Understanding Counterparty Risk: A Key Consideration in Raising Capital

The implosion of Silicon Valley Bank (SVB) sent shockwaves through the startup community earlier this year, leaving many entrepreneurs scrambling to ensure the safety of their deposits and their ability to make payroll.

Although the US government eventually stepped in to protect depositors, this move was not guaranteed and left tech entrepreneurs rethinking where and how they were storing their cash. In the aftermath, nearly 60% of founders indicated plans to diversify company funds by banking with multiple banks and placed a greater emphasis on safer, less volatile institutions – namely, those banks previously deemed ‘too big to fail.’

Suddenly, entrepreneurs were forced to consider a risk that had largely gone overlooked: counterparty risk.

Counterparty risk is the risk that those involved in a financial transaction may default or become insolvent, leading to financial losses for the other party. In simple terms, it refers to the possibility that the person or entity on the other side of a financial agreement may not fulfill their obligations as agreed upon. For example, a lender may default on a loan, or a borrower may not repay the loan as agreed.

We believe there are two main considerations when it comes to counterparty risk for startups. The first is what happens to deposits, such as cash held in a bank account, in case of a default. The second is what happens to the funding or loans that were granted. In this post, we will focus on the latter.

In the past, equity was generally viewed as the only financing option available to young companies, making life simpler for founders. Capital providers deploy their own money, or they had a fund of "safely" committed capital, which obligated them to provide liquidity when requested by the company. The investment decision was straightforward, and there was little to no ambiguity afterward.

However, in the last 5-10 years, the funding landscape has changed significantly, and non-equity options have seemed to become more prevalent. While this gives startups greater flexibility, it can also increase complexity and introduce new risks.

Revisiting the example of SVB, the question top of mind for the bank’s 40,000 customers was: “what will happen to my deposits?” However, there was also a less obvious but equally significant question that caused ripples through the tech world: “what happens to the funding if the lender gets into trouble?” If a bank was forced to sell its assets, such as loans given to companies, to cover losses and make depositors whole, what would happen to those assets? Who would buy the loans, what would they do with them, and would startups be open to working with those possibly unfamiliar entities?

The main takeaway here is that it matters who provides the funding – and entrepreneurs need to think about counterparty risk before they raise funds.

To provide a rough framework of how to think about this, we’ve listed a few of the questions and considerations founders should examine based on which of the four capital provider types they’re dealing with:

1. Banks have a complex business model and can fail. While funding costs are usually on the cheaper end of the spectrum, that comes at a different kind of price – uncertainty.

2. Brokers initiate loans, but they are not responsible for managing them or the relationship with the borrowers. This opens the door to a number of questions entrepreneurs should consider: Who will be the actual lender? Who holds the relationship that was built during the investment process? Who will startups talk to in case there is a problem? Is there a principal-agent problem?

3. Leveraged non-banks are non-bank financial institutions that rely on borrowed funds to finance their operations. The questions become: What happens if interest rates rise too high in comparison to the anticipated results? At what point will they get into trouble? What happens if their lenders get in trouble?

4. Unleveraged non-banks provide capital from a fund that is committed by their fund providers. Those funds are contractually reliable alongside a direct, personal relationship. They may be more expensive, but the tradeoff can be less risk.

The collapse of SVB and the subsequent shockwaves it sent through the startup community served as a wake-up call for founders, highlighting the importance of diversifying company funds and considering counterparty risk. While the funding landscape has become more flexible in recent years, it has also introduced new risks, including counterparty risk. Entrepreneurs need to think about who provides the funding and assess the type of capital provider that is the best fit for their business. By engaging with the different options available and learning about them, entrepreneurs can make informed decisions in this new funding environment while minimizing undue risks.