Today the FDIC announced that JPMorgan Chase Bank is assuming the deposits of First Republic Bank. The bank failed, it was seized by regulators, and the FDIC struck a deal with JPMorgan for the latter to acquire the bank. First Republic has been in the news for the last few weeks since the SVB failure, so this outcome isn’t surprising given how many weeks have passed.

Banks are complicated, and I’m not knowledgeable about the industry. But one thing caught my attention as I learned more about the First Republic situation. According to a Bloomberg article, First Republic catered to the wealthy and lured them to the bank with attractive mortgage products. It reportedly offered wealthy clients mortgages with up to 10 years of interest-only payments. Combine this with the rock-bottom interest rates of 2020 and 2021, and the bank saw a flood of wealthy clients take out mortgages. A few interesting points from the article:

• In 2020 and 2021, First Republic originated $900 million of interest-only mortgages in two small sections of Beverly Hills, California. Said differently, they originated almost a billion dollars of interest-only mortgages in one neighborhood. Beverly Hills has some of the most expensive residential homes in the country, but that’s still an incredible data point.
• First Republic originated more than $19 billion of interest-only mortgages in just three metro areas: San Francisco, Los Angeles, and New York. Again, all these areas have some of the highest prices for residential homes in the country, but $19 billion is a staggering amount of interest-only loans in three cities.
• $58 billion worth of First Republic’s loans at the beginning of the year were interest-only, and the majority don’t require principal payments until 2028 at the earliest.
• At the beginning of the year, the bank estimated that the mortgages it made were worth $19 billion less than their carrying value if sold at that time, and it had a $4.8 billion loss on its bond portfolio (bond losses sank SVB).

To be fair, there’s nothing wrong with interest-only mortgages. They’ve been around for a long time and, when used responsibly, can be a viable financing product for responsible borrowers. First Republic appears to have offered this product to borrowers with the highest credit scores who also earned high incomes. These loans may have been a great product for borrowers, but they weren’t so great for First Republic. I’m not sure about many of the details of these loans (fixed, variable, etc.), but the meeting of low rates on many of these interest-only mortgages with rising interest rates and strong deposit withdrawals appears to have contributed to a perfect storm for the bank.

A friend sent me an article about private equity consolidating segments of the automotive market, specifically tires and service centers. CCAW Automotive Group operated in this market, so I know it well.

I’m not surprised that private equity is targeting this market, because it’s fragmented and inefficient and requires significant capital to hold inventory. Rising interest rates are likely pressuring profitability of smaller players. This makes the market attractive to private equity funds looking to execute a roll-up strategy. In my opinion, it’s really the only viable strategy for this mature industry. Growth is slow (probably 3%–5% annually), so growing organically is hard because you mostly have to take customers from someone else. Buying smaller players and integrating them into a larger organization so economies of scale can be leveraged is a good strategy.

I wouldn’t be surprised to see private equity consolidate parts of this industry and then sell to a large upstream player (manufacturer, distributer, etc.) who could benefit strategically and financially. Then again, the consolidated segments could be taken public if market conditions are favorable. I’m curious to see how this plays out and hope the end result is a better experience for consumers.

Today I talked with a founder looking to start a new brick-and-mortar business. His model is interesting. He’s renting out space in a building designed to cater to an overlooked segment of entrepreneurs. It’ll be recurring revenue, and he already has a few customers committed once he launches. We talked through capital for his project. The revenue potential of the business is capped based on the square footage of the real estate, so it won’t be high-growth. He wants to do debt, but he’s faced some hurdles in getting financed with banks because their underwriting is more conservative. Venture capitalists would love to invest in him, but that isn’t an option because the company isn’t high-growth.

We started talking about the perfect situation for him, and it ended up being a mix of equity and debt. The equity would be permanent capital, meaning the investor isn’t targeting to sell in a certain number of years like a PE or VC fund. They would plan to be an owner and receive profit distributions in perpetuity. The debt would be normal term debt with fair terms. The kicker is that he’d like to do this type of deal with a single person or capital partner.

