billion at one go, following which the authorities stepped in and shut the bank down. It is easy to dismiss this as errors made by bad managers. In reality, it is a systemic problem waiting to unravel.