Bankrolling celebrities has given City National Bank its reputation. From serving Frank Sinatra and legendary sportscaster Vin Scully to working with Tony Award-winning shows like “Beautiful-the Carole King Musical,” the Los Angeles-based firm is known as the bank of the biz.
Now the 60-year-old company is trying to recreate that magic in Silicon Valley, where tech entrepreneurs are assuming their own celebrity status. At a time when venture capitalists are investing in start-ups at a rate not seen since the dot-com bubble, City National is offering something that, for many companies, is even more irresistible: cheap debt.
Competition is fierce. Using an environment of record low interest rates from an extended period of government stimulus, City National is among a handful of banks aggressively trying to convert developers and their companies into clients. If it all pans out, maybe they’ll have lasting banking relationships with the next Google, Facebook or Twitter and lots of money to manage from newly rich programmers.
That’s a big if. Technology is well into its fifth year of a major boom, and the combination of frothy valuations, high burn rates and a volatile stock market is leading industry pundits to recount unpleasant memories of past cycles.
Unlike equity, debt has to be repaid even when business turns south. The doomsday scenario worries venture capitalist Jon Sakoda of New Enterprise Associates, because debt “can handcuff boards and narrow the options available for start-ups that need to pivot,” he said.
As things stand now, business is up and to the right. Banks like City National are looking to get a slice of a market that has long been the purview of Silicon Valley Bank, or SVB, in Santa Clara. The other aggressive players taking on SVB are Comerica, which has been active in spurts, and smaller niche firms Square 1 Bank and Bridge Bank. The race for clientele is pushing prices so low that early-stage Web companies with some momentum can borrow a few million bucks at a rate that’s a little higher than what they’d pay on a home mortgage.
“Our competition sees us in the marketplace and the result has been very favorable terms on pricing for venture-backed companies,” said Rod Werner, the managing director of City National’s technology and venture capital banking group in Silicon Valley. “We’ve created a marketplace that’s more competitive.”
Werner joined City National in late 2012 after two decades at Comerica, where he specialized in venture. Since starting the practice at City National less than two years ago, the venture group has hired almost 20 people nationwide, including from SVB and Comerica, and added 100 early-stage clients.
Smarter Remarketer is one of them. In August, the 4-year-old online marketing company secured $7 million in debt from City National. Six months earlier, the Indianapolis-based company raised the same amount in equity from Battery Ventures. Chief Executive Officer Howard Bates said having the debt available will allow the company to push out its next equity raise if necessary or just provide a cushion if the markets turn. The debt line can remain untapped, and if the company does use it, the interest level is a little over the prime rate, which is currently 3.25 percent.
“We have almost complete flexibility,” Bates said. “It’s always better to go secure funding when you don’t need it.”
For City National, in addition to having a new borrower, Smarter Remarketer is now a commercial customer, storing its deposits with the bank. And like with most venture debt deals, City National owns some equity warrants in Smarter Remarketer, so if the company is acquired or goes public at a big valuation, the bank will get a handsome return on its stock.
That’s what happened with Bizo. In June of 2013, City National provided $12.5 million in debt financing to the San Francisco-based marketing software company, and a year later LinkedIn bought Bizo for about $175 million. For companies like Bizo, debt has “extended their runway and allowed them to execute,” Werner said.
Venture-backed companies typically raise debt because it doesn’t require giving up a stake in the company. They just have to repay the principal plus interest, and provide a few warrants in the event of a big exit.
“With commercial banks in this market, the economics are such that early-stage start-ups have access to essentially free extensions of their runways to future milestones without dilution to current shareholders,” said Yoav Leitersdorf, managing partner of YL Ventures. “What board of directors could say no to that?”
Still, according to Dow Jones VentureSource, the number of debt deals isn’t going up. In fact, there were 176 of them in the first half of 2014, totaling $924.6 million, putting this year on pace to finish below the recent average.
But venture bankers say pricing pressure is as intense as ever and more companies are taking advantage of it.
Jake Moseley, senior market manager at SVB, said he’s seeing debt requests from about 35 to 40 percent of companies raising their first round of equity (Series A), up five to 10 percentage points from previous years. A loan that a couple years ago would have come with a rate of 7.5 to 9 percent rate is now around 6 percent. “Pricing has gotten compressed,” Moseley said.
At Comerica, loans issued to technology and life sciences companies surged more than 30 percent in the second quarter from a year earlier, while total loans rose 4 percent.
“We want the loan and deposit business from young companies as they grow,” said Greg Belanger, president of the tech practice.
