The events of March 2023 will change the way many startup companies think about managing their cash. Our recommendations are simple, and they are not unique.
In a nutshell
Understand the basic options you have to hold "cash" and what differentiates demand deposits, like most checking accounts, from other forms of short-term holdings, like money market mutual funds, insured cash sweeps, or treasuries.
Manage risk mostly by selecting the right products instead of the right banks. If your short-term holdings are in the right products, you can worry less about your bank. Avoid keeping more than the FDIC-insured amount in demand deposit accounts by using a linked money market mutual fund or an insured cash sweep product. Recognize that despite popular misconceptions about how banks work, under current law, any amount in a demand deposit account above $250,000 is effectively an uninsured loan to your bank.
Have two bank relationships for redundancy. Fund the secondary account with enough to get by, and be sure to set up the second account in linked systems like payroll and payment processing. Ideally, a second bank is not just a "backup," and may bring some unique value.
Select banks for your business primarily based on service quality or unique capabilities. If you are using the correct products to hold your cash, you can pick your bank primarily on service quality — even if it is a smaller institution.
Be mindful of legal issues surrounding qualified small business stock under §1202 of the Internal Revenue Code in consultation with your legal counsel, particularly if using money market mutual funds instead of deposits, insured cash sweeps, or treasuries.
If a bank-provided debt line comes with strings attached on where you park funds, understand you should be able to negotiate diversifying your deposits to other banks, with some caveats.
As a startup founder, you should devote most of your effort into building your team, delighting customers and growing your business. Get the cash basics in place for safety and prudence and return your focus to where it belongs: building! As your company grows, you should have a finance leader who can take responsibility for more sophisticated treasury management.
Cash comes in many colors
There are several ways you can store your startup’s cash in the traditional financial system:
- Demand deposits
- Insured cash sweeps
- Money market mutual funds
Demand Deposit Accounts
Contrary to popular belief, cash deposits are not stored in a drawer, they are more akin to a partially insured loan the depositor has made to the bank. Up to $250,000 of this is insured by the FDIC; any amount above $250,000 is considered an "uninsured deposit." Banks carry deposits on their balance sheets as a liability owed to you. The FDIC insurance is on a per-bank basis, so if you split $500,000 evenly between two banks ($250,000 each), the full amount will be FDIC insured. However, it is not practical to split $5 million by opening 20 bank accounts!
Insured Cash Sweeps
What if, instead of opening accounts at 20 different banks, you could get a magical money router that would distribute your money evenly across 20 banks without you needing to worry about it? Heck, why limit it to 20 — why not 100 or more banks?
You have just discovered the concept of an insured cash sweep account. These products are enabled by a network of banks working together. If you deposit $1 million into the bank using an ICS type of account, the bank will keep $250,000 (the maximum FDIC insured limit) on its own balance sheet, then distribute the remaining $750,000 out to at least three partner banks in the network, such that no single bank holds more than the FDIC-insured amount on its balance sheet. The details of these money movement operations are taken care of by the network.
Two examples of such networks are the Evolve Bank Deposit Custodial Program, which powers Mercury’s $3 million FDIC insurance program and IntraFi, which can scale to support up to $150 million of FDIC insurance. Ask your bank if they offer such a product. Many do, but may not market it aggressively, as the ICS product serves to move deposits off a bank’s balance sheet and may offer a higher rate of interest than the bank’s native deposit account offering. You can also look up participating banks on the IntraFi website.
Money Market Mutual Funds
You can invest your cash into a money market mutual fund. While they sound like "money" and they trade at a "share price" of $1.00, they are not cash; they are mutual funds that seek to preserve their value while providing liquidity and generating some interest income. Under the covers, the manager of these funds invests in things like treasury bills, agency securities, repos, commercial paper, and other highly liquid, lower-risk short-term instruments.
When you invest in a money market mutual fund (MMMF), the fund’s assets are held separately from your bank’s assets, and the fund is managed by a separate investment management company (like BlackRock or Morgan Stanley). Let’s say you have $10 million in a BlackRock MMMF held by a bank that fails like SVB did. Unlike demand deposits, your $10 million is not a loan to the bank, and it is not a liability on the bank’s balance sheet. Rather, your (now failed) bank was acting more like a custodian. It would be similar to if you held 100 shares of Apple stock and your brokerage went out of business. Your securities can be transferred from the failed firm to a new firm through a process called Automated Customer Account Transfer ("ACAT"). It’s inconvenient, and the process may take 5-7 days, but all $10 million of your MMMF will be there, even if your former bank or brokerage is kaput.
MMMFs are not risk-free, but they are very low risk. As of this writing, there are two instances in recorded history where a MMMF lost value, known as "breaking the buck" (normally, they trade at $1.00). This last occurred in 2008, when the Reserve Primary Fund announced its net asset value had fallen to $0.97. The root cause was that the fund held about $785 million in Lehman Brothers’ commercial paper and medium-term notes, which led to a run on the fund (almost two-thirds withdrawn in two days), causing further losses. The other case was a much smaller fund in 1994 making some bad derivatives investments resulting in a fall in NAV to $0.96. By comparison, there have been over 550 bank failures in the last 20 years, though depositors have rarely lost money in those situations, either.
