Earlier this month, Fortune reported on a new product being offered to tech companies in Silicon Valley from JPMorgan Chase (NYSE:JPM). This product, which is largely off the radar screen of the vast majority of investors, is a great example of financial innovation of the best kind.
Brief primer on the capital markets for venture-backed start-ups
The product, known as an "SPL" (short for "Stay Private Longer") was designed to fill a void in the capital needs of late-stage start-up companies.
These companies often operate at a loss, sacrificing short-term profits to focus on fueling high growth and user adoption of their product(s). To remain capitalized and solvent, these companies rely on funding from equity investments from individuals, venture capital firms, and sometimes loans from banks.
Each of these funding sources has unique advantages and disadvantages. For the company considering new equity investment, the upside is no structured repayment schedule (a la bank debt), and therefore no drain on cash flow or over-leveraging of the balance sheet. The downside is that existing shareholders will have to part with some of their equity via dilution.
For example, if I own five shares of MyFakeCompany, and there are 100 shares outstanding, I effectively own 5% of the company. If the company is worth $1,000, then my five shares are worth $50. If the company raises capital by selling 50 new shares, then my percentage of ownership will go down. That situation is acceptable if the company is worth substantially more than when I initially invested. Owning 3.33% of a $10,000 company is better than owning 5% of a $1,000 company.
In this situation, for my shares to maintain their value, the company must be valued 50% greater than it was originally, in this example, $1,500. But for late-stage companies, those that are fast approaching an IPO, the equation rarely works to the benefit of existing shareholders. Bringing in new equity capital will oftentimes reduce the value of existing shares.
In the case of bank loans, the drawbacks are related to cash flow and allocation of capital. Traditional bank loans require a regular repayment schedule -- monthly or quarterly payments. Plus they often come with covenants, or requirements, the bank puts in place and monitors. If the company doesn't follow the bank's rules, the bank defaults the loan.
For banks, this business can be quite strong. A main player is Silicon Valley Bank, a subsidiary of SVB Financial Group (NASDAQ:SIVB). The company's success speaks to the potential of these loans. SVB reports total assets in excess of $22 billion and was ranked No. 83 on Forbes' list of Fastest Growing Companies in 2012, with average loans outstanding doubling to $9 billion since Q3 2009. They've managed all this growth while maintaining exceptional low problem loans -- non-performing assets are an impressively low 0.42% of total gross loans outstanding.
With that level of success, it should come as no surprise that other banks will come knocking on the door.
For companies where traditional bank debt and/or dilution may not be palatable, JPMorgan now has its SPL product. Each deal is a customized package of financing that generally centers around a PIK (payment-in-kind) note. A PIK structure does not require regular payments, but instead requires full repayment of principal and interest at some specific point in time in the future. JPMorgan generally charges both interest as well as requiring warrants convertible to equity when the company eventually does IPO.
Banking is a relationship business
For JPMorgan, an international mega bank with north of $2.4 trillion in assets, why are a couple of deals worth less than a billion dollars even worth mentioning?
Because banking is all about building relationships, and JPMorgan is using this product to do just that. When these companies decide the time is right to IPO, they will already be familiar with JPMorgan, and JPMorgan will already be familiar with them. The company will need a bank to assist with cash management, a service JPMorgan will be more than happy to provide. A few years down the road, when the company wants to raise capital through a bond offering, JPMorgan is once again the first name that will come to mind. When the company is considering a strategic acquisition, they will be more likely to call JPMorgan for advice and guidance.
JPMorgan is setting itself up to get the first and last look at all future deals for these companies. The profit potential is incredible.
Banking innovation at its best
This product is innovative, it is in demand, it creates a pipeline to future business, and it flies completely below the radars of most investors. This product is a welcome bright spot in the finance world -- the banks that can find new ways to add real value to the clients they serve will be the long-term winners in terms of customer loyalty, cross selling, and ultimately, value creation.
Fool contributor Jay Jenkins has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.