To win that business, Comerica has sacrificed about 1 percent of profit, mostly in the past year, meaning a 6 percent loan is now down to 5 percent. “It’s very aggressive out there and we’re competing hard to win the best deals,” Belanger said.
It’s not just the lower rates. Banks are also giving companies longer periods to draw down the loans and more time to pay them back. There’s so much excitement that a company like Instart Logic, which raised $10 million in debt last year, is already being pitched again. Manav Mital, founder of the Mountain View-based company, said he’s in the process of raising a debt financing that’s “significantly” larger than the previous round, though he wouldn’t specify the amount or the lenders, because the deal hasn’t closed.
Instart is taking on Akamai Technologies with software that speeds Web traffic flowing to mobile applications. Mital said having more cash will help the company meet demand for its technology and serve new customers. Because it’s a subscription business, the revenue from incoming deals will flow in over time, while debt provides an immediate infusion.
“The money will just help us grow the business faster,” Mital said. “We’re growing like there’s no tomorrow.”
Square 1 Executive Vice President Sam Bhaumik said we’re in “unprecedented times” for technology growth and capital chasing it. He said over 50 percent of Series A companies are in talks to raise venture debt, presenting an opportunity so big that Square 1 has about doubled its Bay Area presence to 25 people in the past year and is boosting its loans by 30 percent annually.
Since the beginning of September, Square 1 has announced credit facilities for Orbis Education, Varentec, PowerReviews and Major League Gaming.
Bhaumik’s pitch is that Square 1, which went public in March, is the only “pure play” venture bank not named SVB. Bridge Bank has a similar claim, but one that’s geography based. Bridge and SVB are the only venture banks that are headquartered in Silicon Valley. Square 1 is based in Durham, North Carolina, and Comerica is in Dallas.
Bridge CEO Daniel Myers said the bulk of his bank’s start-up activity is focused on companies that are further along and need growth capital, as opposed to the riskier, unproven businesses. Bridge backs companies generating enough revenue to repay debt based on their own operations.
“That’s different from early-stage venture debt that relies almost exclusively on the continued positive support of investors,” Myers said.
Until recently, the venture debt market looked very different. Other than SVB and Comerica, the primary players have been non-bank lenders that either raise funds from outside investors, the way venture firms and private equity firms operate, or are publicly traded and can raise money by selling shares. In both cases, the cost of capital is significantly higher, because only banks can borrow from the Federal Reserve and lend money using customer deposits.
With banks piling into the space, the traditional lenders have been forced to adapt—or go away. Lighthouse Capital Partners, a 20-year-old San Francisco-based firm, is not raising another fund. TriplePoint Venture Growth went public in May, giving longtime lender TriplePoint Capital an entity that could raise money from the public markets.
Hercules Technology Growth Capital in Palo Alto has been public since 2005 and has a stock market value of over $850 million. The firm originated over $705 million in loans last year, and CEO Manuel Henriquez said it’s on pace for $700 to $800 million this year.
Even though Hercules can’t compete on price with the banks, Henriquez said the company is seeing an “explosion of demand” because of its history in the business as well as its willingness to write bigger checks than many of the banks. But he’s concerned that low-quality borrowers are taking on too much debt. Some companies that Hercules won’t lend to at 12 percent interest are raising debt from others at half that rate, Henriquez said.
“Banks are killing themselves and we’re sitting back watching this bloodbath,” Henriquez said. “A commercial bank should not be taking on sizable loans in companies whose outlook is opaque at best.”
City National’s Werner is confident his team has the right risk precautions in place. After all, the bank held up remarkably well during the financial crisis in a part of the country where firms like Countrywide Financial and IndyMac got crushed by playing fast and loose.
Werner has also been through multiple boom-and-bust cycles. “We’re prepared, knowing it will turn again,” he said.
Whether banks truly are doing the proper due diligence to avoid future write-offs will only be known when the music stops. For start-ups, the decision is whether to take cheap debt while it’s available or stick to running on equity and old-fashioned revenue.
Eric Bachman, the operating chief of payments start-up Marqeta, said the terms he was offered a year ago from Comerica were too attractive to pass up. The Emeryville-based company raised a few million dollars at less than 5 percent interest.
With that, Marqeta handed Comerica some warrants and its banking business, a small price to pay for knowing that it would have a strong enough balance sheet to avoid any desperate measures.
“We don’t want investors to have us over a barrel because we’re running out of cash,” Bachman said. “This really was intended to be a safety valve.”
Image credit: CC by David