The more we talked about it, the more I thought about how big the market is. Many entrepreneurs building traditional businesses would probably benefit from a capital partnership like this, especially if interest rates stay at current levels or go higher.

Early-stage founders have been asking for advice about their fundraising plans lately. Many are planning to raise this year after avoiding a difficult fundraise environment in the second half of last year. Many of these companies don’t have runway past 2023. They’re looking to raise venture capital to extend their runway.

If last year taught us anything, it’s that the availability of venture capital funding isn’t a given; it’s heavily impacted by macro conditions. Venture capitalists themselves were impacted by macro conditions and had a difficult time raising capital from their limited partners in the second half of last year.

Raising capital isn’t the only way to extend a start-up’s runway. Increasing revenue and reducing expenses are also levers founders can pull to extend runway. Expenses can be cut only so much, but revenue growth is limitless (hypothetically).

In today’s environment, I’m a fan of founders with limited runway taking control of their destiny by trying to get their companies to breakeven. It’s not possible for all founders, but if it is a possibility (even a slim one), it makes sense to work toward it if you have limited runway. It reduces or eliminates cash burn, extending runway. If venture capital is still an objective, it puts the founder in a better position because they don’t “need” the investment to survive. This approach has its downside, too. It could negatively impact growth. That’s not ideal, but a slower growing company is better than a dead company. If a founder achieves breakeven and manages to show growth (even slightly), it’s a good signal to investors and could increase their desire to invest.

If you’re a founder running out of runway, consider the option of moving the company toward breakeven.

Some founders seed their companies with their personal capital in the early days. There are a variety of ways to handle this, with a loan from the founder as a shareholder being the one I’ve seen most. When a founder plans to grow their company quickly and raise venture capital, they have another option: they can classify their capital as an investment in the company. The easiest way to do this is through a convertible note or simple agreement for future equity (SAFE).

Why would a founder want to do this? For many reasons. One is that it helps to separate sweat equity from financial equity. If a founder must leave the company for some reason and their equity as a founder doesn’t vest, they still have their financial equity. The founder will own a percentage of the company based on their investment, regardless of what happens with the equity tied to their employment.

There are other benefits too, such as owning—for the financial equity—preferred equity versus common equity.

This week’s Silicon Valley Bank (SVB) failure was unexpected and happened in less than 48 hours. I’ve chatted with a few founders and venture capitalists whose companies have assets with SVB. As of Friday afternoon, SVB accounts were frozen, meaning customers couldn’t add or withdraw any funds. Most of the people I talked with were busy establishing relationships with other banks in anticipation of being able to move their funds. The venture capital firms were assessing their own exposure and the exposure of their portfolio companies and updating limited partners on the situation.

The FDIC insures deposits up to $250 thousand. Insured deposits will be available Monday morning. Anything above $250 thousand likely won’t be available until the FDIC sorts through everything, which could take time. My gut tells me that SVB customers will likely get most of their money back, but when that will happen isn’t clear. The longer it takes, the more difficult decisions there will be for SVB customers to make.

I’ll be watching this closely as it unfolds.

Yesterday’s post was about in-kind distributions that venture capital (VC) funds make to their limited partners (LPs). A friend pointed out that some larger funds, such as Sequoia, A16Z, Thrive, and a few others, may be focusing more on making in-kind distributions to their LPs. These and other firms are starting to become registered investment advisors (RIAs), which my friend assumes is related to making in-kind distributions. I’ve been reading about funds becoming RIAs, and I don’t think it’s related to making in-kind distributions to LPs.

A VC fund that makes an early-stage investment in a company doesn’t need to be an RIA to do in-kind distributions. If one of the fund’s portfolio companies goes public or is acquired in a deal where some or all the purchase price is paid in stock of the acquiring company, the general partners can distribute that equity to their LPs. There may be reasons to wait to do so: for example, an IPO lockup period or wanting the acquirer’s equity value to increase before distributing stock to LPs. There are nuanced rules around VC funds holding a material percentage of fund assets in something other than private companies, but I won’t get into those details.

