Why CDs Are Not Ideal Investment Vehicles for VC-backed Startups
Now that interest rates are higher, bankers that serve VC-backed startups have been pushing CDs (certificates of deposit). CDs, despite their perceived benefits, are not necessarily the optimal investment option for cash-rich startups. For sure they aren’t the worst place for founders to park excess cash (certain crypto investments made in 2021 come to mind…) but there are superior products available from the top startup-focused banks that beat CDs 9 times out of 10 on all aspects, from yield to maturity to safety.
What is a Certificate of Deposit?
First of all, let’s explain what a CD is. A Certificate of Deposit is a savings vehicle where a bank holds your money for a set period, often at a fixed interest rate. CDs were popular investments in the 70s and 80s when interest rates were higher, as they offered significant returns in a low-risk setting. However, the attractiveness of CDs declined as interest rates fell after 2009.
Interest rates are much higher than they were in 2020, and the SVB banking crisis has forced many founders to think about their treasury/cash management strategies. As interest rates have been rising recently, we are seeing some clients with excess cash ask about CDs, to earn a decent yield without risking their funds. These startups agree to lock up their cash for a set period with their preferred bank, say six months, to get a higher return.
Reasons Why CDs are Not Great for Startup Cash Management
CDs are not the worst product banks have to help manage a startup’s cash - but at this moment, they are also clearly not near the top of the list of products founders should consider. First, let’s review the key tenets of startup cash management so we can have a baseline for understanding the issues associated with certificates of deposit.
Main Tenets of Startup Treasury Management
The key tenets of startup cash management revolve around capital preservation, liquidity, risk management, and yield. Here is a summary:
Capital Preservation
The main objective of capital preservation is to safeguard the existing funds without focusing on high growth investments. Startups need to prioritize security over high returns as their runway typically ranges from six to 24 months. Any risky investment could lead to a significant drop in value, potentially shortening the runway and negatively impacting the company’s credibility with investors. Moreover, founders have a fiduciary responsibility to their investors to act in the best interest of the company. Any high-risk investments that result in losses could expose founders to potential litigation.
Liquidity
Liquidity is the ability to access your funds when expenses need to be paid. Investments like Certificates of Deposit (CDs) may offer higher yields, but they tie up cash for a specific term. Therefore, a well-planned cash management strategy should account for this liquidity requirement by, for instance, using a CD “laddering” plan that ensures availability of funds each month. And an overly large percent of a company’s funding should not be put into a single investment with a mid to long term maturity.
Risk Management
Startups need to be extremely cautious when choosing the right savings or investment vehicles for their venture capital funds. The preferred strategy should be to accept a low or no return, rather than risking money by chasing higher yields. More conventional choices like savings accounts, short-term Treasury bills, money market accounts, and carefully selected CDs are better suited for startups. Poor treasury management resulting in loss of VC funds can not only harm the founder’s credibility but also strain the relationship with the VC firm, impacting the ability to raise additional funding in the future.
Yield
While yield is an important criterion, it should never supersede safety and liquidity. High yield often comes with greater risk, which is not suitable for startups. Investment options can be explored to optimize yield, but high-risk options should always be avoided. Startups already take considerable risks in product development and go-to-market strategies; needless risks in treasury management should be avoided.
Four Reasons CDs are not a Great Investment for Startup Cash
Limitations of FDIC Insurance
The Federal Deposit Insurance Corporation (FDIC) insures bank deposits, including CDs, up to a limit of $250,000 per depositor, per insured bank. For individuals and small businesses, this serves as a safety net, protecting their deposits against bank failure. However, for VC-backed startups flush with millions of dollars in cash, the FDIC limit can present a significant risk. Deposits above the insured limit are not guaranteed by the government. And since most startups will purchase a CD from the bank that already holds their operating bank account, they are likely to be well over the FDIC limit for that institution.
In other words, a CD with your main bank isn’t likely to be protected by FDIC insurance, so it doesn’t offer you safety benefits over getting a treasury product.