Take note that some banks may offer a high-yielding account with a similar sounding name: "money market demand account." A money market demand account is not a security or a mutual fund, it is a form of demand deposit, and any amount kept in an MMDA over the FDIC-insured limit is uninsured. Some SVB depositors learned this the hard way:
— Figure from a Q&A for SVB depositors in the wake of the bank’s collapse explaining the difference between MMMF and MMDAs
Finally, take note that unlike bank deposits (including insured cash sweeps) and treasuries, money market mutual funds may be considered "portfolio stock and securities" for the purposes of IRC §1202(e)(B)(5), which specifies a limit on the amount of such securities a qualified small business may hold as a share of its assets, subject to a carveout known as the "working capital rule." While as of this writing there is no case law or private letter rulings on the QSBS "working capital rule," there are law firms that would like to advise you about this, for a fee of course.
If you want the safest, "risk-free" asset, you could use your cash to buy short-term US Treasury bills. In such an arrangement, your counterparty is the US Government. Many banks may have a business unit able to sell you Treasuries, or you can establish a separate brokerage account. Your business can also purchase T Bills directly from the US Government using TreasuryDirect with no fees or commissions.
As of this writing, the annualized yield on T-Bills ranges from 4.15 – 4.59 percent, similar to the annualized yield offered by leading Money Market Mutual Funds.
Summary of Recommended Products
Manage your account to keep "demand deposits" under or as close to the $250,000 FDIC-insured amount as possible, with the excess amount in a money market mutual fund ("MMMF") account that is setup to automatically replenish your checking account as its balance declines. Alternatively, use an "insured cash sweep" type of account. These two approaches offer simplicity for a founder looking to "set it and forget it" as in either case, you largely eliminate counterparty risk with your bank. Ensure as part of your overall QSBS strategy (talk with counsel) that your cash management approach is consistent with the working capital rule, if applicable.
As a company’s short-term holdings grow over $5 million and certainly as they grow over $10 million, your company will likely have a finance leader who should decide on the best course of action, which may include holding a portion of your assets in treasuries or other short-term instruments held in a brokerage account.
If you choose the right products, you should not have to become a bank underwriter — you can focus instead on the stuff that actually matters in growing your business, and you can select banks based on the service provided, rather than financial strength alone.
Have redundant bank relationships
Select a bank based on the service they can provide your business. Let’s call this favorite, "Bank A." Then, establish an account with a second bank, "Bank B." This could either be a bank that is runner-up to be your favorite bank partner for day-to-day operating needs, or it could be that Bank B offers some unique capability that Bank A does not (e.g. sending SWIFT wires to international suppliers more easily).
Follow the advice provided earlier — keep no more than the FDIC insured amount of $250,000 in a demand deposit account with a linked money market mutual fund account or, instead, use the insured cash sweep offering. Typically, you’ll keep most of your assets with Bank A, but it’s a good idea to have enough assets at Bank B such that you could fund operations for one or two months if something were to go wrong with Bank A.
Many startups have key systems tied to cash in-flows and out-flows (payment processing, payroll, etc.). Go through the process of connecting these systems to both of your bank accounts in advance. Sometimes when you set up such links, they may take several days to validate (for example, using micro deposits). You do not want to face a multi-day delay connecting these systems when you really need them.
Other best practices for cash management
Understand which bank your payroll provider uses — hopefully they have redundant bank partnerships in place. If your payroll provider’s bank were to become unavailable, understand how you might run payroll by printing physical checks for your staff instead of direct deposit (keep sufficient paper checks on hand if possible). Failing to "make payroll" can trigger significant labor law problems — this is a system that can never go down.
It is common for banks providing a debt line to insist on a loan covenant requiring your business to keep deposits with that bank. However, in the wake of the SVB failure, bank lenders are willing to negotiate on this point. First, your business should never be required to keep uninsured deposits with the bank — the bank can offer an insured cash sweep account or you could use a linked money market mutual fund account. Second, bank lenders should not require you to maintain an exclusive relationship with their bank — redundancy is reasonable. Last, bank lenders may insist on a Deposit Account Control Agreement or "DACA" allowing the lending bank to get at your funds held at the other redundant bank in the event your business defaults on the loan, in which case the lending bank will likely take action to get repaid.
Implement internal controls for cash management to safeguard assets, prevent fraud, and ensure financial accuracy. Even a seed stage startup can implement these simple basics:
Segregate Duties: Divide cash management responsibilities among different employees to reduce the risk of fraud or errors. For example, the person responsible for receiving payments should not be the same person responsible for recording the transactions or making bank deposits.
Reconcile: Regularly reconcile receipts and disbursements with bank statements. The reconciliation process should be performed by an employee who is not involved in the initial record-keeping, and any discrepancies should be promptly investigated. For example, your outside accountant’s bookeeper could do this.
Secure Credentials: Use secure password management and multi factor authentication to protect access to online banking. Limit access to authorized personnel only, and keep a log of who has access. Don’t forget to remove terminated employees.
Dual Control: Your bank can setup dual control for transactions over a limit amount, such as wires or checks over $50,000 to require multiple signatures or approval (e.g. CEO and CFO).. Dual control requires two employees to complete or verify the task, reducing the risk of fraud or mistakes — just like launching a nuclear missile requires two keys to be turned.
Keep Records: Maintain detailed records of all transactions by using an expense management solution like Ramp or Expensify, and require receipts for transactions over a threshold amount.
Don’t Chase Yield
Focus on what matters most: growing your business. The decimal dust resulting from yield on your cash has little to do with whether your startup succeeds or fails. Go through the motions to be sure your cash management approach is prudent and safe. Then, get back to building!