All the firms my friend mentioned are run by very smart people who have had a lot of success over several years. I don’t have any inside information on their strategic reasons for becoming RIAs, and I’m curious and plan to learn more. I wouldn’t be surprised if it’s related to their ability to invest in and hold a broader variety of assets for a longer period. Said differently, I wouldn’t be surprised if it allows them to expand their firms into areas outside traditional venture capital investing.

Today I was chatting with a “spotter” entrepreneur about the details of an opportunity he’s considering pursuing. He plans to build a business to solve an overlooked problem of solopreneurs. He needs capital to launch the business but doesn’t have experience raising capital from investors, so he asked for my thoughts on structuring a deal that includes investor capital and bank debt.

As we chatted about the business model and numbers, we began discussing the bank debt portion of a possible deal. In the past, he’s used his own capital and bank debt to launch businesses. But interest rate increases mean that debt service on a loan would materially reduce cash flows from the business. This spotter has his own capital, but not enough to finance this entire project. Nor does he want to take on that much risk. Given this reality, he’s considering, for the first time ever, raising capital from investors. The problem is, he doesn’t know where to start.

When interest rates were low, spotters could partner with banks exclusively. The principal and interest on their loan payments didn’t materially impact cash flow, and they maintained 100% ownership. They preferred to work with a banking partner and cheap debt rather than give up equity to investors and have to report back to those investors.

In today’s interest-rate environment, selling an equity stake to investors can be a more attractive alternative. Deals where bank debt would significantly reduce returns or cash flows because of high rates can be more palatable with investor capital. Of course, this depends on how the deal is structured. The devil’s in the details.

Today’s conversation got me thinking. How many more spotters are doing the same math and coming to the same conclusion: I should consider raising capital from investors. If it is—or will be—a material number of people, this could be an interesting market that will likely be underserved.

I had a conversation with a friend about the difference between wealth and income. They’re not the same thing. I realized through this conversation that some people aren’t aware of the difference between the two.

Wealth is the value of the assets you own (minus your liabilities, or debts). Assets include real estate, personal property (art, jewelry, etc.), and equity (i.e., ownership) in public or private companies.

Income is the money generated from your labor, wealth, or ingenuity.

Money isn’t wealth. It’s more of a medium of exchange that facilitates trade. It allows you to buy goods and services.

One of the hardest concepts for people to understand is that you can have high income but not wealth. For example, if you make $1 million a year and have $999,999 of annual expenses, you’re not increasing your wealth.

Conversely, you can have wealth but not generate enough income to pay your living expenses, which depletes your wealth.

Wealth and income are different, and it’s important—especially for entrepreneurs—to understand why.

An investor shared details of a deal he’s been evaluating. He loves the sector, loves the founder, and loves the product. He hasn’t done the deal because he has concerns around the cap table—specifically, how much capital has been raised from investors in previous rounds and how much is being raised in the current round. The company has an enormous burn rate of around $400 thousand monthly, hasn’t achieved product–market fit yet, and doesn’t have much revenue from customers. Yet, it’s raising a third multimillion-dollar round of capital.

The major concern of this investor is the amount of dilution at such an early stage. The CEO-founder will own less than 20% of the company after the current raise. If the company can raise the current round, find product–market fit, and raise additional rounds of capital at later stages, the CEO-founder could have a small ownership stake in the company. This investor sees the CEO owning less than 10% as a real possibility. If that happens, it will take an enormous outcome and many more years for the CEO’s small equity position to have a major financial impact on his life. Rather than go down that path, the CEO might leave and pursue something else with a more attractive risk/reward ratio. That wouldn’t be ideal for those who invested in the company.

This isn’t the first time I’ve had an investor tell me this, and it likely won’t be the last time this year. Raising too much capital too early can cause lots of downstream problems if the company can’t achieve significant traction. This story highlights the excessive dilution problem and why investors are hesitant to invest when the founders don’t have material equity ownership in an early-stage company.

If you’re an early-stage founder, keep a close eye on your burn rate relative to company traction. If the traction isn’t there (i.e., you haven’t founder product–market fit), don’t be afraid to adjust the burn rate.