Liquidity Concerns / Maturity Risk
Startups are inherently risky endeavors characterized by a high degree of uncertainty. Unpredictable operating expenses, capital expenditure requirements, or sudden market changes can often necessitate immediate access to funds. CDs, with their defined maturity terms, can lock up funds and impede cash flow, creating potential liquidity problems. The penalties for early withdrawal from a CD can be hefty, typically involving a loss of interest earned and, in some cases, even a portion of the original investment. There are investment products that offer same day liquidity, like money market products, that are superior to CDs.
There are better products that make it easier to access your funds than CDs, many of which pay higher interest rates.
Comparatively Lower Interest Rates
Despite higher interest rates than conventional savings accounts, CDs do not always offer the best rates in the market. To illustrate this point, let’s take an example from late May. A money center bank was offering a 4.2% interest rate on a CD, which might seem attractive until you compare it to the 4.99% yield available on US Treasury money market funds offered by the same bank. Over a substantial sum of money, that 0.79% difference can translate into a significant amount of foregone interest income, coupled with same day liquidity in the MMF vs. a 3 month holding period for the certificate of deposit.
CDs pushed by banks often pay a surprisingly low interest rate!
Yield Loss in Rising Rate Environments
In an economic environment where interest rates are increasing, having funds tied up in a long-term CD can cost your startup potential yield. As interest rates rise, the yield on newly issued CDs and other financial products increases as well. If your funds are locked into a long-term CD with a fixed lower interest rate, you will miss out on the opportunity to benefit from these higher yields. The inability to adjust your investments in response to rising rates is a significant drawback of CDs, especially for cash-rich startups that need to optimize their financial management strategies.
Choosing an investment product with shorter maturities in a rising rate environment is better, although it probably makes sense to choose a product that changes yield automatically after rates go up.
Alternative Investment Options to CDs for Startups
While Certificates of Deposit (CDs) might be suitable for certain businesses or individuals, they might not always be the best option for VC-backed startups, especially given their constraints around liquidity and risk. Instead, startups can consider alternatives like money market funds and accounts, treasury bonds, or fintech platforms for better flexibility and potentially higher yields.
Money Market Funds and Accounts
Money market funds and accounts are great alternatives to CDs. They provide the safety of principal, competitive yields compared to CDs, and high liquidity. Money market funds invest in high-quality, short-term instruments like Treasury bills and commercial paper, which carry low risk. Money market accounts, offered by banks, are interest-bearing accounts that typically pay a higher rate of interest than regular savings accounts. Furthermore, they offer high liquidity as you can withdraw your funds without any penalties or lock-in periods. One item to ask your banker is around the safety of these funds, if they are held in your startup’s name or in the banks, etc.
Treasury Bonds
Treasury bonds can also be a suitable alternative to CDs. Treasury bonds, notes, and bills are government-backed securities and are considered one of the safest investments. They offer various maturity terms and are highly liquid. These can be purchased either through a bank or directly from the U.S. government via TreasuryDirect.gov. Many banks have wealth management or treasury groups that will purchase these for you; ask about fees and if there is a custodian, and who owns the bonds.
Fintech Platforms
There are a number of fintech companies like Arc, Meow, and Treasure that offer investment services for startups. They provide a range of investment products, including high-yield savings accounts, short-term bonds, and other cash management solutions. They are often more flexible and innovative than traditional financial institutions and may provide higher interest rates or other advantages. Their services can be accessed digitally, offering ease of use and accessibility. However, it’s essential to understand the risks and terms involved as they might vary from traditional banks. Also note that we’ve partnered with several of these players, and have financial relationships with them.
In conclusion, while CDs have their merits, they may not always align with the specific needs and strategies of a startup. Startups can explore these alternatives depending on their risk tolerance, need for liquidity, and overall cash management strategy. Remember, the focus should always be on safeguarding the principal amount while ensuring sufficient liquidity to meet operational needs.
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